On Rational Markets

• Posted by Derek
• on January 12th, 2013

“Markets can remain irrational longer than you can remain solvent” John Maynard Keynes

Having believed that line for most of my trading years, I’ve evolved to a slightly different view of rational and irrational markets. The gist is that I think it’s a useful but overused distinction; quite often what appears irrational is simply (justified) self-preservation.

Take the first Reformed Broker post of 2013…“Stocks Soar on News of Rapidly Shrinking Paychecks”. Don’t let Josh’s wit and snark distract you; he knows what’s up and made up a perfect headline to describe why Main Street gets so confused by Wall Street. It’s a mistake for the distant observer to assume either a) we’re all so lucky a deal was made in DC or b) markets are wisely looking ahead to the future benefits of this deal. It accomplished just about nothing, other than a payroll tax hike that is about to become a source of ire. So doesn’t this rally show us how irrational markets can be? I say no.

Consider that the January 2 launch was a completely rational response to widespread angst leading into the fiscal cliff. What if a fund had foreseen limited upside into January, and decided to collect income by selling calls? In that case, the buying back of those calls may have been a completely rational response to the emerging rally. Short gamma cuts both ways, often a quite natural example of Soros’ reflexivity in action.

Being short calls may have been a wrong decision, but if buying them back when losses exceed “X” dollars was part of the plan, then the response was completely rational. Not buying back the calls despite a plan to do just that? Now that is irrational, and one step closer to forced buying if the trend continues against their position.

And that is the job of the price analyst. The difference between a methodical market response and a frantic one indicates the presence of emotional behavior. A slow grind(average volume and range) has the ability to persist as regretful players slowly correct their “mistakes”. This wall of worry should not be a worry at all, except for those not bound by a process.

So, yes…the market rally is at odds with what the New Years Eve deal promises in economic terms. But a market that was down, then rallies back, is not irrational; it is self-correcting. A market that has rallied big, and then rallies bigger, is one that sews the seeds of its end date as it reveals late(or forced) decisions to finally act.

Now that would be irrational.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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