Is the Stock Market Always Right?

How do you do well in the best stock markets in 2010? Easy – just buy low and sell high. Make sure the trend is your friend, then cut your losses and let your profits run. If you can just remember that it's mind over matter and practice makes perfect, in no time at all you'll be on easy street.

Okay, enough of that. Ugh.

The point of that opening paragraph – sarcasm, as you've surely now realized – was not to impart timeless pearls of stock market wisdom. It was meant to demonstrate the tired, worn-out nature of the hoary old trading cliché.

Now, granted, many of the old sayings have stuck around for good reason. There are certain truths that apply just as much today as they did 100 years ago. Woe betide the trader who forgets or neglects those truths.

But some popular trading and investing clichés are little more than a waste of breath... a lazy man's substitute for clear thinking.

Here is one your editor has never, ever liked: "The stock market in 2010 is always right."

What the Heck Does That Mean, Anyway?

When traders use this phrase – "The stock market in 2010 is always right, you know!" – they never define their terms, or bother to address the clear exceptions to the rule.

For instance: Was the market "right" in the early 1970s, when incredibly valuable franchises like the Washington Post were trading for something like a half or a third of conservatively estimated intrinsic value?

Was the stock market "right" in January of 2009, when high-quality oil service companies with low debt and ample cash flow were trading at an insanely cheap three times earnings?

And was the stock market right in 1999, when various "dot-bomb" top stocks for 2010 were priced at multiples of infinity (because actual earnings were zero and "burn rates" were sky high)?

No, the best stock market is not always right. There are clearly times when the stock market goes off its rocker, in both directions. And because prices are always changing, one could just as easily say "the stock market is always WRONG." (Some traders do, in fact, operate profitably off such a principle.)

I can hear the objections: "Now just hold on a second JL, you're not being fair. Traders who say 'the stock market is always right' don't deny that valuations can run to high or low extremes. They are just trying to point out that, for the trader (if not the value investor), arguing with the stock market is generally a bad idea."

Yep. Fair enough. Your editor still maintains, though, that "the stock market is always right" is an exceedingly poor choice of words. If what you really mean is "don't argue with the market," why not just say "don't argue" instead?

And yet we still have a problem. Every position is an "argument" in the sense that it represents a disagreement with the prevailing market judgment. The purpose of buying or selling, be the intent to hold for three years or 30 seconds, is to make a profit. That implies a belief that, for whatever reason, the market has a better than sporting chance of moving favorably in the direction one anticipates.

But this amounts to disagreeing with the market's current assessment of what the future holds, does it not? Were the market not in error, where would the opportunity come from?

How, then, can anyone truly think "the market is always right" without being 1) vague on meaning, or 2) a useless academic (i.e. a believer in the efficient market hypothesis)?

It's one of those sayings that only works if you don't think it through.

The Parable of Three Umpires

For a better alternative, consider the following anecdote.

Three baseball umpires are sitting in a bar watching the game. The discussion comes round to defining the strike zone – what counts as a "strike" and what counts as a "ball."

The first umpire says: "I just call 'em like I see 'em."

The second umpire says: "I call 'em exactly the way they are."

The third umpire drains his beer and replies: "They ain't nothin' until I DECIDE what they are."

The market is like that third umpire. The price ain't nothin' until the ump makes the call.

"Hold on," some of you say. "Isn't this the same as saying 'The stock market is always right'"?

Nope. Not by a long shot.

How many umpires do you know who have never made a completely screwy call? How many times have you seen that agonizing slowroll video footage showing how badly blown a decision was, or heard groaning sports fans (perhaps including yourself) lament the lack of replay footage in the first place?

The umpire always has final say, but that isn't the same thing as being right.

And this particular ump (Mr. Market) can't be fired, despite his crazy tendencies. Sometimes he shows up to the ballpark drunk. Other times he's hopped up out of his mind on stimulants. Still other times, our beloved ump gets morbidly depressed, or decides to redefine the strike zone based on some wacko new theory from his favorite astrologist.

He Sobers Up Eventually

The guy does have at least one redeeming quality though. He always sobers up eventually.

The key qualifier here being "eventually." You can't always know how long it will take. So you keep a close eye on the old ump... you get to know his habits, his tendencies and quirks. Eventually you develop a feel for when he is out to lunch, and when he's starting to come back around.

Admittedly, "the stock market is a drunken umpire" may not be as pithy or straightforward as "the stock market is always right." It will probably never make it onto that hallowed list of trading aphorisms that never die. But your humble editor considers the umpire metaphor an upgrade nonetheless, because it manages to encapsulate a subtle yet important trading and investing principle. Arguing with the stock market in the short term is an exercise in futility – all it gets you is frustrated, or maybe even thrown out of the game. At the same time, though, there is no reason to assume the best stock market is infallible. Authority and omniscience are far from the same thing.