Sunday, November 06, 2005

Mediocrity Isn’t What It Used To Be- Part 2

I wrote a few weeks ago on the subject of efficient market theory and mediocre participants. My contention is that the theory may have had more validity in the real world, but for the missing assumption that all players must have equal abilities to correctly process the supposedly equally-available information about securities.

The last 6-8 weeks of US equity market activity bear this out. No efficient market could have so many violent updrafts and downdrafts on the basis of so few pieces of genuinely “new” information.

We have, basically, five pieces of information which have been disseminated to the market: energy supplies, energy demand, inflation, consumer spending and economic growth.

Yet, going back to the second week of September, after hurricane Katrina tore through Louisiana, we have had 10 days in which the S&P500 Index rose or fell by 1% or more. There have been at least twice that many days in the same period in which it rose or fell by more than half that amount.

How can an “efficient” market display this many jarring price adjustments to essentially only five data inputs? My contention is that the vast army of mediocre, herd-following analysts and institutional investors are the source of this inefficient market behavior.

Failure of most participants to carefully piece together the puzzle pieces and see that energy demand had not been “destroyed,” and that consumer spending was not permanently crippled, as energy price increases abated as supplies returned to the market, was the cause of some of this market volatility. The practice of business news organizations to ceaselessly flail at all potential outcomes of any breaking economic story is probably another cause.

The truth is, two months after the hurricanes hit, economic growth in the US has been measured at being incredibly robust, while consumer spending continues with the help of increased total wages. It would seem that there was much short-term asset price movement on the basis of incorrect assumptions and expectations.

Yet another reason why my own portfolio strategy patiently holds its positions during periods of confusion and volatile asset pricing such as we are currently witnessing.

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