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Stocks Bang Their Head on an Inefficient Ceiling

Stocks Bang Their Head on an Inefficient Ceiling

Tuesday, 14 July, 2020 - 07:15

Monday wasn't a good day for the efficient markets hypothesis. The idea, you may recall, is that markets incorporate all known information at all times, and thus follow a trendless “random walk,” jumping up or down according to the latest piece of news. Monday’s trading in the S&P 500 certainly qualifies as “random” at first glance, charging upward, then suddenly reversing and ending down for the day. That is until two psychologically important lines are added. The S&P topped its level at the start of the year; surpassed last month’s post-Covid high immediately after; and then, as though it had bounced against a hard ceiling, tanked:

The problem for random walk theorists is that prices are supposed to react to actual news. Neither of these landmarks qualifies. And this is the second time this has happened. Stocks reached positive territory for the year more than a month ago, and then staged a sudden retreat. It has taken until now to make another attack on the summit.

If this sounds irrational, it is — although it is probably better to call it an understandable mental cue for more rational calculations. Doubtless there were algorithms programmed to sell if a new post-Covid high was reached. Beyond that, human judgments were involved. Confronted with the reality that stocks were up for a year in which there have been so many setbacks, investors looked for reasons to sell.

Earnings season is about to get going in earnest, but it is obvious that the pandemic continues to dominate attention. Investment research firms are getting ever more ingenious at finding real-time ways to measure progress in fighting Covid-19, and also to measure the extent of the damage. Over the weekend, investors had a bundle of research that largely suggested reason for caution (although not despair). It seems to have taken this landmark for equity investors finally to confront what the Covid-19 numbers were telling them.

The world is making slow and patchy but clear progress in dealing with the pandemic. Economic activity is similarly making only a halting recovery — it is strongest in continental Europe, terribly weak in the UK, and very unimpressive in the US. Still, we are definitely in a better place than the worst-case scenarios that seemed reasonable to contemplate in March.

If markets were really efficient as random walk hypothesists would suggest, we would have been witnessing mad fluctuations and volatility in response to every little data point of the kind I illustrated above. As markets are not in fact perfectly efficient, and tend to under- and over-shoot on waves of human emotion, a lot of these data were ignored until the market hit a big round number, and then everyone hurried to catch up. That’s the way it works.


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