Introducing the Concept of Local Market Efficiency
Anyone who has experience in the market learns respect. Your account tells you daily the verdict of the market. The Efficient Market Hypothesis, which is a central theme at "A Dash," holds that each piece of news gets accurately priced into every stock in a forward-looking fashion.
I have maintained that markets can get very far from an accurate valuation. One need look no farther than the recent "bubble era" where stocks reached incredible multiples of sales with miniscule earnings. Despite this macro failure, the market operated "efficiently" on a day-to-day basis.
The concept that I am introducing here — Local Efficiency — is an accurate description of how most market participants behave. They accept yesterday’s values as valid and ask what the directional impact is of any piece of fresh news.
Taking today as an example, there was news about increased MIddle East tension. This was obviously a fresh negative for the market to the extent that this geopolitical risk was not already discounted in stock prices. How did it play out?
Let’s look to the comments of Doug Kass in his excellent commentary on StreetInsight, a paid service of TheStreet.com. Kass is generally bearish, calling himself the anti-Cramer, but he makes frequent long-side trading calls and he had one going today when the news hit. He quickly posted two things:
- Cancel all longs.
- The market was not adequately discounting geopolitical risk.
The first of these statements identifies pretty typical market behavior — bids get pulled. Everyone knows this is negative, but perhaps does not know the magnitude. Step back and check it out. The market declined by less than one percent from this point, with extra selling in anything related to a strong economy.
Given that people were pulling bids, what does the selling tell us about the risk factor? From the reaction, not much. The Kass approach is typical of what many (most?) of the fast money traders follow and it has enormous influence. My problem with this approach is that there is no fundamental anchor for where individual stocks or the market as a whole is valued.
Local efficiency assumes that yesterday’s prices were right. Those who are bearish (or reversing the analysis in 1999 were bullish) see each piece of negative (or positive in 1999) news as vindication of their thinking. The same facts are repeatedly discounted without regard to underlying value.
There is no way of knowing exactly how long this will persist. Some of the smartest minds in the business got buried in 1999-2000 by shorting the market at ridiculous valuations.
What is needed is some concept of the overall market risk, my next topic.