Efficient market hypothesis

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Q: We have plenty of recent evidence that the market does not always do what it should do, the efficient market hypothesis lies in tatters in the wake of the past 15 years. If you want to argue cause and effect, rather than point to positive economic developments, I think you'd be better off looking to the effects of negative real interest rates supported by massive liquidity injections on asset prices and their implied discounting rates.

A: Thank you for taking the time to read Briefing.com and for sharing your thoughts. The conclusions you have drawn based on the article you read today are reasonable, though I suspect the time constraints I face in writing the daily Page One article prevented me from addressing all of the points you might have thought would be addressed today, particularly with respect to cause and effect of higher stock prices.

In the past, I have mentioned the Fed put as the ultimate security blanket right now for the stock market, yet strong earnings growth, low interest rates and low inflation, combined with incoming economic data pointing to signs of recovery, have been integral sources of support as well.

While I did not make any mention of the risk premium in today's article, it is an element we have been highlighting repeatedly for our argument that there is relative value in the U.S. stock market (this was highlighted in Monday's Page One article). As it so happens, that risk premium has increased since mid-February, or just before the Libyan situation escalated. The spread between the forward four quarter earnings yield and the 10-year Treasury yield is up 34 basis points to 406 bps since then (it was 430 bps on Monday), though the risk premium has come in a bit since the Japan earthquake. That suggests perhaps that, all of the media reports notwithstanding, the market is worried more about the Middle East crisis as a risk factor than it is about Japan's situation. As an aside, the risk premium averaged closer to 200 bps during the 2003-2007 bull market; moreover, the Middle East is a bigger concern for us as well.

Also, I agree that the market does not always do what it 'should do,' but predicting the day-to-day swings is impossible. We offer our best sense of what the market might do one day to the next, but remain attentive to fundamental factors for communicating our expectation of where we think the market is headed over a longer-term period. In that sense, then, I am not arguing that recent market action proves the market should go up in the near term. Rather, I am arguing that the fundamental backdrop, which includes a very accommodative Fed, is the basis for why the market is being bought on pullbacks and why it is reasonable to think it will continue to go up over the long term.

Some of the key risk factors that could alter our perspective include:

An escalation of oil prices past their prior peak or a continued uptrend in oil prices that prevents companies from being able to adjust properly to a rising price deck
A full-fledged nuclear meltdown that shutters Tokyo
An extensive list of major companies acknowledging profit margin pressures
A sharp spike in long-term rates in the U.S. that is the result of deficit concerns rather than an acceleration in economic growth

Patrick J. O'Hare
Chief Market Analyst

MARKET PLACE