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.

The Week of the Bailout

Well. This certainly has proven an exciting week for anyone with money in the stock market. It started off on Sunday with the announcement that Lehman Brothers was going to declare bankruptcy. Many had thought the bank “too big to fail”, but it seems that US Treasury Secretary Hank Paulson and Fed Chair Ben Bernanke felt otherwise.

The stock market fell quite a bit on Monday, as people began to wonder if AIG was next. Then on Tuesday, Bernanke announced that there was no need to cut rates, because the US economy was strong enough to weather the current crisis.

And the result?

A rally of roughly half the losses suffered Monday as Wall Street figured that this ‘tough love’ was a good sign; then, the next day, it’s announced that Bernanke was offering a loan of $85 billion, or so, to bail out AIG and, in so doing, take over the company. So much for tough love!

What was really peculiar here was Wall Street’s reaction: a huge sell-off of all stocks across the board — and that gold rallied $89 an ounce; the biggest one-day rally ever! This bailout suddenly prompted people to lose faith in the system. The next day was more of the same as the stock market continued to rout and gold continued to rally.

That is, until President Bush announced the biggest bailout in history.

The results are still sketchy, but essentially, the government is going to “buy” all of the bad, toxic, or dubious “assets” off of everyone’s balance sheet. The details are a bit shaky at this point, but the plan sounded bold enough for the stock market to stage a huge late-day rally that’s continued on into today. It would seem the market is nothing if not confused as to whether it wants tough love, or the mother of all bailouts.

Like most bold promises made by politicians, it leaves most of the important questions unanswered:

Just how bad does an asset have to be for the government to buy it?

What price is the government going to purchase it for?

How much is itgoing to cost the US taxpayer?

And, my personal favorite:

Where exactly is the government going to get the money for all of this?

But no one seems to care about all of that right now. Wall Street traders breathe a huge sigh of relief as President Bush pledged taxpayer dollars to cover the sins of their gross excesses. It’s as if the Pope had suddenly visited a whorehouse and not only forgiven all of the sinners, but agreed to pick up the tab.

Truth, as they say, is stranger than fiction and this week proves that yet again. No work of fiction would have all of its major characters be so fickle from one day to the next. Can you imagine if Romeo and Juliet seemed to sway between all-consuming passion and a sober coolness? Or if their warring families had similarly gone from feuding one day to offering an alliance the next? I’m pretty sure that if Shakespeare had penned such a tale that it never would have made it to the big stage, much less become a timeless classic.

Yet, this week we see all the authority figures vacillate wildly between the stances of needing to be cruel to be kind, and offering outright martyrdom for the American taxpayer to cover the sins of the financier’s bad beats. And we’ve seen the market all over the place — going from hating it on Monday, to loving it on Tuesday, hating the bailout on Wednesday, to then loving it on Thursday and Friday.

What remains the biggest mystery of them all is the US Dollar is rallying today on the bailout news. Why a currency would rally when its sponsor government just pledged to spend an extra half-trillion dollars or so that it doesn’t have is truly mystifying, but it seems to go with the carnival-like insanity that we’ve seen the rest of this week.

Until next time,

Preston Poulter