Elliott Wave InternationalmyEWISocioniomics.Net
Home > Stocks

The "Rational Bubble" Theory Goes Bust
Bob Prechter's Theorist Asks: Is the Herd EVER Rational?

By Nico Isaac
Mon, 25 Apr 2011 17:15:00 ET
Add to Facebook Add to Twitter Email to a friend Printer Friendly

The Efficient Market Hypothesis (EMH) was the holy grail of finance for a generation of academics and Wall Street money managers. And what EMH says is simple:
 
  • Knowledge and reason are the basis of investor decisions
  • Equilibrium is the natural state of stock markets
  • Even the occasional booms and busts known as bubbles are, in their own way, based on rational risk assessments.
How often did you hear the phrase "Rational Bubble" used in 2006 and early 2007, to describe the speculative fever in stock prices, credit, and home values? The phrase was consistent with the EMH, which said that because the bubble was born of "rational" risk-taking, its undoing would be gradual. The euphoria would be tamed by a "healthy correction" (or "soft landing"), and ultimately a "return to normalcy."

In truth, there was nothing "gradual" about how the real bubble really ended: the most sustained stock market decline since the Great Depression, the worst real estate crash in living memory, and the widespread implosion of global credit markets.

In the just-published Elliott Wave Theorist, EWI's Bob Prechter shows that the EMH is a fatally flawed model. The story it tells -- "rational" investors producing "random" price fluctuations -- is pure fiction.
 
  • EMH says outside data provides a coincident benchmark of stock value. The FACTS say a close-up of S&P 500 earnings versus economists' forecasts from 1986 to 2008 shows that analysis LAGS reality by at least a year. All "rational" market yardsticks -- dividends, P/E ratio, book values, and more -- have fluctuated across an immense range over the last eight decades.
 
  • EMH says investors make decisions based on current market conditions, so every price move is new (remember the "New Animal" label of the 2007 financial crisis?). The FACTS say that while all bubbles are "qualitatively" different, they all still adhere to the same "quantitative" Elliott wave model: A fifth wave.
 
  • EMH says bubbles are rational, and therefore can not be anticipated. The FACTS say that in August 1983, The Elliott Wave Theorist indeed forecast that the next major bubble would eventually include a "stock market crash... with elements of 1929, 1968, and 1978..."
 
  • EMH says rational investors buy low and sell high. The FACTS say otherwise, namely the data in a host of riveting charts which compare sentiment to stock market activity across five major investment classes. All of them (individual investors, mutual funds, futures traders, and on) are most bullish at peaks and most bearish at bottoms.
The Efficient Market Hypothesis held sway for far too long. Now the writing is on the wall, and the old model has been found wanting.  
 
Empower yourself to think, trade and invest apart from the crowd.

Get the eye-opening insights in Prechter's NEW Elliott Wave Theorist when you start a risk-free subscription to the Financial Forecast Service, the most insightful U.S. market service in the world.
 
You'll get instant access to Prechter's monthly Theorist, the monthly Financial Forecast and the three-times-per-week Short Term Update. Learn more about the Financial Forecast Service>>

 

Rating: - based on [18 rating(s)]
Rate this content:
  
 



FFSEWI's Financial Forecast Service equips you to think, trade and invest independently from the crowd. Here's what you'll get, risk-free:
  • Short Term Update -- Intensive forecasts and analysis 3x/week for U.S. stocks, gold, silver, bonds and the U.S. dollar.
  • Financial Forecast -- In-depth, intermediate-term perspective on U.S. stocks, gold, silver, bonds and the U.S. dollar.
  • Theorist -- Bob Prechter's monthly big-picture insights.
See our new investment insights for only $1 – for the next 2 weeks >>>>
Free Video Course
Learn the Why, What and How of Elliott Wave Analysis

Financial media use news and economic events to explain market moves. Steer clear of this misguided approach. Take part in the Elliott Wave Crash Course to learn what really moves the markets.


© 2014 Elliott Wave International

The Elliott Wave Principle is a detailed description of how financial markets behave. The description reveals that mass psychology swings from pessimism to optimism and back in a natural sequence, creating specific Elliott wave patterns in price movements. Each pattern has implications regarding the position of the market within its overall progression, past, present and future. The purpose of Elliott Wave International’s market-oriented publications is to outline the progress of markets in terms of the Wave Principle and to educate interested parties in the successful application of the Wave Principle. While a course of conduct regarding investments can be formulated from such application of the Wave Principle, at no time will Elliott Wave International make specific recommendations for any specific person, and at no time may a reader, caller or viewer be justified in inferring that any such advice is intended. Investing carries risk of losses, and trading futures or options is especially risky because these instruments are highly leveraged, and traders can lose more than their initial margin funds. Information provided by Elliott Wave International is expressed in good faith, but it is not guaranteed. The market service that never makes mistakes does not exist. Long-term success trading or investing in the markets demands recognition of the fact that error and uncertainty are part of any effort to assess future probabilities. Please ask your broker or your advisor to explain all risks to you before making any trading and investing decisions.