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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
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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.  
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