How Rational Are Markets?

Rational or Irrational? Efficient or Inefficient?

Those are questions that academics wrestle with, and individual investors need to come to terms with.

A classic example is what market action gets credited or blamed on. Yesterday’s sell off was blamed on weak retail sales and Citibank’s big loss and write down. (I have a quote in today’s NYT article, Citigroup Loss Raises Anxiety Over Economy)

However, these events were well known by those people who were looking in the right places (like readers of this blog). So how were these events such a surprise as to cause a major dislocation?

It comes back to crowds getting the big picture wrong, and individuals identifying those instances. I call this Variant Perception and contrarian investing. Ironically, seeing the variant is relatively easy — the harder part is in the timing. That’s what technicals and market internals are for.

Wait — Are you claiming that you are smarter than the markets?

No. What I am very specifically saying is that there are opportunities to be uncovered if you can identify where the crowd is wrong. It happens all the time. Yesterday’s WSJ article on John Paulson’s hugely successful bet against subprime reaping him billions is a perfect example. Its not that Paulson is smarter than the market, its that he identified where the market, as a whole, was wrong.

Last year on CNBC’s Morning Call, I discussed why the Financials and Banks had a lot more write downs to go, and steer clear of the sector. (thanks for the hate mail — it made me even more confident that was the right call)  This wasn’t me being smarter than the market — but it was an identification of where the crowd was being too sanguine, too unrealistic — in short, wrong.

Crowds consists of irrational, emotional humans. We are slightly-cleverer pants-wearing monkeys. We do very dumb things when pursuing the bananas. We have not evolved to understand capital market risk. We are optimistic by nature, and tend to ignore the negative, until its staring us right in the face and cannot be denied. Then, we (irrationally) panic.

Remember, markets consist of lots of people — some ignorant, and some not-so-ignorant. The present market action can be described as the process of the ignorant and the uninformed becoming less so. Where it can become truly dangerous is when the crowd morphs into an ugly mob. Think Soccer hooligans. That’s when things become ugly — when the monkeys start flinging feces.

Now, for the really scary part: That last step has yet to begin . . .   


Citigroup Loss Raises Anxiety Over Economy
NYT, January 16, 2008

Trader Made Billions on Subprime
January 15, 2008; Page A1

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