I’ve posted Entry #169 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s called An Alternative to Fama’s Explanation of Short-Term Price Changes That Also Fits Shiller’s Finding of Long-Term Return Predictability.
Juicy Excerpt: A perfectly rational market would indeed produce short-term randomness. But so would a perfectly irrational market. It is impossible to predict returns that are produced by unforeseen economic and political developments. But it is also impossible to predict returns that are produced by crazy shifts in investor emotions. Fama’s finding that short-term price changes are random supports the idea that the market is highly emotional every bit as much as it supports the idea that the market is highly efficient.
The difference between the two explanations is that Fama’s explanation for short-term randomness is discredited by Yale Economics Professor Shiller’s finding that long-term returns are highly predictable while the explanation that I am putting forward here is consistent with Shiller’s finding. Say that the market is highly emotional in the short term and that is why prices are random in the short term. Could prices be predictable (non-random) in the long term? They could. It could be that there is a second influence on prices that has little or zero effect in the short term but that comes to play a significant role in the long run.
I believe that investors are influenced both by emotions and by economic realities. They generally ignore the economic realities in the short term. But it takes more and more effort as time goes on for investors to push the common-sense realities out of mind. Eventually (it often takes 10 years or so for this to happen), the realities assert themselves. That’s when we see price crashes pulling stock prices back to where they would have been all along had investors made more of an effort to rein in their emotions.