Poway, first a few definitions to aid in this discussion:
“A”: the word “a” means one. For example, “Stock prices are A leading economic indicator.” Not THE leading economic indicator, but rather one of many. Consequently, aggregation of the OTHER leading indicators may trump what stock prices are telling people about the future of the economy, OR THEY MAY NOT, which leads to the definition of…
“Indicator”: as in “indication” or “a person or thing that indicates.” An indicator does not arise from the Oracle of Delphi, does not suggest a future certainty, and thus may turn out to give the incorrect signal in hindsight. (Hence Paul Samuelson’s oft-quoted quip that, “The stock market has predicted 9 of the last 5 recessions.”)
Consequently, you will find MANY examples of situations in which stock prices or other indicators sent the wrong signal. Sometimes they’re right; sometimes they’re wrong. ON AVERAGE, however, these indicators convey valuable information. So going through all of your anecdotes is a fool’s errand.
I suggest you go back and re-read your post in the context of these two definitions.
You keep mentioning market efficiency and now I realize that you don’t understand the nuances of what the term actually means. I’ll be as brief as possible given the complexity of the subject. Market efficiency exists in three “forms,” or degrees – weak, semi-strong and strong – and over two time horizons – short-term and long-term. I’m too lazy to explain all of this, but I’ll explain where I stand on the issue and perhaps you can figure out the rest.
I believe in the “strong form” of market efficiency for the short-term. In other words, it’s very hard to outperform the market over a short period of time – let’s say less than 18 months – because today’s price is an “unbiased estimator” of future short-term price movements. In other words, because most professionals are concerned with the short-term (the average mutual fund manager holds onto a stock for 1 year), their varying informed opinions about where prices will go in the short-term will cancel each other out on average leaving a price that reflects the “right,” or “unbiased,” price for the stock in the short term. Therefore, unless you have information that’s not known by other participants, you will have a tough time outperforming the market ON AVERAGE in the SHORT TERM. (Keep substituting “unbiased” for “correct” or “right” when thinking about market efficiency and it’ll make more sense.)
I believe in something between the “weak form” and “semi-strong” form of market efficiency for the long-term. In other words, the longer your time horizon, the more patient you can be, the greater your arbitrage opportunities. While market participants may on average dictate the “right” – or “unbiased” – price in the short-term, that price may be completely “wrong” (that is, it over- or under-reflects the stock’s long-term risk-adjusted return potential) due to other factors that will affect the stock in the long-term. As an investor, if you can properly ascertain and analyze such factors and have the intestinal fortitude to hold onto the position for a period longer than the average investor, you MAY have the opportunity to generate above-market risk-adjusted returns. But even here you have to know what you’re doing. And you have to remember that as your investment time horizon increases, by definition so does the variance of possible exogenous factors that will influence the stock’s fundamentals and price. That’s the downside/challenge of long-term investing that Chris J correctly alluded to in an earlier post.
Right or wrong, most successful long-term investors (like Buffett) and even many academics hold both of these views.
So when you discuss the market’s “rationality,” or lack thereof, you have to specify to whom, to what degree, and over what period of time. Actions that may seem completely irrational to a short-term trader may be completely rational for a long-term investor, and vice versa. Where an investor/trader stands on these issues often depends on where s/he sits.
I know you think I’m a condescending prick, which is largely true. But if you’re going to start a consulting business that has anything to do with economics (as you suggested previously), it’s better for you to discover the gaping holes in your knowledge base here in the blogosphere, rather than in a client meeting, which would be both embarrassing and professionally damaging.
