The Madness of Mr. Market

Reuters blogger Felix Salmon grumbles that the market’s driving him batty, and so he urges us to ignore it, if only for sanity’s sake. “The one thing I’ve learned over the past three years is that the market just isn’t a sensible or rational place,” he writes.

It’s not the first time that Mr. Market has confused and perplexed innocent bystanders. Looking into the miasma of trading on any given day is just as likely to reveal perspective, or leave you with a dizzy spell that baffles and befuddles. There are two general reactions to these possibilities, one of which Salmon champions with some amount of irritation:

So when the market seemed unreasonably sanguine, in early 2007, it was wrong. And when the market seemed reasonable in its pessimism, in late 2008, it was also wrong. Right now we’re back to unreasonably sanguine again…

If you’re being logical about such things, stocks look incredibly frothy right now, just as bonds do, both in terms of valuation and in terms of psychology. But this market has a way of making everybody look foolish, no matter how logical they are. Which is ultimately just another reason to spend as little time as possible paying any attention at all to the market. It’ll just drive you mad.

Sometimes the market’s wrong, and sometimes it’s… wrong? Not quite. The market can’t always be mistaken. Prices eventually reflect fundamental value. That doesn’t preclude lots of volatility on the path to uncovering that value. Figuring out the future is hard and subject to quite a bit of error in real time, but rest assured that the truth will out.
A few decades ago, it was widely believed that price fluctuations really were random. Now there’s lots of evidence to the contrary. Some people automatically think this is a smoking gun that derails the case for market efficiency. That’s one possibility, although simply disproving random price behavior isn’t definitive. Why? The short answer is that the market discounts the future at varying rates. This looks like chaos on a daily or even weekly basis. But when you step back and consider the longer perspective, there’s quite a bit of economic logic just below the superficial anarchy.
As one example, the current dividend yield in the stock market has done a convincingly good job of discounting expected return for the five- to 10-year period ahead. This is particularly true at extremes. In 2000, for example, equity prices were high and dividend yields were spare; the opposite was true in 1980.
The problem is that the market isn’t usually at extremes, and so reverse engineering the expected return isn’t always easy. It can be done, though, and some investors actually succeed in this dark art. But it tends to be the exception. This empirical fact has been documented so often, and in so many different ways over the year, that to restate it seems ludicrously redundant. And yet it’s one of the most controversial topics in money management. But rather than belabor the details, let’s simply quote Ben Graham, who, in his best seller The Intelligent Investor, observed:

Since anyone—by just buying and holding a representative list—can equal the performance of the market averages, it would seem a comparatively simple matter to “beat the averages”; but as a matter of fact the proportion of smart people who try this and fail is surprisingly large. Even the majority of the investment funds, with all their experienced personnel, have not performed so well over the years as has the general market. Allied to the foregoing is the record of the published stock-market predictions of the brokerage houses, for there is strong evidence that their calculated forecasts have been somewhat less reliable than the simple tossing of a coin.

That was written many years ago, although it’s not obvious that much has changed. Keep in mind that Graham was and remains the dean of active stock pickers. And yet he seems to be making the case for indexing. At any rate, the operative question is still the devastatingly spot-on inquiry: Where Are the Customers’ Yachts?
The biggest challenge to earning a respectable return on your investment is less about perceived chaos in the market vs. muster the personal discipline to respond to the varying expected return offerings extended by Mr. Market at any point in time. Being a contrarian is hard, though, but it has a long history of success. That’s because the market sometimes extends a good deal, even a great deal, but it doesn’t last. Expected return fluctuates, with some degree (perhaps a high degree) of economic logic. The odds of exploiting these fluctuations to your advantage improve if you follow some basic rules:
1. Embrace a reasonably long time horizon. The market looks a lot less chaotic when discounting returns five to ten years out vs. trying to estimate next week’s risk premia.
2. Don’t define “the market” too narrowly. The economic logic of the market is harder to recognize in a handful of securities or portfolio that own just one asset class. And let’s face it: we’re all mistaken at times. But we can reduce the blowback from mistakes by owning a wide mix of risk factors.
3. Avail yourself of Mr. Market’s mood shifts, a.k.a. the constantly changing state of discounts on future return. If you’ve earned above average returns in recent history, take some profits; if returns are subpar or negative over the previous period, consider beefing up the position. But be careful. Most investors shouldn’t try this with individual securities (see Rule 2). Companies can go bust; asset classes are forever.
In sum, develop an asset allocation plan, rebalance periodically, and stay focused on the medium to long-term outlook. That’s hardly trivial advice. Indeed, the record of success in managing risk, rather than chasing return, is impressive. Don’t get mad—invest opportunistically and think strategically.