ON THE SUPPOSEDLY RATIONAL MARKET….
Retail stocks are getting destroyed this week as market participants come around to the fact that the U.S. consumer hasn’t fully recovered from the Great Recession. Since its April peak the Retail Holders Index has been crushed -15%. Market pundits are furiously downgrading retail names and talking about “persistent weakness” in the U.S. consumer. That was not the case just two months ago when just about everyone was convinced that the consumer was back and healthy as ever.
On April 16th I posted a relatively controversial piece claiming that the market had become disconnected from reality. Exhibit A was the retail index which had executed an astounding v-shaped recovery despite almost no evidence that the U.S. consumer was healed. I wrote:
“But where do we sit now? We are beginning to see some glaring disconnects between the market and reality. There are very real improvements versus where we were just one year ago. The recovery is here and it has been stronger than I expected. But there are also signs of irrationality on the fray. This is nowhere more apparent than it is in the consumer sector. The retail holders index is one of the few indices that has experienced a full-blown v-shaped recovery. Just how wide is the disconnect between the consumer and retail stocks. Let’s compare and contrast 2007 and 2010:
We have lost 7.8 million jobs since then. The unemployment rate is 9.7% versus 4.5%. Total unemployed workers are now 15.7 million versus 6.5 million. Real personal income less government transfers is lower by 6.5%, or $624 billion. Real retail sales have rebounded just 4% from their lows and are still down 9% from the 2007 peak. Consumer credit for February showed another sharp retrenchment of -5.6B. Consumer bankruptcies for March were the highest level since 2005. There is a glaring $1.5 TRILLION hole in the consumer balance sheet. Home foreclosures surged 19% last month and are at their highest level since 2005. The consumer’s largest asset (housing) is down 33% since 2007. Meanwhile, the retail holders index (RTH) is back at its pre-recession highs. Granted, the market is a discounting mechanism and this index has benefited greatly from retail expansion and improved corporate efficiency, but operating income at the index’s top 25 holdings is down 4.5% from 2007 and that’s including new stores! This doesn’t rhyme with a near all-time high in the retail index. This price action is acting as if the consumer is (or will become) whole again – which I believe is undeniably false. Is the consumer on the mend and willing to spend again? Most certainly. Whether this is a good thing is a whole different debate, but as of now there are still few signs that the consumer is back to full strength or even close despite the market acting as though Goldilocks is here and ready to party.”
I do not point this out to toot my own horn, but rather, to show a real-time case of an extreme disconnect between reality and price. Careers have been built on the idea that the market is an efficient system. That it is a perfect discounting mechanism that is never wrong. I wholeheartedly disagree.
Any market is simply the summation of its participant’s decisions. Humans, by nature, are irrational creatures. The summation of irrational decisions by no means makes them all rational. This irrationality results in inefficiencies which creates opportunity for those who are able to look beyond the current price action and intelligently understand the underlying forces that are driving it. As simple as this story might sound, the rejection of the efficient market hypothesis might very well be the most important thing you ever do in achieving investment success.
Impeach the President,
nobody’s buyin’,
repel the Zion,
the average guy on,
television is lyin’,
Tel Aviv Zion,
sold you a story about Hell and a Lion.
I say flack that,
get your shine on,
follow Chiron,
ehhhh, I need another Heineken.
Hey old CV fan myself with prized vinyl collection including 12″ Yashar.
“Sensoria” _Microphonies_ Cabaret Voltaire
His head is not his memory.
Visions coming, one, two, three.
Trickle up, trickle down.
Wearily, we come unwound.
Sensoria, sensoria, sensoria, sensoria.
In hard times, hard thrills.
Reaching for the chosen pills.
Dragnets will pull you in.
Tell you that you’re deep in sin.
Sensoria, sensoria, sensoria, sensoria.
In hard times, hard thrills.
Reaching for the chosen pills.
Dragnets will pull you in.
Tell you that you’re deep in sin.
Sensoria, sensoria, sensoria, sensoria.
Humans, by nature, are irrational creatures. The summation of irrational decisions by no means makes them all rational. TPC
I notice that Americans are pretty darn rational when it comes to money. They shop around for the best prices and interest rates, they use grocery coupons, they actually like working overtime. But if they are indeed irrational, might not the blame be laid at the feet of our unstable money system? How about we have a principled, rational money system based on liberty and the rule of law and see how rational the population becomes? We certainly know how irrational people can become during a depression; the Great Depression was a major cause of WWII.
George Soros seems to agree with me (or I him) at least with regard to the housing boom:
A current example of reflexivity in modern financial markets is that of the debt and equity of housing markets. Lenders began to make more money available to more people in the 1990s to buy houses. More people bought houses with this larger amount of money, thus increasing the prices of these houses. Lenders looked at their balance sheets which not only showed that they had made more loans, but that their equity backing the loans—the value of the houses, had gone up (because more money was chasing the same amount of housing, relatively). Thus they lent out more money because their balance sheets looked good, and prices went up more, and they lent more. from http://en.wikipedia.org/wiki/George_Soros
Isn’t it perfectly obvious?
We’ll have a strong dose of rational markets after Q2 earnings surprise to the downside, followed by cautious guidance.
Irrational market participants do not actually mean that the market as a whole is unwise. This is the wisdom of crowds. One investor’s pride seeking, for example, offsets the regret avoidance of another. Markets become unwise when investors, collectively, make the SAME behavioral error. This happens when they no longer approach the problem independently. No doubt the mass of investors merely accepted the notion that the economy was in a v-shaped recovery. Hence, buy retail stocks and other cyclicals! Then the mo-mo guys (who now represent a huge % of daily volume) see the stocks going up and jump on the train. These guys add nothing to the wisdom of the crowd, by the way, as they merely piggyback on the supposed wisdom they see in their stock charts. On the one hand I find this irrationality extremely frustrating. J&J at 11X earnings with a 3% yield? Seriously? On the other hand, if it wasn’t for the stupidity of others (which seems to be increasing daily), there wouldn’t be any opportunity to generate alpha for clients.
> Markets become unwise when investors, collectively, make the SAME behavioral error.
I think the issue is that “investor” became too concentrated. Most of trading is done by big investment houses and they all move in one direction at the same time. Small guys, whle big in number and no matter how rational have no impact on the market.
I’ve tried shorting retailers after they were something like 300% off the bottom only to see them go to 400-500%.
I am seeing the same amdness now tih cloud-oomputing companies like CRM and VMW.
I agree with you. It doesn’t have to be all investors. Certainly, in the late 1990s there were investors who didn’t buy the Internet hype. But if the vast majority of volume is done by people or machines making the same behavioral error or piggybacking on the same behavioral error, the market will be unwise. That’s clearly what’s been happening in recent years. And I think 2010 is by far the worst year yet. I’m seeing moves in stocks that make absolutely no sense at all, and are, in fact, contradictory.
Humans, by nature, are irrational creatures.
I think that you take this too far. Humans are obviously capable of rational thought and behavior. However, they aren’t consistently rational, and the popularity of irrationality can vary over time.
EMH is a mixed bag. There is something to be said for the concept of long-run equilibrium, but that doesn’t necessarily translate into real time short-run pricing being equally useful as an efficiency measure.
I would describe it as a process of the markets hunting for equilibrium. They are trying to find it, but they often don’t get there, particularly when times are difficult. The results can be choppy, and at times like this, you can expect them to be more volatile than others.
With respect to retail stocks, I wouldn’t read too much into price movements when they are this dramatic. We’ve hit a fair trading range, and now we have shifts between greed and fear. While the volatility is indicative of the mood, the specifics of the price movement isn’t much of a macro indicator. You just have to expect volatility in a market like this, and hedge appropriately.
It’s a matter of personal opinion, but I feel as though the minority of human thought is rational….We’re too emotional and as a whole, too ignorant of our real surroundings. Hell, we’ve only just begun to understand the universe. How can we possibly truly understand the world we live in? We might be he most rational species on earth, but that just makes us the most rational in a very irrational lot.
It’s like the old trick of counting the number of jellybeans in a jar. Individually we don’t have the brain power to come up with the right answer. But each guess contains a little bit of information. Thus, each guess = information + error. So long as all of the guesses are independent, if you take the average of a group of people’s guesses, the information adds up to something very powerful (usually very close to the correct answer), as all the errors more or less cancel out. The wisdom of crowds shows how the stock market COULD be efficient. However it’s not, mostly because investors’ independence is compromised. In other words, we base our decisions on what others tells us or what the stock chart is telling us (which is just a way of trying to divine the presumed fundamental information of other investors).
I feel as though the minority of human thought is rational
If that were true, trading and investing would both be impossible, as markets would be entirely unpredictable.
I believe that there is a certain underlying logic based upon fundamentals, but one that is compromised by a shifting between greed and fear, that is further supplemented by varying degrees of ego, fear and a herd instinct. The dance between greed and fear moves and shifts with cycles.
Right now, we have a lot of underlying fear. Given that, you have to expect selloffs that are fairly brutal. I wouldn’t read those dips as responses to changes in perceived changes in fundamentals, so much as I would the market reacting to the underlying fear. Things are going to be volatile for awhile.
Good call TPC. I clearly recall your post chock filled with facts. Market tends to overreach on extremes and not surprised really but again great call.
EMH is not worth the paper its written on unfortunately.
In the short run, the market is a voting machine but in the long run the market is a weighing machine – Benjamin Graham
Overused I know, but still as relevant as ever today!
That’s the most interesting facet of this downturn for me. Financial theory will be forever changed. The death of EMH is like a regime change in many ways. Out with the old and in with the new.
A saying an old friend of mine, a stockbroker, used to say to me “If the world was going to end on Saturday, the stock market would rally until the close on Friday.” Only optimists buy stocks.
Just go back to Oct, 2008. The DOW had fallen just 2,500 points in twelve months to 11,500 when Paulson went to Congress and said he needed $700 billion within a week to bailout the banks or the financial system would collapse. The DOW then fell an additional 5,000 points the next six months.
Out with the old and in with the new. TPC
Here’s my market theory: Our entire economic system is based on a money system that is:
1. Dishonest:
1a. It steals purchasing power from all money holders, including the poor, via FRL.
1b. It cheats savers via negative real interest rates, particularly in housing.
1c. It drives borrowers into overpriced assets via debt that does not fall as the economy contracts. To not borrow is to be priced out of the market.
2. Unstable:
2a. It is the cause of the boom-bust cycle.
2b. The bust phase of the boom-bust cycle increases the demand for socialism and counterproductive regulation. The boom phase is morally and socially destructive too.
3. Murderous:
3a. The Great Depression was a major cause of WWII.
3b. The boom-bust cycle led to Communism which killed millions too.
4. Contrary to Scripture:
4a. Lending at interest to one’s countrymen is forbidden (Deuteronomy 23:20).
4b. “Thou shall not steal” (purchasing power).
4c. Oppresses the poor via theft of their purchasing power
5. Contrary to liberty:
5a. government backed banking cartel
5b. government enforced monopoly money supply
5c. potential alternatives such as gold (yuck!), silver (yuck!) and common stock (excellent!) are taxed while FRNs are not.
6. Obsolete:
6a. Our current economic system is mentally depressing and socially corrosive.
6b. Common stock is a much better form of money. It requires no lending and shares wealth as it purchases it.
Death of EMH?
I didn’t even know what it was…so I searched this site, and came up with this, that did more than define it.
http://pragcap.com/the-uncorrelated-return-myth
Sure, it probably seemed like a DUH-finition to many here, but a few needed a translation.
EMH=Efficient Market Hypothesis
In some circles, it is not a hypothesis, it is an accepted fact, and not subject to heretical dissent or inquiry.
Thanks!
TPC, don’t let anybody ever knock you man. Absolutely! Tim Knight on slope of hope was waiting for that sucker to roll over for 6 months!! Eventually right.
I really don’t understand that either. Good businesses and hard assets, that’s all I want to be in right now.
How’d you like oil. I saw it hit $65 and wished I had $1M to invest in USO or whatever the double levered was at that time. All that oil spilling into the gulf and oil is supposed to tank?? sure…
look no further than today’s price action.
storm gets upgraded to possible depression in gulf
crude oil spikes
dollar sells off
stocks rally! what?
a hurricane in gulf right now would definitely be equity positive…(just don’t tell that to the correlation traders)
Yes, today’s action is funny. The S&P retail index is up almost 1% today, but this bill does little to protect consumers. Instead, it will result in more fees for the rest of us and reduced agg demand at the consumer level. None of this is good for the little guy. But the stocks surge because everyone just falsely assumes that what is good for the banks is good for the market.
What we really need is to develop another “bull market” in equities in form of the Quantitative Easing we had before. Anyone mention “QE2″ ? This time its talk of $5 trillion. Should be enough to cover a lot of everything but real value.
Congratulations TPC on an awesome call! The RTH down 15% since April, totally crushed! Good on ya’ stock market genius!
After making a virtual all-time high in April, the retail index pulls back 15%, basically in line with numerous other indices, and you nailed it!
Wow, amazing!
Fact!
BTW, thanks so much for keeping us in all the way up!
Does anyone know a symbol for a short retailer ETF ?(leveraged or unleveraged)
Thanks to all who reply…