Market Punditry As Astrology

Markets may remain irrational longer than one can remain solvent

By Monty Pelerin

Is recent market behavior the beginning of a market turndown? No one knows, although it is easy to find people providing “answers.” The value of these predictions approach those of astrologers and fortune-tellers. What follows are some thoughts regarding markets.

History and Markets

History is a summary of what historians consider relevant. Selectivity of a limited number of events is required. Behind these events are millions of other events and processes that must be ignored. Many of these are causal elements and not even known to the historian. What is reported is the outcome(s) of these complex interactions. Historians then focus on a few causes that rationalize the outcome(s). Often these are correlative; never do they fully explain the outcome they purport to. That is the nature of all history.

Discussing the performance of the stock market is an exercise in history. It is subject to similar simplification. At the end of each market day, analysts “explain” why the stock market went up or down. These explanations are more rationalizations than explanations. Stock market outcomes can never be explained in terms of one or two variables, regardless of how relevant they might appear to be or how enlightened the analyst sounds. Soundbites preclude more than a couple of variables. Yet complexity does not care about soundbites.

To retain the aura of “expert,” these self-professed gurus must provide short, pithy and incorrect answers. A truthful answer would go something like the following:

I have no idea why stocks went up or down today. Nor does anyone else. There are literally thousands (millions?) of variable affecting peoples’ decisions to buy or sell stocks. No one knows them all and no one knows how to measure or weight them on a particular day. The market went up (down) because more buyers (sellers) participated today.

On some days, one or two major news items may ostensibly move markets, but that doesn’t change the fact that numerous other variables also had impact.

Seasonality

The old Wall Street Advice of “sell in May and go away” proved to be correct, at least for the first half of June. The Dow and S&P 500 are nearly level, each down slightly from their May closes. The Dow is off more than 400 points from its intra-day high on May 28 and slightly more from its all-time May 22 high. This information reinforces the advice to sell in May, not necessarily at the end of May.

But, is this rule of thumb valid?  A look at May closes since 2007 generally supports the market folklore of “going away.” Four of the six May closes were higher than the August closes. One of the exceptions was 2009 when markets were recovering from the 55% drop off their highs. The other was 2012 where the exception was not particularly notable.

One of the reasons attributed to slowdowns in summer was vacations. That reason, if ever valid, seems weak  these days when people can trade at any time and from any place thanks to advances in the internet and telecommunications. Some argue that there are no more vacations in the sense that you are always available.

Seasonality is also attributed to the Fall. September and October are considered very dangerous months for stocks as they have produced the largest downdrafts. Again, the empirics are there, although there is no theory or rationale as to why that should be so.

Many people believe that seasonality can be used to trade properly.  However, unless some causal relationship can be discovered, skepticism is probably warranted. Further, if enough people believe in seasonality, their actions should eliminate the phenomenon as they try to profit from it.

The Relevant Issue

As summer begins, markets have slowed as of mid-June. Is this the beginning of the summer doldrums? Is it the beginning of a severe market adjustment? Or is it just some of the irrelevant “noise” that accompanies markets? Frankly, there is no way to know. Anyone who claims otherwise is a fool or believes you are. Regardless of how smart we are or become, there are always complexities that we cannot understand. Markets happen to be one of these difficult (impossible?) to comprehend areas.

Markets seem dangerously overvalued with respect to underlying economic conditions. Are they pricing in a recovery that most of us don’t see? I don’t think so. There has been no economic recovery thus far and none appears to be in the offing. Even if this assessment is correct, it doesn’t provide actionable advice. It doesn’t provide guidance for market decisions.

Alan Greenspan, the so-called “Maestro,” used the term “irrationally exuberant” to describe the stock market in December of 1996 when the Dow was around 6,000. Greenspan’s characterization was massively mistaken, at least as a market prediction. The market continued to rise to almost 12,000 before a major correction in 2001. Greenspan was the Chairman of the Federal Reserve during this period, had access to massive databases, thousands of experts and actually managed the policy variables thought to be responsible for markets. Yet this man who was alluded to as a financial genius, appeared clueless in hindsight.

The point is that even if markets appear out of line with economic conditions, that doesn’t tell you when or whether they will correct. In Greenspan’s case, he was “wrong” by a factor of almost 6,000 Dow points and about five years in timing!

Markets seem to have the ability for, as John Maynard Keynes said, “remaining irrational longer than one can remain solvent.” It is with respect to this phenomenon that one should not try to outguess markets. Even if you are certain they are under or overvalued, they can become even more so and stay in that condition for a long time.

As someone who anticipates a major economic catastrophe ahead, I am especially cautious. However, no one truly knows whether we are in 1996 or early 2001. Greenspan’s irrational exuberance was correct by every objective measure save one - it was wrong by 5 years and a return of 100%.