Efficient Market Hypothesis

Efficient Market Hypothesis: True “Villain” of the Financial Crisis?

By Robert Folsom

When a maverick idea becomes vindicated, there’s a good story to tell. It usually involves a person (or small group of people) who courageously challenge the orthodoxy of the day — and, over time, the unorthodox yet better idea prevails.

A “good story” of this sort has surfaced during the current financial crisis. A chapter of the story appeared in a recent New York Times article, “Poking Holes in a Theory on Markets.” The theory in question is the efficient market hypothesis (EMH), which the article suggested is so hazardous that it “is more or less responsible for the financial crisis.” This quote tells you most of what you need to know:

“In the last decade, the efficient market hypothesis, which had been near dogma since the early 1970s, has taken some serious body blows. First came the rise of the behavioral economists, like Richard H. Thaler at the University of Chicago and Robert J. Shiller at Yale, who convincingly showed that mass psychology, herd behavior and the like can have an enormous effect on stock prices — meaning that perhaps the market isn’t quite so efficient after all. Then came a bit more tangible proof: the dot-com bubble, quickly followed by the housing bubble. Quod erat demonstrandum.”

In case your Latin is rusty, Quod erat demonstrandum means “which was to be demonstrated.” Its abbreviation (QED) appears at the conclusion of a mathematical proof. In this case, the massive financial bubbles of recent years are the proof that refutes the efficient market hypothesis, which argues that markets move in a “random walk” and are not patterned.

Similar articles in the financial press have reported the demise of the EMH. Just this week an Economist magazine blog included this bold declaration:

“No one has yet produced a version of the EMH which can be tested and fits the evidence. Thus, the EMH must logically be discarded, as a valid hypothesis must be testable.”

QED, indeed — I agreed years ago that the random walk was implausible. But I didn’t come to this view because of behavioral economists, although their work over the past decade has certainly been valuable. Instead, I was persuaded by the work of someone who first challenged the financial orthodoxy more than three decades ago, specifically April 1977. As a young technical analyst at Merrill Lynch in New York, his research circulated among several of Merrill’s clients. His name for these studies was the Elliott Wave Theorist: the April ’77 study was a detailed analysis of the 1975-76 stock market, which offered this comment on the random walk model:

“If market moves are arbitrary (as the random walk proponents suggest), then internal components would rarely ‘make sense’ mathematically, and then only by statistically insignificant fluke occurrences. However, there seems to be enough evidence that mass psychology, as recorded in the Dow Jones Industrials, form patterns that are uncannily interrelated….At least this much can be fairly reliably stated as a result of this work: This idea that the market is a ‘random walk’ is probably false.”

Robert Prechter left Merrill soon after; he has published the Elliott Wave Theorist in every month since. Every issue has, in one way or another, “convincingly showed that mass psychology, herd behavior and the like can have an enormous effect on stock prices.”

So while there may be a good story to tell about behavioral economists, I trust you see why I believe there is a vastly better one to tell.

The “enormous effect” of “mass psychology” and “herd behavior” is exactly what explains the financial downturn that began in late 2007. Prechter’s Elliott Wave Theorist anticipated the crisis and warned subscribers beforehand. Likewise, he alerted them to the bear market rally that began last March.

Editor’s Note: The following article discusses Robert Prechter’s view of the Efficient Market Hypothesis. For more information, download this free 10-page issue of Prechter’s Elliott Wave Theorist.

Hot Stocks Watchlist

Here, we list stocks for which a buy signal was generated but can’t be added to our portfolio because all 10 positions are taken or the overall market conditions are against us (usually during severe market corrections).

There will be no historical returns or statistics for the stocks on this list but we will monitor them on a daily basis and they will be removed from the watchlist as soon as a sell signal is generated by our system.

Last updates:
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Best Stock August 2009

The best hot stock to buy this month is DGT (Dollar Thrifty Auto Group Inc).

Dollar Thrifty Automotive Group, Inc., through its subsidiaries, rents and leases vehicles through company owned and franchised stores under Dollar and the Thrifty brand names primarily in the United States and Canada. It also operates a franchised retail used car sales network.

Hot Stocks Portfolio

Our portfolio lists the top 10 best stocks to buy right now (according to our trading system). Each position represents 10% of the portfolio value at the time of purchase.

Returns are net of fees and taxes.

The buy price is the next market open price after the buy signals were issued, posted on the website and sent to our members.

Last price is the most recent closing price.

Each position is monitored on a daily basis and a sell signal will be issued after market closes, when the up trend is over.

Our portfolio can also hold cash and even go 100% in cash during adverse market conditions.

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Latest Trading Alerts

Here are our latest buy and sell signals. They are also sent by email to all our members.

A new signal is usually added after the market closes and is valid for the next day. The posted date represents the day when the signal is valid, not the day it was posted.

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The Bounce Is Aging, But The Depression Is Young

By Bob Prechter

The following is an excerpt from Robert Prechter’s Elliott Wave Theorist.

On February 23, EWT called for the S&P to bottom in the 600s and then begin a sharp rally, the biggest since the 2007 high. The S&P bottomed at 667 on March 6. Then the stock market and commodities went almost straight up for three months as the dollar fell.

On March 18, Treasury bonds had their biggest up day ever, thanks to the Fed’s initiating its T-bond buying program. The next day, EWT reiterated our bearish stance on Treasury bonds. T-bond futures declined relentlessly from the previous day’s high at 130-15 to a low of 111-21 on June 11.

That’s when there were indications of impending trend changes. The June 11 issue called for interim tops in stocks, metals and oil and a temporary bottom in the dollar. The Dow topped that day and fell nearly 800 points; silver reversed and fell from $16 to $12.45; gold slid about $90; and oil, which had just doubled, reversed and fell from $73.38 to $58.32. The dollar simultaneously rallied and traced out a triangle for wave 4. Bonds bounced as well. As far as I can tell, our scenarios at all degrees are all on track.

Corrective patterns can be complex, so we should hesitate to be too specific about the shape this bear market rally will take. But from lows on July 8 (intraday) and 10 (close), the stock market may have begun the second phase of advance that will fulfill our ideal scenario for a three-wave (up-down-up) rally. In concert with rising stocks, bonds have started another declining wave, and the dollar appears to have turned down in wave 5 (see chart in the June issue), heading toward its final low. Although commodities should bounce, their wave patterns suggest that many key commodities will fail to make new highs this year in this second and final phase of partial recovery in the overall financial markets.

Meanwhile, our forecast for a change in people’s attitudes to a less pessimistic outlook is proceeding apace. Here are some of the reports evidencing this change:

More than 90 percent of economists predict the recession will end this year. [The] vast majority pick 3rd quarter as the time. (AP, 5/27)
Manufacturing and housing reports this week may offer signs that the recession-stricken U.S. economy is within months of hitting bottom, economists said. (USA, 6/15)

Fewer people say they’ve prospered over the past year than in decades, a USA TODAY/Gallup Poll finds. Over the past two months, however, expectations for the future have brightened significantly amid rising optimism about a stock market rebound and economic turnaround. “I think the administration is going in the right direction,” says… Now 36% of those surveyed in the Gallup-Healthways well-being poll say the economy is getting better. That’s not exactly head-over-heels exuberance, but it is double the number who felt that way at the beginning of the year and a notable spike in the nation’s frame of mind. Thirty-three percent say they’re satisfied with the way things are going in the United States; in January, just 13% did. (USA, 6/23/09)

If only to confirm the socionomic causality at work, an economist quoted in the article above muses, “The one anomaly in the puzzle is that people shouldn’t be feeling better because the jobs market is so terrible and unemployment is likely to keep rising.” Of course it would be an anomaly, and people should not feel better, if mood were exogenously caused. But it is endogenously regulated, and it precedes social actions, which produce events such as job creation and elimination. That people feel better is evident in our rising sociometer, the stock market. If the rally continues, economists will soon agree that the Fed’s “quantitative easing” and Congress’ massive spending are “working.” Those predicting more inflation and hyperinflation will have the last seeming confirmation of their opinions. Then, a few months from now, some economists will probably express similar puzzlement when the stock market starts plummeting again despite the fact that the economy has improved.

But all of these considerations are temporary. Conditions are relative, and behind the scenes, the depression has been, and still is, grinding away.

For more information, download the FREE 10-page issue of Bob Prechter’s recent Elliott Wave Theorist. It challenges current recovery hype with hard facts, independent analysis, and insightful charts. You’ll find out why the worst is NOT over and what you can do to safeguard your financial future.

Closed Trades

Returns are net of fees and taxes. The entry price is the next open price following our buy recommendation.

2010 return: -34.96 %

2009 return: 36.72 %

2008 return: 46.74%

Symbol	Entry Price	Exit Price	Entry Date	Exit Date	Gain/Loss (%)
2011
CBS	28.21	26.73	07/20/2011	08/03/2011	-5.53
GGC	37.25	34.57	03/31/2011	05/05/2011	-7.19
WLK	54.82	58.71	03/28/2011	05/05/2011	7.10
JAZZ	34.44	32.07	04/21/2011	04/29/2011	-6.88
AH	27.06	26.14	03/30/2011	04/26/2011	-3.40
OME	14.89	13.68	04/07/2011	04/25/2011	-8.13
AGP	62.28	61.40	03/29/2011	04/19/2011	-1.41
ACHN	6.83	6.55	03/28/2011	04/15/2011	-4.10
SRZ	12.34	10.66	03/31/2011	04/05/2011	-13.61
2010
HTWR	72.61	61.57	06/30/2010	07/20/2010	-15.20
UPI	5.74	3.76	05/18/2010	07/20/2010	-34.49
CVGI	11.87	11.45	05/11/2010	06/02/2010	-3.54
PCYC	5.04	6.99	02/09/2010	05/12/2010	38.69
LLEN	12.71	9.89	04/06/2010	05/06/2010	-22.19
MSPD	6.80	7.80	02/02/2010	04/06/2010	14.71
DAN	12.01	9.84	01/06/2010	02/09/2010	-18.07
NVMI	6.31	4.30	01/11/2010	02/04/2010	-31.85
TSTC	22.94	13.33	01/05/2010	02/01/2010	-41.89
MED	17.26	22.29	09/03/2009	01/19/2010	29.14
AIXG	21.19	30.22	08/28/2009	01/19/2010	42.61
2009
SMED	9.46	8.96	08/10/2009	11/10/2009	-5.29
SWM	32.20	18.55	07/21/2009	11/03/2009	56.24
YONG	11.98	8.92	10/14/2009	11/03/2009	-25.54
DTG	13.59	18.55	07/07/2009	11/02/2009	36.50
SCLN	5.00	4.04	09/11/2009	10/02/2009	-19.20
STEC	34.52	30.98	07/27/2009	09/24/2009	-10.25
CLW	44.86	44.01	08/10/2009	09/22/2009	-1.89
BIOS	6.21	5.65	07/17/2009	09/02/2009	-9.02
KONG	6.06	12.09	04/22/2009	08/28/2009	99.50
GMCR	53.30	58.90	05/11/2009	08/24/2009	12.42
KIRK	13.90	11.81	08/10/2009	08/24/2009	-15.04
SIGA	6.20	6.97	04/27/2009	08/17/2009	12.42
FIT	6.52	5.93	07/29/2009	08/07/2009	-9.05
STAR	16.04	22.41	03/10/2009	08/07/2009	39.71
PEGA	18.73	25.37	03/27/2009	07/21/2009	35.45
CENTA	8.79	11.07	04/27/2009	07/20/2009	25.94
ARO	29.91	33.63	04/15/2009	07/06/2009	12.44
DBRN	14.91	14.61	04/22/2009	07/01/2009	-2.01
DRIV	33.35	37.23	04/22/2009	06/30/2009	11.63
GSBC	22.31	18.89	05/29/2009	06/23/2009	-16.14
HGG	16.75	14.91	04/15/2009	05/22/2009	-10.99
SXCI	21.25	17.87	04/01/2009	04/30/2009	-15.91
AIPC	24.45	28.50	01/22/2009	04/27/2009	16.56
APOL	80.50	65.54	01/29/2009	03/05/2009	-18.58
ORH	53.71	41.71	01/06/2009	03/04/2009	-22.34
ENDP	24.00	19.04	12/22/2008	03/02/2009	-20.67
EBS	20.19	22.49	11/14/2008	02/19/2009	11.39
QCOR	8.30	7.25	11/14/2008	02/10/2009	-12.65
2008
LG	51.11	47.29	11/10/2008	12/10/2008	-7.47
CRD.B	16.53	10.01	09/26/2008	10/10/2008	-39.44
FSYS	56.95	37.50	08/13/2008	09/30/2008	-34.15
MITI	6.50	4.60	08/29/2008	09/23/2008	-29.23
SCL	58.46	58.58	08/06/2008	09/23/2008	0.21
SQNM	21.86	20.45	07/24/2008	09/22/2008	-6.45
AFAM	39.62	38.51	08/07/2008	09/18/2008	-2.80
PPO	27.12	21.31	08/28/2008	09/16/2008	-21.42
IPHS	36.67	29.43	08/07/2008	09/16/2008	-19.74
ISYS	48.52	18.90	08/06/2008	09/09/2008	-22.09
GHM	84.03	71.01	07/28/2008	09/05/2008	-15.49
CYBX	27.52	20.40	07/24/2008	08/29/2008	-25.87
FLIR	41.50	39.74	07/24/2008	08/04/2008	-4.24
ANR	40.49	104.62	03/03/2008	08/01/2008	158.38
CLR	25.07	55.00	02/01/2008	07/30/2008	119.39
GMXR	72.27	63.60	07/21/2008	07/29/2008	-12.00
POT	146.50	198.74	01/02/2008	07/29/2008	35.66
CWEI	115.31	90.03	06/24/2008	07/29/2008	-21.92
HK	46.00	33.11	07/16/2008	07/29/2008	-28.02
JRCC	11.18	38.00	01/02/2008	07/23/2008	239.89
BZP	11.28	20.80	01/02/2008	07/23/2008	84.40
PCX	95.49	116.08	05/28/2008	07/23/2008	21.56
WLT	35.94	86.49	01/02/2008	07/18/2008	140.65
MOS	95.73	127.90	01/02/2008	07/18/2008	33.60
CMP	61.16	72.60	03/14/2008	07/16/2008	18.71
SID	29.91	41.82	01/02/2008	06/24/2008	39.82
WSCI	12.65	11.99	04/11/2008	05/28/2008	-5.22
OFG	13.35	20.3	01/02/2008	04/11/2008	52.06
PRXL	24.16	26.85	01/02/2008	03/14/2008	11.13
AUXL	29.98	32.04	01/02/2008	03/03/2008	6.87
MHS	50.76	50.19	01/02/2008	02/01/2008	-1.12