Are stock markets ingenious or insane?

Are stock markets ingenious or insane?

You’ve probably heard the expression, “crazy like a fox.”  If you’ve ever watched a winter fox in action, you know what that means.  Hunting for prey, the fox will leap around in seemingly insane gyrations until … wham!  It’s scored a tasty tidbit hiding in the snow. 

Has the stock market gone similarly crazy lately?  Like the fabled fox, there are actually some incredibly sensible dynamics behind the market’s seemingly manic moves.  Let’s cover three reasons why investors should ignore its transitory twists in pursuit of satisfying returns.  

Market pricing vs. economic indicators 

To the surprise of most, markets surged in April, with the US stock markets experiencing their best monthly rally since 1991 and the Canadian stock market since 2009.  

So far, May isn’t looking too bad either.  But why?  Why would markets spring upward while the economy remains in such a deep freeze?  The explanation is relatively simple, if often misunderstood. 

  • Economic indicators are in real time.  Unemployment is high right now.  Government debt is piling up.  Coronavirus is ravaging our personal and economic health today. 
  • Market pricing is forward-looking.  When the market is rising, it suggests there are more buyers betting that things are likely to improve than there are sellers betting on even darker days ahead. This doesn’t mean they’re correct, but relatively efficient markets often do “know” a bit more than any one of us can know on our own.

Market efficiency

This leads to another source of confusion for investors and the popular press alike: 

  • The markets can be crazy-volatile in the near-term.  Nobody actually knows what market prices are going to do next – not even the market itself.  To know, we’d first need to correctly predict each new economic or other trends that might change things.  Plus, we’d need to know how the market is going to react to the interplay of every force, combined.  No wonder it may often feel as if the markets are disconnected from reality.
  • The markets are powerfully efficient over time.  While daily markets are as messy as can be, all that volatility is actually efficient price-setting in action.  Each time the news changes, the market arrives at new pricing that incorporates everyone’s expectations – from naive to experienced investors, from pessimists to optimists. Over time, this makes markets incredibly (if not perfectly) efficient.  It makes it nearly impossible for any one player to consistently outsmart them through anything other than random luck. 

Remaining resilient

This brings us to our final point, which is the importance of investing according to long-term evidence, instead of breaking news.  I am currently reading Nassim Nicholas Taleb’s book called “Antifragile”. He underscores this point well when he wryly observes the relationship between meaningless “noise” versus meaningful “signals”:

  • Yearly data is 50% noise, 50% signal
  • Daily data is 95% noise, 5% signal
  • Hourly data (manic market-watching) becomes 99.5% noise and 0.5% signal

In short, no matter how insane the market, the economy, or the world in general may often seem, perhaps the craziest thing of all is to base your next investment decision on gut feels or fast-moving trends.  Or, look at it this way:  The mice that hunker down and remain calm are the ones least likely to end up as a “crazy fox’s” next meal.