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
not
happen.
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.”