A very smart friend was visiting from Manhattan this weekend. His proximity to Wall Street gives him a window into the world of finance. His tendency to be out of sync with the average American protects him from the herd instinct. Despite having a demanding academic science job, he has been a successful individual investor for a couple of decades. In the spring of 2008, with the Dow at 13,000, he moved all of his family’s investments into bonds.
When conversation turned to the latest sag in the stock market, he opined that much worse was yet to come and that the Dow might get back down toward 7000. He cited the moribund U.S. economy and the profligate U.S. government (people who argue for stimulus spending tend to underestimate the government’s ability to waste money, e.g., putting a 6-year-old girl on the no-fly list (story)).
I have trouble letting go of the Efficient Market Hypothesis. If the Dow is at 9700 right now then that is the best estimate of where it will be a few years from now (plus whatever the yield on a TIPS bond is, i.e., 1-2% per year). With the U.S. state and federal governments amping up taxes and handing out the money to the retired, the world’s least efficient health care system, and political cronies, and 15 million Americans unemployed, how can the S&P 500 not be dragged down? My argument is that most of the companies in the S&P 500 aren’t dependent on the continued prosperity of working Americans. General Electric can build factories in and sell products to customers in any part of the world that is thriving economically. Intel can sell processors to families in Turkey, Brazil, and India. Walt Disney can welcome visitors to its Shanghai theme park. Admittedly many of the companies in the S&P 500 would appear to be dependent on American consumers, e.g., Southwest Airlines or various insurers. But even these should still produce good profits. The U.S. economy may end up with big shifts in wealth, e.g., from workers to retirees, from the private sector to government employees, and from competitive industries to government-sponsored industries. The per capita income of the U.S. may fall, as the population increases and the GDP remains constant. But as long as GDP does not fall, the same amount of money is there circulating for a company to collect as profit. [In January 2009, I wrote a posting about how the U.S. economy does not need to crash or boom; it can simply slide sideways as England’s did for decades.]
What do readers think? What plausible scenario causes the multinational companies in the S&P 500 to become worth significantly less than they are now?
* The U.S. is not done spending.
* Europe is going to cut spending.
* China’s real estate bubble is going to bust.
* Current attempts to shore up hot spots like Greece are going to fail.
* Other countries are going to have trouble (Spain for example).
* Political unrest around the world.
* Large layoffs in U.S. state and local govt. sector coming.
* U.S. housing still in trouble, going to be another leg down.
* Still unresolved issues with CA, IL, NY and others.
* Most trading volume is computerized insider day trading, this is an unknown. You can be sure they only trade when there are suckers still in the game, what happens when the suckers give it up and go home? We don’t know yet.
All reasons we will see Dow 8000 in my opinion.
“What plausible scenario causes the multinational companies in the S&P 500 to become worth significantly less than they are now?”
Babyboomers retiring and selling stocks to fund their retirement?
Stock bubble from the nineties still deflating? I think stocks have been going down since the beginning of this century, both in inflation adjusted dollars and in gold. (this is from memory, I could be wrong) In nominal dollars it was interrupted by the loose money policy that caused the housing bubble, but that was just postponing stuff.
The US consumer as we knew him is dead. He spent more than he earned for many years and that game is ending now. Government had same problem. Too much debt was a factor in the Great Depression and now too. Austerity will hurt stocks. If austerity isn’t chosen, maybe one day default will come, or war. War gave the US worldwide power and influence that it is now losing. But war is not humane and I hope there is none in our future.
The US role in the world economy is changing. The empire is in decline, may be heading for bankruptcy and its currency may lose reserve currency status.
Longterm cycles? According to some we’re now in Kondratieff’s winter. Probably correct, but unfortunately this stuff is so vague that it’s not very helpful. Spring should be good for stocks, but when will it come?
The new austerity in the EU probably means they too will buy less, hence less profits for the S&P 500 companies.
Similarities with the Great Depression adding to negative market sentiment?
http://dshort.com/charts/Kimble/then-and-now-100705.gif
P.S. Please delete “I think stocks have been going down since the beginning of this century, both in inflation adjusted dollars and in gold. (this is from memory, I could be wrong)”.
My reasons that stocks may drop further:
1. changes in US tax code (expiration of Bush tax cuts) mean that if you are going to sell some stocks, you should do so by the end of the year – thus some will start selling early, figuring that others will sell at the last minute, depressing prices.
2. A change in capital entering or staying in the market (i.e. net flow of money out of mutual funds that invest in the stock market) is likely as by the end of July some 3 million people will no longer be receiving unemployment benefits – as reality hits they may start to cash in any stocks or 401Ks they have held off from touching. Further, hard times in other countries may lead to investors there, also selling stocks and going to cash.
I’m seeing the idea that the stock market is going to bite it again — and hard — from several places now. I believe it, but I don’t know what to do about it.
My brother-in-law works for an investment company, and he’s worked both the stocks and the bonds side of the business. In late 2008, I asked him about the situation, thinking I would shift all of my holdings into long-term stuff. He told me the worst was over, and that I ought to get really aggressive. So I did nothing, and, of course, have lost a significant chunk of my nest egg. At this point, what can I do? Take it all out, pay the exorbitant taxes, and get out of the market? The 30% hit would cover a pretty big downswing.
The worst part about it is that, with government spending the way it is, I don’t want to put it in T bills. What does that leave me? Gold? Foreign markets? (Probably worse!)
Maybe I should just start a business with the money…
Ethan: All of your points except for the last one (computerized trading) should already be priced into the market, no? Investors already know that Greece and Spain won’t contribute to S&P 500 profit growth. Managers at big companies have already turned their attention to Latin America and Asia, no?
Jan: Has the stock market been deflating since the beginning of the century? Google Finance says that the Dow was 11,500 on Dec 31, 1999. That would be 15,060 in 2010 dollars, according to the Bureau of Labor Statistics’s CPI calculator. So the Dow is down 36 percent in real terms.
Patrick: I’m not sure that the unemployed have significant portfolios of stock in their 401ks. Let’s assume that the median American family net worth is back to its 2004 level of $93,000 (that includes equity in a house). Let’s assume that unemployed people tend to have been poorer than the median, with a net worth of $70,000 and perhaps $25,000 of that in stocks. If all 15 million unemployed Americans sold $25,000 in stocks each, that’s $375 billion in sales. http://seekingalpha.com/article/199294-world-stock-market-value-reaches-20-month-high says that world stock market value is about $50 trillion.
How does a of volatility index relate to efficient market hypothesis? Is this an index which tries to predict our ability to predict the future direction of the market? If so, I guess I am saying that volatility is high and given that any index can be wrong, I believe volatility is higher than the index states at the moment.
Phil,
Stick with your gut not to abandon the efficient market hypothesis, especially on macro events or indices. Using Google Archive News search, you can review what smart prognosticators have said in the past about then-future dates. Almost no one is correct on macro events more than once sequentially (if there are enough guesses, someone will be correct).
The reality is both camps can site a large number of reasons for their case, as your initial post shows. It’s a system with a massive number of players, emotions, and variables, all interacting. Predictions play to our human desire to understand something. Many people will try to make money capturing attention with predictions.
“Forecasts of the future tell you more about the forecast than the future.” – Warren Buffett
Increased inattention to the market increases returns: http://papers.nber.org/papers/w15010
Dow 7000 is as low as it can go, barring unforeseen events. A large portion of all instruments are held by entities with structural restrictions on what they can do with their funds, usually devised by people who haven’t noticed that 20 year stock market returns are around 0.4% (compound).
I once read about two stock market simulations, using genetic algorithms to evolve agent strategies. In the first, agents based their activities on their perceptions of fundamentals. Stock prices were stable and consistent with company values. In the second, agents traded based on their predictions of what other agents would do. Prices turned completely chaotic.
Which strategy do most people use these days?
And if you think the efficient market hypothesis is still valid and prevents any likelihood of a crash to 7000, then how do you explain the last time, and the immediate recovery?
Dennis: I didn’t say that the efficient market hypothesis “prevented” a crash down to 7000. Only that the best estimate of future value is current value. New information could arrive that would result in lower or higher prices. I think that the hypothesis says only that the current price is based on all currently available information.
Part of the last crash was a liquidity crisis in which some institutions or individuals had to raise money quickly and the only thing that they could sell were stocks. The world is currently awash in cash so I think that distressed selling will be less of a factor.
Another factor in the last crash was uncertainty about what the U.S. government would do. Would the feds nationalize banks, raise taxes to 85 percent, let GM, AIG and Fannie Mae go bust? Nobody knew. Now we can be pretty sure that the federal government will print money in response to any challenge. That may or may not be good for investors, but at least it is a predictable risk that can be planned around.
Phil,
How about this, there are two scenarios,
1. The US government is able to fool its creditors and buy its way out of the recession and economy goes into an expansion. Result = Dow 14000.
2. The bond market forces austerity on the US, and the US goes into a deep recession. Result = Dow 6000.
Say the odds of each scenario are 50-50, giving an expectation value (or best estimate) of the Dow at 10000. Whether people believe scenario 1 or 2 depends on a lot of things, and can change dramatically. Much government spending and human psychology distorts the signals of whether scenario 1 or 2 is actually happening. Confusion reigns, until one of the two equilibrium states is reached.
Clearly the expectation value of the dow, will depend on the shape of the scenario distribution, which no one can know or calculate, but the idea is that the efficient market isn’t necessarily connected to a stable value.
Another way to look at is, we may know about all the issues listed in Ethan’s first comment, but we don’t know their effect on the economy. As we learn their effect, that’s new previously unknown information that the market will “efficiently” adjust too.
How about accounting and stock market fraud? Cendant (or its’ predecessor), Arthur Andersen, Enron, Waste Management, et al, are not such a distant past. How many cases like Enron will it take to really shake the current market? whatever accounting and financial reporting reforms they came up with, may not help much given enough determination – Madoff is but one such example.
How about the possibility of peace-seeking, virgin-loving freedom fighters (or whatever the current politically correct term for them may be), bombing the Intel HQ, R&D offices, and factories – and then AMD, Cisco, and whatever else they can reach, along with a couple of factories? Not all of these companies have everything of importance in bomb-proof facilities. And then the handlers of those mujahideen can short the stocks.
Then there’s always the possibility of some unforeseen regulations shaking up the industries – should they allow enough nuclear power stations to make say electric heat cheaper than oil, what would that do to the oil industry? Should they chase all the illegals out of the country, what will that do to meat processing industry, construction, or whoever can be relying on abundant supply of cheap labor?
How would large-scale market intervention by the government (say, manipulating the gold prices or the interest rates) affect stock indexes?
Here’s another possibility:
A US company outsources development to India. The whole business (a substantial part of a major corporation) consists of 2-3 mainframes, one main application, and the customer database – and a small army of sales people. They outsource their development to India. Instead of providing the Indian developers with a subset of their customer database, or dummy records, they ship the whole database, and the whole code base, on mainframe backup tapes to India. And they’re helpful enough to transmit periodic updates as well.
A little while later, an unknown off-shore company begins direct-marketing the same service to the same customers – no sales people, just email. The service is provided by the web site – it took the company a couple of decades to perfect. The result? The company did not go out of business altogether – they had established customer and vendor relationships, name recognition, long-term contracts, etc. But the stock tanked.
Similar to that – the guy who stole the micro-trading code from Goldman Sachs and took it with him to the competing Chicago-based outfit.
Sentiment. A rising tide lifts all boats and a receding one will lower them all.
I think it was some minor English economist, who I disagree with, who pointed out that railway stocks went up just before a bank holiday, and that companies selling winter goods went up as winter arrived, as if such events count not be priced in earlier.
How many stocks do you think are purchased based on an assessment of that particular company ? I bet it’s a lot less that would seem sensible.
“The best kept secret in the investing world: Almost nothing turns out as expected.” –- Harry Browne
Got it. My main point though is that when most investors base their decisions on what they think other investors will do, instead of on the underlying fundamentals, the market stops being a good predictor of fundamental values. That’s why we get bubbles. The stratospheric market caps of the dot-com era weren’t actually good estimates of company prospects. The efficient market hypothesis would tell you they were, based on the information available at the time, no matter how crazy it seemed when you looked at the fundamentals.
Believing in the EMH means that prices justify themselves. There’s no need to do all that hard work reading balance sheets. Any price is just as valid as any other, because the market is smarter than you are. But if everybody thinks that, how do prices stay connected to reality at all? How efficient is a market full of dart-throwers? The market is most efficient if everybody ignores the EMH.
The book The Wisdom of Crowds talked about the conditions that make group decisions accurate. One was independence of thought. When people base their opinions on what everybody else thinks, group think sets in and they go off the rails. Independence, along with a way of aggregating all those disparate opinions, gives great results.
Few investors have the arrogance to think they’re smarter than everyone else. The EMH gives them justification for doing what they want to do anyway: the same thing as everyone else. Believing in the correctness of market prices is the ultimate group think.
Consequently, the market isn’t always a wise crowd. Sometimes it’s a thundering herd. I don’t think it’s necessarily true that the sorts of fundamental problems mentioned by other people in this thread are already priced into the market.
I think whether I side with your friend depends on whether he shifted his money to *Treausuries* or mortgage/corporate bonds in spring 2008. World of difference in terms of his credibility! :->
Efficient market theory is good excuse for intellectual laziness. If all known information are accurately reflected in stock prices, then there would be no value in gathering information as you would just easily rely on current market prices. Yet finance companies do have big research departments trying to get competitive edge over one another by gathering and interpreting information. Information are neither equally distributed, nor equally absorbed and interpreted in the same way by participants. Market pricing is just a collection of actions taken by individuals based on their interpretations of whatever angle of market information they have available. General environments (such as market mood) do provide anchoring points for these participants to interpret market information. Successful investors exploit inefficiency in market pricing all the time.
If you are having trouble letting go of the efficient markets hypothesis you may wish to read “The Limits of Arbitrage”
Anderi Shleifer and Robert W. Vishny, 1997, ‘The Limits of Arbitrage’, The Journal of Finance, American Finance Association
This used to be available free but no longer, it seems. It explains why not all mispricings can be arbitraged away.
Didier Sornette’s work on rational bubbles – yes investing in bubbles can be rational – is also very illuminating.
scholar.google.com shows a bunch of available copies of ‘The Limits of Arbitrage” for anyone interested.
Here’s one:
http://portal.ku.edu.tr/~cdemiroglu/Teaching/Investments/Limits%20to%20arbitrage.pdf
If markets were efficient (per the efficient market theory) then we would see much less volatility in pricing. Taleb addresses this as did Robert Shiller.
Taleb: “Prices swing more than the fundamentals they are supposed to reflect, they visibly overreact by being too high at times (when their price overshoots the good news or when they go up without any marked reason) or too low at others. Prices do not rationally reflect the long term value of securities by overshooting in either direction.
The government will eventually tax away all corporate income and most corporate assets.
Don’t know what that means for stocks. Dow 0?
Efficient Market Theory suggest to me that the value of a share at any instant should be equal to the present value of expected net future cash flow which that share is responsible for. From my limited experience on this planet I don’t see how a rationale being could model this cash flow without a crystal ball.
I would say that the price level in “efficient markets” reflects participants *current* limited knowledge *and* current perception of the likelihoods of future events. Knowledge and perception can change drastically in a short period of time.
Also, I wouldn’t call our stock markets “efficient” by any means; in fact, I don’t think they deserve the “market” moniker at all right now. Participants have different rules applied to them based on who they are.