- 2000: Volume 9, No. 2 Is Efficient Market Theory Still Valid?

Prior to WWII many economists, including such giants as Adam Smith and John Maynard Keynes, made use of human psychology in their economic theories. However, much of this thinking was put aside after the war in favor of a more rational market approach. Since then, there has been a prevailing theory that the stock market is highly efficient and that rational investors set stock prices. The new market economists believed in an efficient market model that relied heavily on mathematics, which was much easier to apply if investors were presumed to be rational. The "efficient market theory" was even promoted by Forbes magazine which ran a contest between those throwing darts at the Wall Street Journal versus professional money managers (the darts won). The Efficient Market theorists have the viewpoint that you cannot beat the market by using historical information or news, which is considered to be reflected in prices. This fostered the idea that technical analysis was a waste of time and small investors should not spend their time analyzing market data. Furthermore, efficient market theorists think that investors should use discount brokers, or invest in index funds, rather than invest with professional money managers.

Recently this theory has come under fire from those who believe that the influx of independent online investors has made the market irrational at times. As well, contrary to many opinions, the fact that fund managers are not as long-term in their trading as they advertise has also had its side effects. Because of the constant pressure to meet the returns of competing mutual funds, fund managers are more likely to turn over or "trade" their holdings more than ever before. Studies have proven that stocks that are held predominately by funds surge more on market rallies and sink lower on the sell-offs. This suggests that fund managers may be getting swept up in the panics and manias that occur during severely volatile trading days. In light of this herd mentality, many economists are reverting to the previous notions of group psychology to explain market behavior. Richard Thaler, who is an economics professor at the University of Chicago and is also a well-known behavioralist, was recently quoted as saying, "it doesn't look like the markets behave as if investors are rational." While every one believes there are irrational investors out there, efficient market theorists say that rational investors set prices. The behavioralists believe that occasionally an irrational segment of the investment world sets prices and this presents tremendous opportunities to the savvy trader.

Stocks vs. Bonds

Efficient market theory is not the only economic theory that is in a retrograde motion in the new millenium. Clearly textbook economic theory is challenged when four percent unemployment and five percent GDP do not produce a whiff of inflation. Economists debate daily the question of what the speed limit on this "new economy" should be. Is the market able to sustain stronger growth without risking inflation? In the background, this debate stirs the question of whether stock and bond prices actually move together at all any more. This assumption is coming under fire and is being viewed largely as a reflection of an investment world that was consumed with a fear of inflation. This can be illustrated by comparing the Dow's performance in the 1970s and the 1980s. The Dow Jones was essentially flat in the 1970s even though earnings were rather good. Concerns of weakening purchasing power had investors selling stocks when economic data was strong for fear of higher inflation. In the 1980s, stocks and bonds soared as interest rates and inflation came under control. While earnings were not as strong as the Dow's performance might suggest, an abating of the inflationary environment gave investors confidence that companies would perform better and retain their earnings purchasing power. A look at the S&P index vs. the bond market for the last 10 years shows two independent markets. Solid economic data today may mean the Fed may hike interest rates to "tap the brakes" on our economy, which would subsequently lead to lower bond prices. This would not necessarily mean that we are in an inflationary climate that would be bad for business. Higher interest rates do not mean run away inflation any more. A rate hike from 5 1/2 percent to 5 3/4 percent today with inflation at 30 year lows obviously does not have the same effect as a rate hike would have had in the 1970s.

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What to Do?

What's a trader to do in this new environment? As many old market relationships fade away, many economists feel adrift at sea with no anchor. Well-trained investors stumble as a new breed of "irrational market players" fuel an increasingly dangerous marketplace. Traders need to be aware that in order to be successful, markets need to be viewed independently of one another. Not only stocks versus bonds, but also S&P vs. Dow Jones vs. NASDAQ. These developments are nothing to be afraid of. Indeed we need to embrace and accept some new/old paradigms in the market place. Furthermore, investors need to be re-trained to identify when the market is behaving irrationally so as to profit by these opportunities.

Remember: the best plan is, as the common proverb has it, "to profit by the folly of others."-Publius Syrus, 42 B.C.

In order to identify occasions when stock indexes are behaving irrationally and also time my entry with precision, I apply a couple of tools to the marketplace. First, I monitor the stock market in three different time frames. Dr. Alex Elder discusses a three-screen approach to the market in his book Trading for a Living that I modify somewhat in this instance. Initially I identify the trend of the market on a daily chart. If the trend is bullish I will only trade from the long side and if it is bearish I will only go short. One of the reasons I like the "three-screen" approach is that it is flexible enough to use any indicators you are familiar with in the appropriate time frames, just be consistent with them. In this example I used a MACD to identify a bearish trend in the daily S&P on January 5. This bearish condition means I now look to a smaller time to trigger only sell signals.

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The second screen is a 60-minute chart that is used to identify either an overbought or oversold condition using an oscillator. In this example, since the daily S&P trend is bearish, I am only looking for an "overbought" condition in an existing bear market to establish a short position. When investors push prices to extremes against the prevailing trend, a tremendous opportunity presents itself. On January 10 the 60-minute S&P chart registered an overbought condition when RSI went above 75 level. This is a market climate that is typically exuberant beyond rational thinking. Jake Bernstein, President of MBH commodities and a 30-year market veteran, offers a statistical way to help us identify these times as well. Having been formally trained in psychology, Bersntein has always been aware of the importance of identifying when the public is behaving irrationally. Jake is aware that most small traders lose money and are most often wrong at market extremes. He measures this in a "Daily Sentiment Index." The "DSI" is measured by actually poling individual traders each day and asking them if they are bullish, bearish or neutral on all the markets. His theory is that if the public is over 90 percent in agreement one way or the other it usually means the markets will likely move the other direction. When the second screen is reading overbought or oversold the DSI also is typically hovering near extreme readings.

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Finally, I am ready to act when I see a trigger generated in the third screen, which is a 10-minute S&P chart. On this time frame you should use a trend following indicator or a breakout approach (sell on a break below the low of the last five 10-minute bars for example). Oscillators should not be used at this step. In our example the S&P's gave sell signals on January 11 using moving averages. The subsequent collapse in prices was very swift with few bumps along the way. At this point it is up to the individual trader to determine if he wants to exit this as a day trade or keep it until the trend changes. This second approach has more risk, but yields far greater returns.

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For me, trying to find opportunity every day in the market is trying too hard. I am much more comfortable having most decisions made outside of market hours. For example, I knew that on January 5 the trend on S&P's was bearish so I was only looking for a short trade. I obtained my second condition of being overbought on January 10, suggesting market prices may have been set that day by our friends the irrational traders. Only then did I go into the day thinking of a trade. This process not only limits the times I am in the market, but it also helps me avoid being subjective in my trading.

Financial markets are changing and adapting each and every day. As the stock markets continue to set records the bets get to be bigger and bigger. It is important to note that the larger the bet, the larger the emotions we as human beings attach to the outcome of those bets. In this article I hoped to introduce some discussion on whether we should revisit some old market theories, if some current market assumptions are in tune with our new economy, and how we can profit by the mood swings of the oceans of new investors. As we move ahead, there are occasions to look over our shoulder and see if there is anything worth bringing along.

Kevin Riordan is managing director of Riordan Futures, LLC. Riordan Futures is a registered CTA and publishes The Riordan Report. His articles, as well as market commentary, are available everyday at www.riordanfutures.com, along with daily hotline, educational articles, quotes, charts and news. Sign up for free e-mail at trading@riordanfutures.com 1-800-281-3654. Charts courtesy of CQG: www.cqg.com.