Valuation-Informed Indexing #206

by Rob Bennett

Stock prices go down a bit and someone says “the market sees more inflation on the horizon.”? Or stock prices go up a bit and someone says “the market sees that the economic recovery is accelerating.”

It’s painful to read these sorts of comments. Presumably, people fall for this sort of thing or we would not so frequently hear the idea expressed that the market knows best. All of us know some things and get mixed up on other things. The market is no exception.

What makes these claims persuasive to many is the suggestion that people who invest in stocks have something on the line when they form their opinions as to whether there is more inflation on the horizon or whether the economic recovery is accelerating. Presumably the market reflects their expertise.

The reality, of course, is that we all have something on the line when we form our opinions of whether there is more inflation on the horizon or whether the economic recovery is accelerating. An owner of a small business is affected by inflation and by economic recoveries even if he has no money in stocks. Those who work on political campaigns are affected by inflation and by economic recoveries even if they have no money in stocks. Economists need to know about inflation and economic recoveries even if they have no money in stocks.

The market is comprised of people who own stocks. The market is us. When we argue that the market is smart, we are flattering ourselves.

The only way that the market could be smarter than the rest of us is if the people who comprise the market were smarter than the rest of us. Rich people own more stocks than people who possess low or moderate amounts of wealth. So, if you believe that rich people are smarter than people of low or moderate wealth, it would not be unreasonable to believe that the market is smarter than the rest of us.

But you don’t often hear people saying “rich people think inflation is headed upward” to support their arguments. The idea behind claims that the market believes something is that there is some ruthless truth-telling quality about markets that make their beliefs especially credible. I don’t see it. Markets are comprised of people and people get some right and some wrong regardless of whether they participate in markets.

Rich people are not necessarily better able to tell when inflation is on the upswing in any event. Does having money make one clairvoyant? It’s probably fair to say that rich people care more about the effect of inflation (since they have a claim to more of the money being inflated). But that might make them more emotional re the subject. It might be that rich people have less of an ability to form objective assessments re inflation and economic recoveries and all the other subjects re which the market is thought to possess special knowledge.

People often claim that markets “foresee” both recessions and economic upturns. Say that there is strong statistical support for that assertion (I don’t know whether that is so or not, but I certainly do not dismiss the possibility). Could it not be that it is the market causing the recession or economic upturn? When stock prices go down, millions of people feel poorer and thus spend less, causing the economy to slump. When stock prices go up, millions of people feel richer and this spend more, causing the economy to perk up. Now I don’t say that the market is uninformed. It is as informed as the people who participate in it. What I am saying is that the act of these people bonding together to form a market does not make them smarter. We are all dumb about some things and smart about other things. And all that a market is is a combination of our many dumb takes and our many smart takes.

There’s a marketing slogan that has become popular during the Buy-and-Hold Era that evidences this belief that when semi-smart people join together to form a market this act transforms them into super-smart people. You Can’t Beat the Market! Tell it to Warren Buffett. Tell it to the millions who learned from Buffett how to beat the market on a regular basis.

If you challenge the Buy-and-Holders on this one, they will often acknowledge that it is only that no more than 50 percent of investors can beat the market because the market performance is the average performance and 50 percent of performances must fall below the average just as 50 percent of performances must fall above the average. Okay. Then to say “You Can’t Beat the Market!” is no more true than to say “You Are Certain to Beat the Market!” There’s a 50 percent chance both ways.

A variation on the theme is the claim that any individual investor who tries to pick stocks effectively is foolish to think that he can outrun the geniuses who run mutual funds. The people who run mutual funds may really be geniuses. But the full reality is that those geniuses have their hands tied in ways that ordinary investors do not. Mutual-fund managers need to please their customers and that means that they cannot invest in the company that has been doing poorly for a long time but is now priced so as to be a super long-term prospect. Having freedom of movement can be more important than having smarts.

People have a foggy understanding of markets. So they become intimidated when you claim that The Market Has Spoken. We should try to get over that unfortunate inclination. The word “market” suggests something big and complicated and scary. But markets are people. They are all around. They mess up all the time.

Just as we are always trying to improve ourselves, we should always be trying to improve the market. It’s not just that we can beat the market, it is that we must try to do so. If we are not trying to beat the market, we are not improving the market. If we humans who comprise the market do not improve it, who is going to do the job for us?

Rob Bennett has recorded a podcast titled Confidence Limits, Logic Chains, and Emotion Waves. His bio is here.