Much of classic economic theory is based on the study of equilibrium positions. This contends that as a commodity rises more sellers will come into the market and as it falls more buyers will come in. This will occur until the commodity or security reaches its " fair value ".
This also the basis of "perfect competition." The theory states that under certain circumstances the unrestrained pursuit of self-interest leads to the optimum allocation of resources. The equilibrium point is reached when each firm produces at a level where its marginal cost equals the market price and each consumer buys an amount whose marginal "utility" equals the market price. This theory, however only holds true if:
The participants have a "perfect knowledge."
The products are homogenous and divisible.
There are a large number of participants.
No single participant can influence the market.
Events over the last 3 years have taught us that the market participants' is anything but perfect. Indeed activities have shown us that the inadequacies of the participants have led to many of the problems. Soros calls this his " Theory of Reflexivity" and he states that it is this that renders equilibrium unattainable. This can be seen in the following examples:
EBITDA
The use of Earnings before Interest, Tax, Depreciation and Amortisation
was a tool invented by accountants and analysts to justify the high valuations
of tech companies that made no money. As Warren Buffet quotes: "References
to EBITDA make us shudder- does management think the tooth fairy pays
for capital expenditure?"
SHARE OPTIONS
A large amount of companies, mainly in the US, have issued significant
amounts of share options. Under US accounting rules these are not thought
of as an expense. Once again I will use a quote from the master: "If
options aren't a form of compensation, what are they? If compensation
isn't an expense, what is? And if expenses shouldn't go into the calculation
of earnings, where in the world should they go?"
PENSIONS
Again the US has led the way in pensions trickery. US rules dictate that
in preparing income statements, companies should include estimated gains,
not actual gains or losses, from pension fund investments. This allows
companies to put pension "earnings" as income and has been much
abused. According to its annual report released in March 2002,
Verizon Communications had a strong year in 2001. In the opening pages of its report, the company announced an annual profit of $389 million. If one went through the small print in the document you would have learned that reported earnings included $2.7 billion in gains from its pension fund investments; profit that didn't really exist. The company pension fund actually lost $3.1 billion in 2001.
As I write this the S&P is at 985. According to market analysts it is trading on a Price to Earnings ratio of roughly 22 times. However if one were to strip out share options and pensions earnings the figure balloons to 48. Now how efficient is that!
As traders we need to understand that the markets are inefficient in order to make money. During the late 90's a number of analysts and hedge fund traders thought that the rise of the tech market was irrational and sold into the move. Though they were eventually proved correct they had by that time lost all their money. They went against one of the cardinal rules of trading. THE TREND IS YOUR FRIEND.
The inefficient nature of the markets insures that there are large fluctuations; boom and bust.
But, MORE IMPORTANTLY once we as traders completely accept the premise that the markets are not efficient and are hardly ever rational we can gain the necessary skills to profit from these large fluctuations: