There’s an old joke: two economists are walking down the street. One sees a 20-dollar bill lying on the sidewalk. As he stoops to pick it up, the other one stops him. “Don’t bother,” he notes. “It must be fake. If it were a real 20-dollar bill, someone else would have picked it up by now.”
The ideal of market efficiency—that securities reflect all available information in their prices—has been with us for over 50 years. Academics have argued over it, investors have fought against it, investment companies have raised trillions of dollars based upon it. And it’s the basis for the economist joke above. If the streets were cleaned efficiently, $20 bills wouldn’t be just lying around.
Intuitively, this makes sense. When a company reports its earnings and expectations about the future, buyers and sellers adjust their models and the company’s stock and bond prices change. In an era of webcasts, websites, and blogs, it doesn’t take long for that information to reach the world.
But if all the booms, busts, and bubbles of the past two decades have taught anything, it’s that markets make mistakes. Things are never so rosy as the bulls expect, nor as gloomy as the bears predict. By being fearful when others are greedy and greedy when others are fearful, investors can add value over time.
Where are we now? It seems the market is getting greedy. 30% returns last year and 25% annualized returns from early 2009 don’t appear to reflect the world we live in: a simmering currency crisis in Europe; an ascendant imperial Russia; pension problems in US cities and states. Maybe stock prices are just discounting low interest rates for the foreseeable future, but the market feels exuberant.
Markets can remain irrational for a long, long time, though. Managers who went to cash when Alan Greenspan warned of “irrational exuberance” in 1996 missed out on one of the great bull runs of history. The market never really came back to that level. So while we’re still long, we’re apprehensive.
To mis-quote Cromwell: trust in the market, and keep your powder dry.
Douglas R. Tengdin, CFA
Chief Investment Officer