My understanding of the “efficient market hypothesis” is that all information is already “priced in” to the market and that only new information that is different than expectations can move markets. I’m not sure which is funnier, that at one point I was willing to believe that, or that a lot of people a lot smarter than me continue to believe it and develop asset pricing models around it?
The market is as inefficient as rectangular tires.
Whatever the market once was, I think it has changed. If it once was a discounting mechanism and a way to distill future information into a valuation, it is now something that lurches from headline to headline in search of the next move.
The market seems to me to only be able to focus on one issue at a time. Whatever the “next” event is takes on a role that is disproportionate to its actual impact on the market, or likely outcome, and events just outside of the visible time horizon are ignored.
I’m struggling because I know what I’m trying to say, but having difficulty expressing it, so let’s walk through a few examples.
For a period of a few days or weeks, the market was focused on the Fiscal Cliff. Little if anything else mattered. Talking about earnings was about as interesting to most people as Al Gore talking about global warning. No one wanted to talk about earnings because the cliff was there.
Worse than that, the cliff had morphed into some sort of binary outcome. It isn’t and never was a binary outcome. Technically we went over the cliff on January 1, but passed laws in time to avert the consequences. Had the laws been passed on January 7th would it have changed much? The answer is no, yet that is not how the market reacted. The way the cliff played out let it be deemed a “risk on” moment and we could ignore (for the time being) the “austerity” element of the cliff.
The election example. Obama was favored in most polls. The market tended to react positively on every Romney gain, and had some weakness when Obama seemed stronger. But coming into election night, the hopes of a Romney win seemed illogical as most polls were predicting the opposite. Obama won and stocks initially sold off, yet finished the overnight session in the green. That made no sense, but the drop from 1,430 to 1,350 seemed overdone and can only be explained that somehow the market could focus on the election (immediate present) but not the cliff (near term future)?
Same sort of thing with QE when that sent the markets to new highs, only to slowly lose investor interest (in spite of the ongoing influx of Fed money).
Apple’s lawsuit with Samsung and release of the iPhone 5 seemed to pretty much time the end of the run up in stock prices.
In a more traditional sense of being inefficient is the paradox of CDS (credit default swaps.) Right now, CDS looks more attractive than bonds, yet, if we see any weakness we know CDS will sell off first and fastest. This is one where the rational “value seeking” mind must not be allowed to act because the wrong decision will be made. Being long credit via CDS has to be because you think we get another round of capitulation tighter in the already tight products, not because it is the cheapest way to play credit.
Maybe some of this is just the “buy the rumor, sell the news” but is seems more myopic than that.
I think hedge funds and the media have changed the market.
Let’s say I’m correct and the way the market trades has changed. If this phenomenon is more than just “buy the rumor, sell the news” then there should be some explanation of why the market has changed.
I think the media is a part of it. It wasn’t that long ago that to find financial news you could search out some channel no one else watched that had some grainy ticker tape running across the bottom of the screen, or wait until the nightly news came on and flashed some shot of how the Dow Jones Industrial Average did.
Now, we are inundated with information. Whether it is TV, newspapers, the Internet, or Twitter (which occupies some special place in hell for longer term investors), the information is out there and being jammed in front of you. No one wants to talk about something as mundane as potential earnings in two weeks. What people want to see (or at least people that drive the media think you want to see) is the latest story or headline. Nothing gets more attention than a stock with a nice big move up or down. The Washington, D.C. stuff is great for the media as it is divisive with no shortage of sound bites.
As the media hones in on a topic, investors have to pay attention, whether they like it or not. If you are going to a client meeting, you know full well they are likely to ask you your opinion on the item of the day and how you are prepared for that. For all the alleged focus on long-term results, half of any hour long meeting will be spent on the topic de jour. So the attention to the issue, even if originally more from the media, becomes part of the mainstream investing. You cannot ignore it. (Well you actually can, and probably should, but that isn’t how it feels at the time.)
When an item is at the forefront of everyone’s mind, it tends to grow in importance. Even if you think an issue is nothing it takes on a life of its own. I for one thought the cliff wouldn’t be an issue and liked the market below 1,400. That was scary at times as market continued to sell-off. Eventually, it worked out well, but the reality is that most of December and part of November was spent second-guessing the only logical and by far most likely conclusion.
But the headline driven mentality isn’t enough to cause the moves. Its partner in crime is the focus on monthly returns. Hedge funds in particular, but more and more asset managers of all stripes are so focused on monthly returns that they work in tandem with the media to create trading noise where none should be.
For the manager that has no strong opinion, because he or she didn’t think a subject is meaningful, to ignore the barrage of headlines and a 2% move in conjunction with those headlines is almost an impossible feat. “Doubling down” is almost out of the question and somehow, the “prudent” thing to do is to cut risk because someone else must know something and it must be important.
I remain convinced that in the “old” days managers could (or at least did) focus on information further down the road. Now, I think the amount of information forces them to react too much to near term information, and the fight to keep AUM (assets under management,) and protect returns with stop losses, amplifies the importance of those headlines.
So what does this mean for the way you should invest?
Don’t let price determine investment thesis. Give investment ideas time to play out. Price moves are exaggerated by the headlines and stop loss orders and are less meaningful (even when you are right) than you realize. Too much of the market is getting caught up in the headline mix and the price move, and avoiding that is where the money will be made. I’ve seen lots of dogs chase their tails, and few have been successful.
No matter what your view on the debt ceiling is, no one will care for another few weeks. We have finally moved on to earnings season. If you were banging your head at the wall for the past month, or were standing in the corner by yourself at holiday parties mumbling about earnings, while everyone else talked fiscal cliff, now is your time to shine.
The market will focus on earnings for now. Talk about how the fiscal cliff resolution will help the economy will not reach the light of day. Fed QE will, but now it seems the story is that they will cut back asset purchase programs far faster than raising the short-term rate. So that will be the secondary story in this market that looks more like a soap opera than a mechanism for calculating valuation in the largest economy in the world.
With earnings coming out, I think we will see some signs of disappointment. The biggest disconnect I see in the market is the market’s belief that the fiscal cliff will inspire business people to grow. I think we will be disappointed by that as most businesses are too big and too global for the little that was done to meaningfully change their plans.
I remain near term bearish because of that, but from the bullish side still like long Spain/Italian 10 year debt vs. short 10 year bunds.
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