Today, a wsj article said that we are approaching 7th inning in our bull market before the level out. As we learn of the efficient market theory and other assumptions that many economists use like rational expectation, I would like to show what the stock market has fared recently in relation to the theories mentioned above. Also at the end, I would like to add my thoughts looking forward as there has been many factors that influenced the stock market in past few months.
So, how have we fared in the lens of long term? Ever since the end of recession in 2009, the stock market had performed fantastically. Just to look at few indices, the S&P 500 showed 113% increase and the Dow Jones showed 101% increase in value over the past five years (see graph below). That is about 16.40% and 14.74% compounded annualized return, respectively.
Well, what are some of the factors that carried this high growth rate in the market? First of all, as I and numerous others have pointed out, the easy money policy or the quantitative easing, coupled with zero lower bound interest rate had a significant effect in the economy. Also, a large sum of money that was used in fiscal policy financed many investments and purchases of assets kept the economy from completely falling. Despite the down trodden conditions after 2008, fiscal and monetary policy supporting the economy had put us back on track on recovery. It is true that there are much debates about whether the magnitude and degree of recovery track we are on is enough, but what we all agree on is that we are coming back.
How does this tie back into the rational expectation and efficient market theory? What investors were most interested in during the past 5 years was to see what the federal reserve was going to do. To put myself into an investor’s perspective, the quantitative easing and the zero lower bound would mean it is very cheap to do many kinds of investment activities. Therefore, firms in the US might take this opportunity to carry out some projects they had in mind previously. Now if we can blow this up into macro perspective, many firms would be spending money as necessary and the spending of many firms would fuel the economy.
Another twist to this account is that even though this may seem like zero lower bound and easy money would surge the inflation rate, the interest rate that banks receive from the Fed simply by putting them in the vault had risen to a positive number. In other words, financial institutions were lending only those money that are deemed viable. This decreased the velocity of the money all the while having much of necessary investments being financed.
Knowing these information as an investor, people who handle money would have allocated money right back into the stock market–or at least keep it there–after the announcements from the Fed. This, according to the efficient markets theory and rational expectation in force, would have corrected the stock prices immediately so that people only benefit the “normal” return.
But, we see that this is not the case in many accounts as investors. Anyone who went into the market in 2009 was deemed as a contrarian and was considered very bold. We see that the two indices enjoyed 16% and 14% annualized return which compared to 10 year annualized return of around 4% for each indices if they had kept the money. We know as humans it is hard to keep our animal spirits inside us and be cool headed in times of recessions or extraordinary booms.
I personally agree with what the author of the article in the beginning said. The bull and bear can only last for so long. The bull we see today is only the ramifications of the trough we saw 5 years ago. So, if you do not have the guts to be a contrarian–not many people do and you can still make a good sum of money without being one– I suggest like the random walk theory or the efficient market theory suggest, invest in indices and keep your head cool.