The theories of Rational Expectations and Market Efficiency are two of the most important economic ideas to emerge from the previous century. Respectively, these ideas hold that a.) at most points in time, the prices of securities and other assets rationally reflect investors’ anticipation of how future events will affect the values of these assets, and b.) as new information becomes available, the relevance and importance of this information is rapidly and accurately reflected in asset prices.
When you ask business executives (or politicians) about their preference for government- vs. market-based mechanisms and outcomes, and get a response along the lines of “markets always know best,” their answer reflects how these ideas have been, to a large degree, seamlessly adopted as unquestioned asssumptions that drive many of the opinions we hold and conclusions we reach.
I was discussing these ideas with a student recently, who asked the following question: “It seems that many people now believe that Barack Obama is the worst President of all time, and that his policies are bad for business — some even say that Obama is ‘anti-business.’ If this is true, why has the stock market risen so much during his presidency, and why does the stock market react positively whenever there’s an announcement of a new bailout or another round of Quantitative Easing?”
The student’s question intrigued me, and our ensuing discussion led to the following analysis (data supplied by Robert Shiller of Yale). The first graph below depicts the continuously-compounded nominal returns to the S&P 500 by President, with labels indicating the total returns earned at the 20-month and 60-month marks following the month of their inauguration (click to enlarge):
The second graph depicts the continuously-compounded real (inflation-adjusted) returns to the S&P 500 by President:
The total returns earned during the first 20 months of the Obama Bull Market (25.9% nominal and 22.4% real) are the highest among the previous 4 presidents — Reagan, GHW Bush, Clinton, and GW Bush. Even more interesting, at the 20-month mark, the stock market had accurately predicted which Presidents would preside over the best — and worst — 5-year performance. The stock market rankings as of month 20 perfectly predict the 60-month performance, using both nominal and real returns.
Interpreting the above results using a “markets always know best” framework, one would conclude that a.) markets love Obama’s policies, and b.) the Obama Bull Market has several more years to run.
And what’s the morale of this little story? Oversimplifying economic theory — in this case, summarizing complex academic research into the “markets always know best” heuristic — can sometimes backfire; because, as Benjamin Franklin reminded us:
So convenient a thing it is to be a reasonable creature, since it enables one to find or make a reason for everything one has a mind to do.
Let’s all remember to theorize responsibly this Thanksgiving.