3/5/14 – Pop/Drop/Pop: Is the Market Rational Vs. Is the Market Right

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Mar 5, 2014 8:42:48 AM

and tagged Commentary, Politics and the Economy

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Over the past couple of days, we’ve seen the market pop (on Friday), drop (on Monday), and pop again (yesterday). Admittedly, there was some news there—the Russian invasion of the Crimea over the weekend—but still, pop/drop/pop seems a bit strange.

I was talking with a reporter the other day who asked me a very reasonable question: “Is there a rational reason for all this activity?” He clearly didn’t think so, and while I certainly saw his point, I took the side of a rational market: given the Russian invasion, it clearly made sense to take risk off the table, and then (in theory) to move back in when it seemed the invasion was over. In the short term, you can make a reasonable case that the market response was rational.

A different—and from a utility standpoint, more interesting—question is whether, even if the market is being rational, it is right. Rationality and correctness are two very different things. Schizophrenics often, for example, develop very detailed and self-consistent worldviews that, nonetheless, are not connected with reality as the rest of the world sees it. (Think of the movie A Beautiful Mind, about a man who, professionally, was an exemplar of rationality, a mathematician.)

A market example can be found by looking back to 2000. At that time, everyone thought the Internet would change the world, that new companies would be born, and that life would be better. In the real world, this was a rational view, and it turned out to be right. The investment expectations, however, were just as rational but turned out to be disconnected from the real world.

Much of the debate about market rationality hinges on whether rationality necessarily equates to actually predicting what will happen. In fact, these are really two separate domains. The gap comes when rational expectations are based on the wrong assumptions. This is a good description of the dot-com bubble and crash, and also the housing bubble and crash. We get a bubble when rational expectations are based on poor assumptions, and a crash when those assumptions come into visible conflict with reality.

The best way to try and predict the markets, then, is to look at the assumptions underneath the expectations, and see whether they agree with your own version of reality.

If we look at the market reaction to Crimea on Monday, there was a decline of about 1 percent to 2 percent, depending on the market. The underlying assumption here was that the invasion could result in political and economic uncertainty in Europe and around the world, which seems reasonable since European gas supplies from Russia transit Ukraine and would be at risk. This was a valid underlying assumption, and one which justified the decline.

If we assume that drop was reasonable, though, the pop yesterday would seem to be based on the assumption that the situation in Ukraine had been resolved, and that there was no further risk, which warranted a return to previous price levels. Whether you agree with that assumption the market is making determines your investment stance.

Personally, I don’t believe the Ukraine situation has necessarily run its course, nor, even if it has, that the other assumptions baked into current pricing are solidly based. Nonetheless, that is what the market seems to be making its (rational) determination on. Whether rational means right will depend on whether, in fact, Russia is finished with the Ukraine, and whether all the other assumptions continue to play out.

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