It is very difficult for either amateur investors or even professional money managers to do better picking their own stocks than the performance of the major stock indexes, such as the US Dow Jones Industrial Average (DJIA) or the Japanese Nikkei Index. In fact, most investors in active funds do worse than broad stock averages, after netting out what is paid to fund managers. Funds that do better than stock averages for several years are usually taking sizable risks that eventually catch up with them through sporadic sharp falls in the values of their portfolios. This happened to many exotic funds during the present financial crisis. This difficulty in "beating the market" is behind the development of index funds that simply hold a broad portfolio of stocks whose price movements mimic that of the overall indexes.
While the difficulty of beating market averages suggests that stock markets are reasonable efficient, conclusions about efficiency are far more complicated when the criterion is whether stock prices are determined by market fundamentals: present and future earnings, interest rates, and the degree of risk associated with earnings and interest rates. On the one hand, prices of individual stocks do very much depend on their present and expected future earnings, interest rates, and their systemic risks- the betas in finance theory.
On the other hand, prices of both individual stocks and of aggregate indexes often fluctuate in ways that deviate from the fundamentals. For example, during the Internet bubble, shares of many Internet companies sold for more than $50 or even $100 a share, even though these companies were not only losing money, but had no significant sales. These high prices were supported by radically wrong expectations about the future prospects of these companies. Many of these stocks became worthless, while most surviving Internet stocks lost almost all their prior market value. Even many non-internet stocks were excessively priced during the bubble years, as the stocks in major stock indexes were selling for a while at well over 20 times their earnings.
Stock markets are not performing efficiently when stock prices are either too high or too low relative to risk-adjusted discounted earnings. Sometimes, however, it is not easy to determine whether and how much prices deviate from fundamentals. For example, corporate profits were very high when the DJIA peaked in 2008 at 14,200, so that if these profits had continued, this price level did not imply excessive price-earnings ratios. The sharp fall of this index to its present value of about 8000 has been associated with a plummeting of actual and expected earnings, which led to a collapse in financial stocks and in prices of other stocks as well. Perhaps it should have been clear that profits in 2004-07 were too high to be sustainable, but it surely was not apparent to the vast majority of participants.
Can one say that individuals and funds are behaving irrationally if they are not shorting stocks, or are not mainly invested in bonds and other assets, when stock prices are much too high relative to fundamentals? Similarly, are investors rational when they are shorting stocks, or investing in other assets than stocks, when stocks are too low relative to fundamentals? The answers are not clear without further information since stocks may remain high (or low) relative to fundamentals for quite a while. Therefore, going long (or short) may also be profitable for a while.
To be sure, at some point the day of reckoning always comes when stock markets move much closer to fundamental levels. At that time, persons and funds lose a lot if they are long on stocks when they fall back sharply toward levels determined by fundamentals, or short on stocks when they rise sharply. However, predicting when the reckoning comes may be extremely difficult even for highly rational and far-sighted persons with extensive knowledge.
Interesting research years ago by Benoit Mandelbrot, that has been made more popular by Nassim Taleb's book The Black Swan, analyzes the incidence in stock markets (and elsewhere) of very small probability long tail events that give rise to large upward or downward movements in stock prices. By their very nature it is extremely difficult to forecast the timing of these low probability events. This is one reason why even most experts' forecasts of the large movements in stock prices are usually so bad. One can then hardly expect even reasonably rational stock market participants to be able to predict major turning points in stock prices.
A "rational" stock market bubble would be a situation where stock prices reflect present earnings and the expected future earnings of the large majority of market participants, and where future earnings are expected to rise over time. Then equilibrium stock prices would also rise over time. These earnings expectations eventually deviate far from the earnings that would be determined by sales, costs, and the like. In this scenario, more or less every participant is acting rationally relative to his expectations, yet the market is not behaving efficiently. Considerable frontier research in finance and macroeconomics is trying to determine whether much credence can be placed in the real world relevance of such rational price bubbles.
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