IS THE STOCK MARKET RATIONAL?
Is the stock market rational? In a rational stock market, the future is predictable and financial planning is possible. In an irrational stock market, the future is unpredictable. To be rational is to act for good reasons, that is for reasons that are related to the subject in a comprehensible manner. An equilibrium model of the stock market is therefore useful for the following discussion, providing a quantitative measure of rationality. It pertains over the long term measured in years and also alerts investors to extreme short term markets.
In an equilibrium model of stock market behavior, investors are more willing to invest in stocks than long term bonds when expected capacity utilization in the real economy (and therefore earnings) is increasing and when expected inflation is decreasing. This model states:
Bond Yields (t) = .022 * capacity utilization(t+1) – .079 * inflation(t+1)
Stock Earnings Yields (t)
The model 's correlation with the (1968-1999) data is more than .95. Its New Economy calculated value is 5.3% above a calculation utilizing (1968-1992) data. This model factors in structural economic change, but there will always be an error term due to extreme investor behavior that is unquantifiable. It is called investor irrationality.
Concerning irrationality, it is possible to take one of several tacks: Make market predictions after an abstruse examination of economic indicators. Reduce econometric error by mining the data, adding additional economic variables until the revised model fits the data (in effect adding epicycles to the theory). Or suggest that a mathematical model doesn’t describe all possible contingencies; and then proceed with an analysis using a model of irrational investor behavior, keeping in mind that we have assumed an exception. This is our tack because it is in accord with the observed facts and moreover allows a discussion of the existing literature on market irrationality.
There is an exception to the model of investor rationality; this occurs when investors are, at times, irrational. In "Manias, Panics, and Crashes," the economist Charles P. Kindleberger (1977, 2000 ed.) writes:
"The a priori assumption of rational markets and consequently the impossibility of
destabilizing speculation are difficult to sustain with any reading of economic
history. The pages of history are strewn with language, admittedly imprecise and
possibly hyperbolic, that allows no other interpretation than occasional irrational
markets and destabilizing speculation."
The objects of speculation will differ from time to time. They may be tulip bulbs, real estate, or many dot-com stocks; but there is a common pattern. Where there is speculation, there is then a crash. Kindleberger details this process, that covers the final upswing of the business cycle and its initial downturn. We paraphrase extensively:
Speculation begins when:
1) There is an exogenous shock to the macroeconomic system such as
the outbreak or the end of a war, a bumper harvest, a crop failure,
adoption of an invention with widespread effects... .
2) The monetary means of payment is expanded by the banking system,
the development of new credit instruments.
3) Euphoria results in the overestimation of future profits, or we would
say the underestimation of risk.
4) Excessive gearing (leverage) arises from cash requirements that
are low relative to the price of the asset.
5) As the number of firms and households involved grow large,
speculation for profit leads away from normal rational behavior
to what has been described as "manias."
6) The speculation detaches itself from really valuable objects
and turns toward delusive ones.
7) At some stage, a few insiders decide to take profits and sell
out. At the market top, there is hesitation as the purchases of new
speculators are balanced by insider sales.
8) There ensues a period of financial distress, as it is perceived
that there is risk to the overestimated profits and that markets
cannot go higher. For the economy as a whole, there is the perception
that a rush for liquidity may develop. The next stages may or may
9) Prices decline as the race is on to be out of real
or long term financial assets and into cash.
10) Prices fall to the point that people are again tempted
to move back into less liquid assets, markets simply
cease, or a lender of last resort such as the Fed succeeds
in convincing the market that there will be enough money
made available to meet the increased demand for liquidity.
If stocks are the object of speculation, the stock market will follow a momentum model
until (7) occurs.
Due to the misallocation of resources, speculative markets can adversely affect the real economy and are problematic for most investors (Barron's, May 28, 2001, p. 23; et al.). Here is a suggestion on how to identify a possibly speculative stock market and to make the appropriate asset allocation adjustments, particularly for value investors. We make one more assumption, that speculation will push the stock market up to and beyond a specified statistical extreme.
Using historic data, speculation occurs when the market exceeds the
modeled equilibrium value by 30%. If the market can be described
by the moderate Gaussian statistical process, the market will remain
below this limit 95% of the time. However, as readers of our article
"The Behavior of Markets" know, the market is more accurately
described by the more volatile Paretian process. Thus the market
exceeds this 30% limit more often than a Gaussian process
predicts, perhaps more than two times as often (one year in eight).
Investors probably take this long to forget the previous excesses.
If the market exceeds this level, stocks are the most likely object of speculation. It would be a very good idea to be alert to the signs that Kindleberger writes about, review our model of short term stock market behavior, and start decreasing your asset allocation to the stock market in a manner appropriate to your temperament and circumstances. Also, buy Professor Kindleberger's book.
(We deleted a section where we expected the S&P 500 to return 7-8%/year from 6/14/01. We did not predict two other major irrationalities: 9/11/01 and the U.S. reaction in Iraq. As a result, the S&P 500 has since grown only about 2.7%/year from that date to 3/23/07. We think, however, there is a useful lesson to be learned, a lesson about predicting the behavior of complex systems and the stock market. Since stock investing involves future profits or cash flows, it is at least to some degree a prediction about the future. Between 1982 and 1997, the stock market was not too perturbed. When a balanced and rational adjustment of interests occurs, the market results are almost predictable by mathematical formula (using year-end data anyway). Under these conditions the processes of the stock market, like those of democracy, are more predictable. On the other hand, when the stock market and/or the international system are highly fraught, as at present, they become less error-correcting and predictable. Statements about the future then have to be increasingly qualitative.)
Voters and investors get the kinds of markets they choose.
We ran across this apt description of investors’ mental state during a financial bubble, in the 3/14/05 issue of Barron’s.
“Bad news is totally ignored, neutral news is viewed as good news,
and good news is viewed as spectacular.”