Technical Review

Markets Fail to Discount Forks in the Road

One of the most widely accepted axioms on Wall Street is that markets are a discounting mechanism. It implies that markets possess a form of collective wisdom and those who listen to the “message of the market” are “smart” investors.

Copper is reputed to have a Ph.D. in economics because of its ability to predict turning points in the global economy and is therefore referred to by some market strategists as “Dr. Copper.” Investors in the bond market are considered by some as more astute than stock market investors. An increase in bond yields is interpreted as a reliable sign of improving economic growth, while a decline in bond yields suggests growth is faltering. When bond yields declined and the stock market rose in the first half of 2021, some stock market investment professionals worried that the bond market was revealing something negative about the economy that the stock market was overlooking. The stock market continued to go up anyway.

I find the almost universal blind faith that markets are a discounting mechanism perplexing for one reason.

At every major top and bottom, markets are always wrong. Not sometimes wrong—always wrong.

And the amazing thing is that this truism isn’t just limited to the stock market. Here are some examples:

  • Was the bond market telling us in 1981 that Weirmar Republic inflation was right around the corner after Treasury yields jumped to more than 15%?
  • When gold leapt to more than $1,900 per ounce in September 2011, was it forecasting that the increase in the Federal Reserve’s balance sheet was about to cause hyperinflation?
  • When the Dow Jones Industrial Average and S&P 500 Index were making new all-time highs in October 2007, was the stock market flashing an all-clear sign about the housing market and the economy?
  • As equities were plunging into the depths of a bottomless pit in March 2009, was the stock market discounting Armageddon and the end of civilization as we knew it?
  • The market in all of its wisdom certainly took good care of all those lucky homeowners who purchased a home in the spring of 2006!

At every major top and bottom, markets are always wrong. Not sometimes wrong—always wrong. At tops and bottoms, Contrary Opinion is superior. When 9 out of 10 investors have bought or sold, buying and selling power is nearly exhausted, which is why a reversal in trend often follows.

So the next time you hear an “expert” on Bloomberg or CNBC say that the stock market or bond market is discounting the future or anticipating some future event, I would suggest you remember this analogy.

The expert and you are in a car and the expert is driving. After awhile, you notice that the expert is driving the car by looking through the rearview mirror. Concerned you ask him why he’s not looking ahead as he drives. He replies that there is nothing to worry about since he can see that the road we’re driving on is straight. The expert believes that the straight road he sees in the rear view mirror is discounting the straight road ahead. By the time the curve in the road appears in the rearview mirror, the car you’re in is hurtling toward an unwelcome outcome.

The trend is your friend—until it isn’t. Markets don’t discount the future, but they do an excellent job of discounting the past. But, we already knew the past, didn’t we?

Jim Welsh

About the Author

jimwelshmacro [at] gmail [dot] com ()