A short explanation for those who are not familiar with the Star Trek TV and film franchise: Mr. Spock is the science officer and second in command aboard the starship USS Enterprise; his mother was human while his father was a Vulcan, a race that managed to save itself from violence and war only by turning to hyper-rationalism. Spock’s human half, of course, is emotional and irrational and his logical side struggles to keep it under control.
Once you think of Mr. Market as Mr. Spock, the raging disconnect between the economy and equity prices becomes easier to grasp. Consider the following points:
Investors are rational
Much of the time, markets are understandable and make intuitive sense to investors. When the economy is expanding and profits are rising, so do stocks. If the economy tanks, shares plunge. There are long periods when stocks meander higher, reflecting positive developments in technology, taxes and inflation. This is the Vulcan logic of equities, reflecting investors’ rational, quantitative calculations of value.
Investors are irrational
Sometimes, markets seem to bounce from giddiness to panic almost overnight. It is especially obvious at turning points: Recall the March 2000 dot-com highs, when new companies were trading at 100 times earnings. Or the March 2009 financial-crisis lows, when prices were cut in half and selling was indiscriminate. The points where groupthink takes over the crowd, where emotions run rampant and greed and fear can overwhelm investors – that’s the human half at work.
It is rare to hear someone asked a question about a market move and not give a detailed after-the-fact explanation. Few are willing to admit that they really don’t know or that many market moves are simply random.
The Nobel Prize committee recognised these two opposite forces in 2013. [By awarding the Nobel Prize to both Eugene Fama and Robert Shiller, the committee acknowledged this schism. Fama’s thesis was that the pricing mechanism of markets were so efficient that they were difficult (if not impossible) to beat; Shiller’s data overwhelmingly showed that markets could be as irrational as the humans who traded in them. Bubbles form, prices detach from reality, then crash.
Most recently, we’ve seen this with day traders buying bankrupt companies because their prices are rising while others sell quality holdings at very low prices because others have also done so. Irrational investors create opportunities for those few who recognise this.
Markets are efficient
The volume of information is so enormous, it can never be fully grasped by one person. Yet prices reflect all of what is known, which gets communicated to all participants through the impact of buying and selling.
Price, in other words, is the most efficient collective probability bet about the future. Very rational, indeed.
Markets are very inefficient
Efficient, yes, except when those efficient expressions turn out to be wildly wrong. Note this is not when a trade turns out to be a money-loser. Rather, it’s when the analytical framework underlying the trade turns out to be completely unfounded.
This is where our emotional half sends the rational half off the rails. Rather than describing markets as efficient, it is more accurate to describe markets as efficient except when they’re not.
Most investors do not know they don’t know:
Most explanations of recent market behaviour reflect hindsight bias detailing what everyone now knows. It is rare to hear someone asked a question about a market move and not give a detailed after-the-fact explanation. Few are willing to admit that they really don’t know or that many market moves are simply random.
Here, Mr. Spock is quite different. He often notes his lack of understanding with a simple response of “fascinating.” His logic and ego control allow the admission of not knowing. He is subject to the Dunning-Kruger effect much less than most. Investors often get into trouble when they imagine they have an understanding about things they don’t.
Spock’s mixed human-Vulcan heritage was a great plot device that allowed Star Trek to subtly comment on the human condition, exploring the tension between logic and emotion, between our intellectual capacities and our baser drives.
Investors who recognise and take account of the Spock market will better understand what is going on, and – one can hope – use it to guide their actions for better results.
Ritholtz is a Bloomberg Opinion columnist. He is chairman and chief investment officer of Ritholtz Wealth Management, and was previously chief market strategist at Maxim Group. He is the author of “Bailout Nation.”