Are Markets Dumb?

Yesterday Mark Thoma had an interesting look at the efficient market hypothesis (EMH) and cited a couple of papers in an exploration that questions the value of the theory.

One way to think of EMH is that the market prices in all known information. So then the task of beating the market, for those interested in beating the market, becomes trying to figure out what the market does not know.

Based on what we have seen over the last decade or so it seems like maybe the markets know very little. My thoughts have been the same for a while. I do believe that markets price most things correctly most of the time and does provide various types of warnings but things change and the market does get some things wrong, more correctly perhaps it fails to anticipate things.

Markets go through cycles and changes in cycles are often marked by similar things. Additionally the fortunes of companies change. Some company we are not familiar with (maybe it doesn’t even exist yet) will come up with a drug that will cure some previously incurable malady and make a lot of money doing so. Along its way it will have various tests and milestones to work through and maybe competitors to beat to the market but it will happen and some folks will successfully navigate all of that in owning the stock.

Another way to view EMH is that it believes markets are rational. Well do you believe in that enough to let your financial future ride on it? The market is made up of its participants which are people and people are from from rational. If markets rationality could be relied upon then I don’t think and Webvan would have ever IPO’d, the Nasdaq would not have gone above 3000 ten years ago and Johnson Control would not have dropped 75% a year ago.

Additionally, at some point some well regarded mega cap company will do something, like make a huge and peculiarly timed acquisition ala BAC buying MER, that will impair its future prospects for some lengthy period of time and some folks will see that for what it is and get out in a timely fashion.

The notion that no one can pick good stocks or avoid bad ones implies that no one can do analysis which seems like an odd conclusion to draw. This is not to say analysis is easy or that anyone who does analyze companies will always be correct but fundamental attributes change and these changes often influence prices and some of these changes can be observed and navigating them is not impossible.

Looking at the country level from the top down it is simple work to get the statistics for a place in terms of debt levels and GDP and get a sense for what makes the country tick. It is also easy however to view a country as being healthy but draw the wrong conclusion about stock prices in the short term but as we look at the world now countries with low debt and good growth prospects are a likely to treat your money well over the long term regardless of what the market “knows.”

A final point here is that a theory that relies on the type assumptions that EMH relies on is a tricky business. Assumptions about efficiency and rational behavior strikes me as a huge leap of faith and while there are people who are clearly comfortable relying on this with their money it is not what I will bet my financial future on.

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