Market Efficiency and the Bard

Question: who authored this line of poetry?

"Whether 'tis nobler in the mind to suffer
The slings and arrows of outrageous fortune,
Or to take arms against a sea of troubles,
And by opposing end them?"

On first blush, it would be perfectly reasonable to believe this an artful, if not a bit melodramatic, soliloquy from an embattled hedge fund trader, grappling with his soul and the state of today's credit markets.

But no! It's actually part of Hamlet's "To be or not to be" speech. And, honestly, we're just about at the point where it wouldn't surprise us to see such a real world Hamlet-like headline soon. Here are a couple examples of what we mean:

"Dow Drops 226 Points, Dollar Tanks: Bloodbath Not Likely to Be Over"
- Daily FX, July 24, 2007

"Don't Underestimate How Bad Things Are"
- TheStreet.com, July 25, 2007

Anytime we can make comparisons to the Bard's greatest of all preoccupied brooders and stock market headlines…it's time to reevaluate things. As an investor, it's important to have a very particular and focused point of view on navigating the media.

Our main weapon in this fight is the principle of market efficiency. It's an axiom of finance theory that stock markets reflect all widely known and discussed information. MarketMinder commonly refers to this as "priced in." If a news story—no matter how big and bad it may seem—is already widely known and discussed, it no longer has the power to move stocks much.

Media outlets can regurgitate headlines about subprime woes or credit crunches all they like, but by now those stories are well known to investors and reflected in stock prices. Thus, market movements pertaining to such issues are either derived from sentiment shifts or brand new information. But the same old story can't do it. This isn't to say, however, that market efficiency is absolute. Markets are efficient over intermediate and long time horizons, but very short term moves can be driven by sentiment having little to do with the discounting of new information.

Consider how important and valuable this simple rule is. With it, you're armed against 99% of financial headlines bombarding you. You know, no matter how many times pundits tell you to fret over high oil prices, trade deficits, or carry trades, stocks won't sink for good because the market has already digested the issue.

A great example is the hysteria surrounding Y2K. Stocks in the latter portion of 1999 were jittery as the populace boarded up windows and headed for the storm cellars in anticipation of civilization's end at the hands of…what, exactly? The calendar changing?

But once the information was digested by markets, stocks actually rallied in December of 1999 leading up to January 1, 2000. Why? Because the market had figured out well before the pundits that Y2K was a sham. The news was priced in.

Remember the media's goals and your own goals as an investor are dissimilar. The media is designed to report information, not necessarily analyze (though they often make the attempt). More importantly, media outlets almost ubiquitously have a profit motive. Yep, they're trying to make money! Which means they're competing with other media outlets for your attention.

How do they get your attention? With sensationalized, fear-laden headlines. There are few emotions in the human spirit more powerful than fear (especially when it comes our money!). Hence, "Bloodbaths" and warnings of "Armageddon" abound—those keep us tuning in time and again.

Lastly, when navigating the media, make sure you know who the "expert" is. Most journalists are great at reporting and presenting information concisely, but few are trained to analyze. There's a big difference between an Editorial in the Wall Street Journal from Treasury Secretary Paulson and a snarky commentary from the farcical The Daily Show.

Media histrionics can weaken the knees of us all. The Bard again says it best:

"And all our yesterdays have lighted fools
The way to dusty death. Out, out, brief candle.
Life's but a walking shadow, a poor player
That struts and frets his hour upon the stage,
And then is heard no more. It is a tale
Told by an idiot, full of sound and fury,
Signifying nothing."

That one's from another preoccupied brooder, Macbeth.

But you can protect yourself from a tragic investing fate by asking the seminal "to be or not to be" question: Is this truly new information, or is it already priced in?

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Source: Shakespeare. Hamlet, Act III, scene i