Are Efficient Market Theorists in Hiding?

by: Dorsey Wright Money Management

By Mike Moody

In a recent article, Bespoke Investment Group discussed the amazing volatility the market has exhibited lately:

… the S&P 500 has averaged a daily hi/lo spread of 5.33% over the last five trading days. It’s been a truly remarkable trading period, and efficient market theorists are currently in hiding.

[Click to enlarge]

Source: Bespoke

You can look at the volatility in a couple of ways. First, I think it shows how important it is to try to distinguish the underlying trend from the noise. When markets get very choppy like this, you’ve got to have an intermediate to long-term model. Otherwise you just get whipsawed to death.

Second, as Bespoke remarks, if the market were actually efficient, it wouldn’t whip around nearly this much. The underlying value of the companies is obviously not changing nearly as rapidly as the market price. What’s going on is pure psychology: Market participants trying to handicap supply and demand.

Strategic asset allocation relies on assumptions for returns, correlations, and volatility to generate the optimal pie chart. If you’re just a little off on some of the factors, your allocation can be way, way off. It’s safe to say that a few volatility estimates might have been revised over the past couple of days.

In contrast, tactical asset allocation driven by relative strength does not make any assumptions about returns, correlations, or volatility. It just tries to stay with the strongest trends at any given time. Simple, and effective too.