“We ARE the Market — If We Are Dumb,
the Market Is Dumb”

A neighbor recently sent me the following e-mail:

Heard a financial talk-show host say: “The 10 yr treasuries are at 3.15% and the 10 yr TIPS are at 1.75%. So the market’s read of inflation over the next 10 years is the difference between the two, that is 1.4%”. Then he kind of held a knowing pause.

Most people are worried about govt deficit spending bringing on inflation in a few years. How can the market be saying this and do you agree that the subtraction of those two payouts is an indicator of market sentiment?

Set forth below is my response:

This is an interesting question. My personal view is that no one alive today is a true “expert” on this sort of question because our collective knowledge of investing topics is not yet sufficiently advanced for the term “expert” to properly apply. I’ll offer you my take, for what it is worth.

The fellow on the financial talk show is right that comparing the pricing of Treasuries and TIPS indicates that “the market” is not anticipating huge inflation. If the market believed that inflation was going to be huge, it would demand a higher return for ten-year Treasuries because 3.15 percent would not be enough to make the buyer whole after experiencing the huge inflation. The TIPS owner is covered for inflation. The market is saying that not being covered for inflation justifies an additional interest payment of 1.4 percent. The suggestion is that the market anticipates inflation being somewhere in that neighborhood.

There are some details not being factored in here. But I think that the guy is generally presenting a logical case. What he is saying adds up IF you assume that the market is rational. 

My personal view is that the market often DOES NOT set prices rationally. This view of mine is extremely controversial. But I personally believe that I am right about this.

If the market does not set prices rationally, then what the guy is saying does not follow. The market might be setting those prices for all kinds of crazy emotional (NOT rational) reasons. I think that is probably what is going on. The TIPS market might be more rational than the Treasuries market. The buyers in the Treasuries market might just not be demanding enough of a return to justify the inflation risk they are taking on. It might be that there are some in the Treasuries market who are today so frightened of the idea of being in stocks (or who represent people who are frightened) that they are willing to take just about any return to avoid being in stocks (but who for some reason or another don’t care to be in TIPS).

Under the now-dominant theory of how investing works (the Efficient Market Theory), this cannot happen. When you look at the record, you see that it happens all the time.

Under the Efficient Market Theory, stocks were priced properly both In August 2008 and today. Yet the market capitalization of the U.S. market has dropped by about $8 trillion in that time. Has something happened to cause the market capitalization to drop that much in a rational sense? I say “no.” The market capitalization dropped because investors collectively became more negative in their EMOTIONAL assessments of future stock prices. There is of course some rationality that enters into these assessments. But I say that the emotional factors dominate over the rational factors.

The root question here is — What is “the market”? The suggestion in the fellow’s comments is that the market is some all-knowing being, that we had all better pay attention to what the market says because it surely knows better than any of us. The reality is that the market IS all of us — We ARE the market. If we are dumb, the market is dumb. If we are scared, the market is scared. The market is us and we do not gain any insight into how to invest by listening to the market (all we are doing when we do that is listening to ourselves, which means we are taking comfort that we are getting somewhere by running in circles). I say that we become effective investors by rising above the market’s mix of prejudices and marketing slogans and half-truths and learning how to rationally assess what is going on (the market as a whole is incapable of doing this because the market is too much influenced by the emotions which drive too many of those who participate in it — this will remain so for so long as the Efficient Market Theory remains dominant).

The market is like an opinion poll. It properly describes how large numbers of people respond to a particular question at a particular point in time. But there is little long-term meaningful content to either market assessments or the results of
opinion polls. Some little event can come along and cause opinion-poll results to swing from one extreme to another; Bush went in not too long a time from being one of the most popular presidents in U.S. history to being one of the least popular. It’s the same with market assessments of the appeal of various asset classes. What the market says today about Treasuries and TIPS is not necessarily anything in the same ballpark as what the market is going to say re this question one year from today. If you go by today’s opinion poll in making  a decision that you will need to stick with for 10 years, you may be disappointed to see how much the market assessment has changed in 12 months.

My bottom line is that what the guy is saying is LOGICAL but NOT ACCURATE. He is ASSUMING that the market is RATIONAL in how it sets prices. I do not view this as a proper assumption. Buyers need to make independent assessments (making an effort to be as rational themselves as possible) of the relative appeal of the two asset classes to know which offers the better long-term value proposition.

My personal take is that TIPS offer the better deal of these two possibilities because of the big inflation risk that you mentioned. That is NOT a prediction that there will be huge inflation. It is an assessment that there is enough of a risk of huge inflation that the investor needs either protection from inflation or a higher premium for giving up that protection than is being offered by Treasuries at the prices quoted by the financial talk-show host.

Rob

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