Monday, June 08, 2009

Rational Market on the Dunce Stool

A triumvirate of idiot siblings has enormous influence. The rational or efficient market theory shares the wobbly throne with supply-and-demand and the invisible hand. Investors, analysts, economists alike have oversimplified the theories and, well, irrationally applied them.

The current worldwide recession has a strong link to the fantasy that in aggregate markets know everything important about a share and its company. The rational rational market will thus correct for both the undervalued and undervalued relatively quickly. The resulting economic model will then be the standard bell curve and pretty damned predictable.

The damned is the key adjective there. This theory is too often damned wrong.

A recurring theme in this blog is how most of us are uncomfortable with ambiguity, uncomfortable enough to force our perceived reality into binary options and clear forecasts.

The hit of the mid-global recession books is unquestionably The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street. Blowhards like I will be prone to expanding beyond that myth to the severe shortcomings of those other dunce siblings. Yet, the rational-market analysis has plenty of punch on its own.

Author Justin Fox seems to be a master of self-promotion, making the most of his extraordinarily timely theory on a theory. Everyone along with her brother and nephew seems to have reviewed the book. While I am very positively inclined to the Financial Times reportage and analysis, its current review is not as meaty or as pointed as the Washington Post's.

Also, a precursor piece by FT columnist Tony Jackson attacked the theory on its own. He concluded about the long run of bull markets, "Behind all that was a group of theories about rational behaviour, which are now blown to the winds. What will replace them is unclear, but we are better off without them."

Admittedly, if efficient markets remained on the whiteboard as a theory or general guideline, there'd be little harm and maybe even considerable benefit. The problem comes with any of the three dunce siblings is when we cannot deal with their ambiguous and theoretical nature.

When economists and market analysts extrapolate into market and individual stock performance on their nifty, smooth line models, it goes to hell. Yet, which of us is immune to that preference for the certain and easy? Even following dot-com bubbles and the present financial disasters, we'd like to punch up a computer model and pretend we know the near future.

Fox points to numerous proofs, both in dollars and in research over the past 35 years or more that efficient markets aren't necessarily rational or efficient. Even their former proponents and definers admit to glaring errors and contradictions. Yet, he also writes that huge pension funds among other investments gamble on these theories with great trust. Likewise, the U.S. and other country's regulators have used the models extensively.

We can look back to Adam Smith's Wealth of Nations, which refined and advanced both the invisible hand and supply and demand. Many well educated and otherwise smart people are willing to shout down anyone who questions either theory in any way. They often assume that two theories are absolute, regardless of how some markets are really near monopolies or oligopolies and ill suited to such certainty. Likewise, given Western history since the Industrial Revolution, assuming that capitalists work for the pubic good and their employees' benefit — without any government oversight — goes beyond myth.

The reviews of Fox' book tend to ask how all the parties involved could continue to believe so strongly in the rational market. While that's an academically attractive question, it seems more to the point to ask whether our great recession right now will force regulators and chastened financial houses to do the necessary observation and thinking rather than just living the myth.

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