The Not-So-Efficient Market

There is a theory in stock circles called the “Efficient Market Hypothesis.” It was first proposed by a student of famed mathematician Benoit Mandlebroit (who proposed Chaos Theory) named Eugene Fama. The theory is easy to understand; markets such as the stock market have so many players that it reacts instantaneously to process all known information about a given security. A corollary of this theory is that because all information about the market has already been “priced in”, that it’s impossible to beat the market because any actionable information about a given security is already reflected in its price. This theory was popularized in books such as A Random Walk Down Wall Street. It has been attacked in a number of books including Benoit Madlebroit’s The Misbehavior of Markets as well as my book, What Do You Mean My Money’s Worthless.

I’ve found that some of my biggest investing mistakes are caused by giving any credence to the notion that the market has priced in any information at all. Case in point, for much of this year I was an investor in the Prudent Bear Fund (ticker=BEARX) which is a mutual fund that is short the market, yet, despite many of my predictions of doom and gloom coming true, the stock market continued to hold its value in the face of more and more bad news. Then came October. Paulson and Bush announced that they were going to do a massive bailout of all troubled assets on bank balance sheets after allowing Lehman Brother to fail, and the stock market rallied strongly. 

At that point I lost faith that the stock market was going to decline. It seemed that the Federal Reserve and the US Treasury were simply going to inflate the problem away, and the market was responding in just such a direction. So the logical move to me seemed to be to invest in gold in order to protect from inflation and away from shorting. I figured that, with all the bad news that has come out, if the stock market was going to crash it would have already done so. I closed my short positions just before one of the most violent stock market collapses ever based on the belief that knowledge of the credit freeze and oncoming recession were already “priced into” the market. I’m still up on the year (which few people can say) but I missed out on a great opportunity to profit due to my putting ANY credence in the notion that the market was efficient. 

Now I’m realizing that the key to investing is not to predict the tomorrow’s headlines, but rather to figure out which of yesterday’s headlines will the have staying power to shape market movements in the future. That’s what I’m trying to do today. Call it the “Slow Market Hypothesis”- which significant piece of news will the market take the longest to get through its thick head? A question that is very much on my mind today. 

The headline that’s dominated the last couple of months has been that “Deflation is Coming. Run to Cash!” Call me crazy, but I think that headline’s played out now. The headline of today was that “Dollar slides as Obama vows stimulus.” Gold moved strongly up and Barrick Gold, my personal investment vehicle of choice, closed the day up 8.39%. I think that the headlines going forward are going to become more focused on inflation rather than deflation as markets react to the new ending stream of new dollars being cranked out by the Treasury and the Federal Reserve. Just today, it seems that Congress and Bush are dipping into the bailout goody bag for $15 Billion to loan the auto industry. The hard figures on M2 straight from the Federal Reserve says that our money supply has expanded by 7% over the course of year, which is not nearly as alarming as the “Adjusted Monetary Basis” (a measure which accounts for changes in the reserve requirements as well as changes in foreign exchange market intervention) which the St. Louis Federal Reserve Bank publishes. Here, take a look at it yourself:

That’s a rather astounding rise in the monetary base (1400% annualized), and it’s only going to get worse. The next stimulus package that’s being proposed by Barack Obama is roughly $1 trillion

The rise in the value of the dollar was caused because liquidation was forcing people to sell their assets in order to meet margin calls that were written in terms of US dollars, but that’s going to be a short lived phenomenon. As the full impact of these monetary shenanigans start to sink in, the market will seek a safe haven that isn’t being grossly tampered with, and that’s going to lead them back to gold. That’s my prediction anyway, we’ll see how it turns out.

Volatility in the Dow

The Dow is up a breathtaking 11.08% today (936 points at close). For me this is another reminder of Benoit Mandelbrot’s The Misbehavior of Markets. Mandelbrot is the mathematician who discovered chaos theory as well as fractal geometry. In that book he examines the stock market for mathematical patterns: a task that many mathematicians have tried to do and failed. Mandelbrot discovered that the market is far wilder than finance theory takes it for, and he also made some other interesting observations. 

For one, he discovered that volatility begets volatility. If one day had a wild swing up, the next day would tend to have another wild swing. It might be up, or (more likely) it might be down, but it would tend to be of far greater magnitude than the average market return. This disproves one of the tenants of the Efficient Market Hypothesis which assumes that each day is independent from each other day, and it is a principle that we are seeing in action today. Mandelbrot proved that, as he puts it, “markets have memory.” He further proved that markets are a bit like elephants in that they never forget. 

Last week the Dow was down far more than it ever had been in any one week period regardless of whether you measured it in percentage or nominal points. So I had figured that today at least we would probably see a large move to the upside, and what a move it was. As a betting man, I’d say that tomorrow might bring a rather large move to the downside, or it could be up again. But either way, the magnitude of the move should be much higher than we say the market moving just a few weeks ago. Volatility begets volatility and vice versa. Right now the movements of the Dow more closely resemble those of a high flying tech stock in the 99-00 market than that of the 30 most solid blue chip companies in America; I should point out that the Dow lost one of its member companies with AIG had to get a government bailout, so being a Dow Jones company is no guarantee against suddenly going bankrupt in this economy.

As I’ve stated before and in my book, the Dow will continue to lose ground against gold. It did well for itself today, but the long term trend is clearly for it to continue to lose against the yellow metal. The only money to be made off of these huge moves in the Dow is for traders: this kind of volatility is a traders dream come true, provided he or she is on the right side of the move! For all others, I’d encourage all readers to seriously reconsider leaving their money anywhere near the American stock markets. The worse is yet to come.