Steve Ross' Lament

In a book published in 2005, the great financial economist Steve Ross lamented that the finance profession could not understand what moved the market. By this he did not mean the inability of the profession to predict the market, he knew there was a theory that explained why that was not possible. Namely that the market reflects available public information, so it should only move significant when new information arrives. But by definition new information must be unpredictable, otherwise it would not be new. What Prof. Ross lamented was the inability of financial research to explain what had moved the market after the fact. As an example of Prof. Ross’ lament, Cutler, Poterba and Summers, Journal of Portfolio Management, (1989) and Cornell, Journal of Portfolio Management, (2013) attempt to related the largest moves in the overall market to the arrival of value relevant information. To emphasize, these are the largest moves of the entire market observed over decades. If anything should have an obvious explanation it would be such moves. But no luck. Both papers conclude that a majority of even the largest market moves cannot be tied to value relevant information. (Of course, the financial press tends to come up with non-value relevant explanations like profit taking but that is just after the fact rationalization, not a meaningful economic explanation.)

Get The Timeless Reading eBook in PDF

Get the entire 10-part series on Timeless Reading in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

I bring all this up because I have no explanation for the continued advancement of the aggregate US stock market. Those who follow this blog will remember that six months ago, I wrote that I felt the market was becoming overvalued. I was not alone. Howard Marks, the founder of Oaktree and a savvy investor, distributed a memo to his clients wringing his hands regarding the overvaluation of most major asset classes. Unfortunately for me, I put my money where my blog was and reduced my exposure to the market. Now six months later the market is even higher.

Here is my after the fact rationalization - not to be confused with a verifiable economic theory. Investors have concluded that the risk of equity investing has fallen and thus they require a smaller risk premium. This translates into a lower discount rate and, thereby, higher stock prices. If my speculation is right, the reaction of investors is not without reason. Market volatility has been close of an all-time low for a year now. As of this writing, there have been only two days on which the S&P 500 declined by 1%, or more in the last six months. In the last two months, the S&P 500 his risen (generally to record highs) on 75% of the trading days.

My suspicion is that this could all change drastically. Investors may be thinking that they can ride the trend upward and sell when it reverses. But when it reverses, that is when there are a couple of days with sharp declines, who are the buyers going to be? Because there must be a buyer for every seller, it may take large price drops to clear the market. Of course, this is all my speculation but that speculation is currently impacting the way I manager my fund.

Article by Brad Cornell's Economic Blog