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9:00am  Monday  June 8, 2009

All available information is already in the stock price! Do you believe this? It’s called the efficient market hypothesis. The thing about hypotheses is that you choose one of two answers – accept or reject – after you’ve made your observations.

I for one am not a firm believer that all available information is in a stock price.  The time element, trading liquidity and market psychology are some subjective factors that are ever changing.  So, if there are always moving variables affecting stock prices, will all information available always be built in the price? I seriously doubt it.

The behavior of the crowd or herd mentality is another powerful factor that seriously affects stock prices.  Ever think why stocks become expensive (very high Price/Earnings or Price/Book ratios) when the market bullish or the other way around when the market is bearish.

Over the weekend, I read a New York times article describing how a present day fund manager – Jeremy Grantham – and a Time Magazine business columnist – Justin Fox, have expressed their contrary beliefs to the efficient behavior of the financial markets. Mr. Grantham said that he had always doubted the Efficient Market Hypothesis which was a theory that grew out of the University of Chicago’s finance department and long held sway in academic circles.  Justin Fox, on the other hand, recently wrote a book entitled “The Myth of the Rational Market.” Their common issue was the periodic development of stock market bubbles such as the bubble of 2000 and the recent derivatives bubble. How can efficient and rational markets countenance such extreme swings where stock prices go way ahead of values. The irony of it all is that investors have seen so many bubbles, yet the greater majority fail to recognize the one they are currently blowing.

Why am I talking about stock market bubbles when we have just come off the bottom of a major crash? Well, I merely want investors to examine their motives in entering the market. So far, we have had a good run from very undervalued prices to seemingly overvalued ones. Markets have rallied on the belief that the worst in the global financial markets are over, and because the markets are no longer falling, they must rise. Markets have in fact risen, but should they really keep on going the other way indefinitely. Does that make sense?

Justin Fox may truly be correct in saying that rational behavior of markets is a myth. Right now, it looks like a pack of wolves going after the only gazelle in sight. At least, that is what the Philippine stock market looks to me like. Everyone sees a killing to be made, so everyone’s out there chasing whatever is liquid or whatever is moving. It doesn’t look rational to me nor do I think that current prices of some stocks reflect their fair value already.

I think investors should start questioning their motives for buying right now. If it’s because they think that if they don’t buy now, there will be no other opportunity to buy stocks cheap, well think again. The “E” in P/E is still in question and if we see another weak quarter in the economy, we may not see that “E” where we think it should be.

Rationality? Common Sense? My high school teacher used to say that common sense was not at all common. I wonder.

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