"... markets can remain irrational much longer than an investor can remain solvent ..."John Maynard Keynes - Economist
In the chapters on interest rates and financial markets, Keynes makes the point that if we all had perfect knowledge of how the markets operate, then this impact on interest rates would create a yield curve that looked like a step function. However, because we all have different financial, economic and political opinions that influence our decision making processes, it is our rational expectations that drive us to have a different rate expectation to the next person. Thus with a multitude of different rate expectations, influenced by a myriad of different economic and business views, the yield curve is a curve or slope rather than a sharp step function that changes at the point of perfect knowledge. Because of the multitude of different expectations about rates, the step function is "smoothed" out to give a curve.
Taking stock prices as an example, if we all had perfect knowledge, stock prices would stay at the same price until there was a change in some exogenous and influential variable that then lead to the change in the stock price. If we graphed these changes in the stock price over time we would see that it looks very much like a step function and if we all had perfect knowledge of the markets we would all buy or sell that stock at the same time as the change took place. This would reflect perfect knowledge and an arbitrage free market.If we take a look at National Australia Bank, (NAB), over the past five months we can see that back on the 21st May 2010, NAB completed a Wave 3 decline and began to retrace into a rising Wave 4. As we have discussed in many posts over the past five months the Wave 4 failed on numerous occasions.
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| NAB 15th October 2010 (click chart to expand) |
Keynes idea of rational expectations has a lot to answer for here. If the market, or in this case NAB, were arbitrage free and market makers and investors alike had perfect knowledge, then under Elliott Wave theory, once the wave three was over, wave four would begin and retrace back up by 38% and then a declining Wave 5 would begin.
But is this what happened. Did the stock move to the theoretical point where the rational trader expected the price to go then turn in the opposite direction ?, No. This is not what is happening, and it is because every market participant trading NAB has a different view of what is going on as well as what key impacts are likely to effect NAB's stock price on a daily basis. Primarily we have seen in the USA in particular, that the market at present is very news driven. In fact over the months of August, September and October, bad economic results for employment, retail sales and GDP were announced and the volatility soared as prices plummeted. Whilst a day later,there was some good news announced on the market, such as a company listed on the DOW posting a favourably revised profit outlook, and markets claimed back all the points they lost the previous day. Where is the rationale in these radical and highly volatile market moves. At this stage of the economic cycle, these moves are unpredictable and often irrational.
In NAB's case the Elliott wave begins the expected retracement, then unexpected news out of Europe, China or the USA changes the whole ball game. At first blush the news may seem important enough to shift the market but on deeper analysis the logic just does not stack up and you are left with an inexplicable market move that will very likely reverse heavily on the coming days to reclaim the original market position.
There is often very little rhyme or reason in these market movements. Certainly not prefect knowledge and certainly not rational expectations. This is why Keynes made the comment that markets can stay irrational longer than investors can remain solvent.
As far as NAB goes the battle for the endless Wave 4 retracement, five months in the making so far, goes on and we continue to live in the hope of a rational expectation.
Cheers
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