Is the Market Efficient or Irrational?
The efficient markets theory says that the market as a whole has all of the information needed to accurately price stocks. If that were really the case, we would have a very hard time making money by trading stock options. An alternative view of the markets has been voiced in recent days as Russia invades Ukraine. Things look pretty bleak as sanctions cut off Russia from the rest of the financial world and the market falls. But then it bounces up again only to fall, bounce, and fall. Looking at the course of the S&P 500 is the market efficient or irrational?
The Market Likes Rationality But the World Is Not Rational
Investors like certainty. This is especially true for folks like Warren Buffett whose preferred time frame for holding a stock is forever. Unfortunately for all of us the world is commonly not rational. The Russian invasion of Ukraine is a case in point. 69-year-old Vladimir Putin thinks that by invading neighboring countries like Ukraine that he can recreate the “glory” of the Soviet Union. There was no glory in a system that killed 12 million citizens. The Soviet era under Joseph Stalin featured mass executions, deportations to “gulags” where people died from execution or neglect, killing of political enemies including the entire upper ranks of the Soviet Army in the mid-1930s, famine resulting from stupid policies of Stalin’s government and wholesale murder by Comrade Beria when he headed Soviet security services. We get a glimpse of where Putin wants to take Russia as we see wholesale destruction of cities in Ukraine. The price Russia will pay will be huge as it is cut off from the global financial system with only China, Syria, Belarus, Kazakhstan, and North Korea as allies and trading partners. Twelve million people died brutal deaths under Stalin and this is the world that Vladimir Putin wants to recreate, while using his nuclear arsenal as a threat.
Timing of Market Efficiency
A problem with the efficient markets theory is that it takes time for the market to digest information and adjust prices. We have noted that very often the opening of the trading session is “amateur hour” as folks like the Robinhood crowd or the pizza review guy who says that stocks only go up place their orders. Thus, the market goes up or down based on wishful thinking or sheer stupidity. That is when we put on bear call spreads and the like and routinely make profits trading stock options. Very often these trades are quite profitable within minutes if not a couple of hours. Depending on the timing of these trades we may take a profit before expiration. The point is that we do not wait for the market to go from rational to irrational to rational again but rather capitalize on momentary irrationality for our profits.
Market Sentiment versus Rationality in the Market
Although fundamentals drive prices in the long run, market sentiment is what drives prices over hours, days, weeks, and even months. Men lie and numbers don’t which is why fundamentals eventually determine prices. So, is market sentiment irrational? In the case of guys giving pizza reviews and saying that stocks always go up the answer is a loud and clear “yes.” But, the market always seeks to see the future and uses whatever information is at hand to do so. In this way the market is as rational as it can be. The problem is for investors and traders to sort through the irrationality of the world. In the case of Putin’s invasion of Ukraine there is nothing good waiting for him at the end of the road. If he takes Ukraine’s cities he will have to occupy the country forever to keep it subjugated. The more brutal his actions the stronger will be the resolve of the rest of the world to isolate him and the greater will be the likelihood that those in Russia with the means to make a difference will remove him from power peacefully like with Khrushchev or violently as with Lavrentiy Beria.