Investors in the second group, the non efficient crew, then base their investment decision on these overbought or oversold conditions, which is a rational decision. of sorts.  However, this line of thinking creates some fairly irrational pricing in the capital markets.

Small investors are, generally speaking, not nearly as effective in the trading skills and buy and sell for a variety of reasons ranging from educated guesses, a hunch they may feel, or advice from a third party who may, or may not, possess any real investment expertise.

Through in the hedge funds, quants and others of the computerized trading ilk and you end up with a hodge podge of investors all chasing potential profits.  Of course, they have all approached their market buying decision through different methodologies.  Nonetheless, they are all after the same goal.

The Fed’s economic policiy has to be thrown into the mix, at this point, as they use market measures to control inflation and unemployment.  The critics of the Fed’s actions are legion, with good reason.  It would seem that often do as much harm as good…just the same they are major players in the overall market scheme.

This begs the question for the trader:  Is the Market Wrong at Times?

Well, the answer is an easy one.  The market is always right, and if you trade why you think is right versus what the market has deemed to be right you are in for an unprofitable ride.  I always have to whisper to myself:  “The market is always right, and I am always wrong.”  This is a very tough pill to swallow, especially if you know a bit about economic theory and the way things “ought” to act given a specific set of variables.  Wrong. Wrong. Wrong.

Trade the market, not the news, not economic theory, not the general consensus not anything but what you see on the chart.  The Efficient Market Theories have one tenet quite right…there is a degree of randomness in the market that cannot be ignored, and the market often wanders in a direction that departs from common knowledge or well thought out economic principle.

The market is always right, because you have to trade exactly the price action on the market.  This makes life as a market scalper much simpler, as I don’t have to make intermediate and long term prognostication on the movement of the equity markets.  No, I am generally looking at what the market might do in the next five minutes, and that is a far easier proposition than the long term.

With the recent spate of bubbles in various equity markets the venerable efficient market theory and it’s corollary CAPM have come under vicious attack by a variety of academics who bear witness to the problems the theory presents.  The least of the problems lies in the very fact that it doesn’t work very well, especially when working with “long tails”: those ticklish anomalies that are ably described by Benoit Mendelbrot in “The Misbehavior of Markets.”

But academics don’t let loose of accepted ideology without a fight, despite a litany of  failures in the Efficient Market Theory’s predictive ability.  It is, at best, a dying testament to an irrational explanation, from an economic standpoint, to the inner workings of our equity markets. If a theoretical approach is not firmly grounded, it is not surprising that the predicted consequences that flow from it should fail to show up consistently in the way that investors and markets actually behave.  Such is the plight of Efficient Market Theory, and economist are scrambling for some sort of working model on the machinations that take place in the equity markets, and markets as a whole.  The idea of “rational investors” seems to have taken a terrible beating of late, but the question of completely abandoning EMT is beyond the scope of many economists and academic thinking.  After all, this theory has been doled out piecemeal to college students for decades as the “Holy Grail” of investing theories.  I suspect it’s demise will be a slow one, as academics are not fond of saying, “Geez, we were completely wrong on this one.”

Enter now, from stage left, the Adaptive Market Hypothesis.  The attempt to bring order and an overarching theoretical framework into analysis of the seemingly unruly behaviour of financial markets was a temptation that has for years proved too great for academics (and many market participants) to resist, but it has turned out to be a long and largely fruitless journey.  And Montier is none-too impressed with AMH:

“However, we are less convinced that AMH is a terribly useful concept. As we understand it, the AMH provides a halfway house where sometimes markets are irrational and sometimes they are rational. We would argue that the amount of time that markets are rational is near negligible. Instead markets seem to be in a constant state of disequilibrium – moving from boom to bust and back again, rarely if ever stopping off at “normal”.

If, as one of us has recently argued (Insight, June 25), the efficient markets hypothesis is the financial equivalent of a dead parrot, then the AMH may be a dodo.”

And so the quest to find a neat explanation for the way the market functions continues, without any real progress.  It seems most of the current literature spends hours debunking current theory and offers little in the way of explanation.

Why?

Mendelbrot had the problem pegged long ago, chaos and randomness…there has been no real explanations because a degree of randomness exists in the market and it is difficult to account for irrational behavior, or market noise.  Yet within this randomness certain substructures exists, fractals, and they are like signposts on a twisting winding road to nowhere.  The problem is simple, human nature has a hell of a time accepting randomness, surely, many argue, there must be some order in a disordered market.

The argument ranges on, and always will.

First and foremost, trading emini contracts does not necessarily make sense.  By that, it is difficult, if not impossible to apply common sense to analyzing a chart.   The markets are ruled, to a certain degree, by randomness and this variable makes accurate predictions based upon common sense nearly impossible.  For example, in times of higher inflation or, at least, the perceived potential for higher inflation, hard assets like real estate and metals ought to rise in price.  Yet the correlation between these two variable is not necessarily valid, and there are countless examples of sharp divergences in what common sense ought to hold as true.

Often times, a very negative report on employment in our country puts one in the mindset that the market ought to react negatively on the market.  After all, less people working equate to less money available for the public to spend on goods and services.  Nope, time after time the market chooses to ignore bad news and continue along its merry way. It can be very frustrating.

So we can rule out an investment style based on what “ought” to happen and accept that there is some degree of randomness, or chaos, that exists in the market.  Though I would not forward the notion that the market is completely chaotic or completely random.  No, there is something there, some information to be mined.

On the other hand you could listen to the news media or listen to your good friend Earl (or any other good friend, you pick a name) and base your investments upon hearsay and anecdotal advice.  Hmmm…even at face value a rational person will stray from this investment style.  The news media is rife with churned news and conjecture and your buddy Earl probably isn’t the Holy Grail of investing, even though he may believe he truly is enlightened.

You might also decide to purchase an “out of the box” system of trading for thousands of dollars and the purveyor of that system will think quite highly of you.  Unfortunately the success rate on these systems is suspect and the methodology is proprietary.  You are not going to learn much with this approach, just trade when certain indicators say it’s time.  I can’t recommend this approach either.

There are countless pitfalls to successful trading, and they all contribute to the 90% failure rate I mentioned at the beginning of the post.

So what do you do?

Learn to trade.  Isn’t that a crazy sounding idea, but the problem lies in the proliferation of hundreds of different styles of trading.  Some are very successful, some are less than successful.  You need to become a student of trading, and read, practice and paper trade.  You need unbiased advice, you need fundamental advice that will help you accept or reject certain tenants of a given trading systems.  For example, I scalp trade and never hold a trade overnight.   This system suits my personality and trading philosophy.

You need to develop a trading philosophy to integrate into your trading…if you are simply going to scan charts looking for “good trades” you will quickly find yourself in the 90% group.  You must have, in your own mind, a sound understanding or interpretation of the way the market actually works, then integrate that philosophy into your trading style.  There is a difference between trading philosophy and trading style, though the two go hand-in-hand.  Trading philosophy entails a broad view of the functioning of the markets you trade, trading style is the implementation of your broad view of the manner in which the market functions.

Never stop learning and always be open to new ideas, lifetime students become very successful traders.   As always, Good luck in your trading.