Efficient Markets Hypothesis?

I've been watching the stock markets lately, which isn't that exciting. I've always watched stock markets. The difference is now I'm trying to back up what I see in the market with what I see in the economic data, so I thought I'd do a little piece about the recent correction, (Dow went from 10,750 to 9,950 in about two weeks).

I discovered something very interesting about the way stocks are valued and the way finance works when I did my analysis of Rockwell Automation for the investment group here at UO. I was working on my comparables analysis, using trailing twelve month data, and a colleague of mine told me I should use forward looking analyst estimates because "they're probably more accurate than past data going forward." This notion really baffled me, and I had to admit, he had a fair argument. Future estimates could very well shed more light on a companies future, than past data, (next time maybe I'll run a little AR(1) model and see for myself). But at the same time I was skeptical, past data is 100% accurate, it 100% reflects the results of the managerial decisions made within an economic environment over some time period. How could simple projections possibly be more useful? My conclusion... They're not.

Let's talk facts. A couple of weeks ago the S&P 500 was trading at over 25 times earnings, its highest level since 2002, (if that doesn't scream overvaluation I don't know what does.) Housing starts were declining, new home sales were declining, apartment vacancy rates were near historic highs, as were malls, offices etc. . . jobs unexpectedly decreased in December by a (now adjusted) 150,000, capacity utilization was high, exports were low, hiring expectations were low, and treasury yields were shrinking rapidly. There were very few positive broad economic indicators. The outlook in general looked fairly bleak. I didn't understand how day in and day out the market continued ticking upward in the face of all the poor data surrounding it. Here's what I've realized. First, Wall Street likes profits. The stock market doesn't care about economic conditions. I've noted in previous posts that profits have largely been driven by increases in labor productivity and lower costs as opposed to top line demand. This allows Wall Street analysts to price in higher earnings, and thus a higher stock price . Second, Wall street also likes pricing in information as early as possible, many times, before the information even becomes reality.

And here's where I get back to my discussion with my UOIG pal, and here's why we were due for a correction. The stock markets had priced in earnings based on analyst expectations that never really materialized. And if you look at the actual data, the result was not surprising. I was calling for a correction in early January. The pace of market acceleration was just not in line with macroeconomic reality. In plainer words, Wall Street got ahead of the recovery, and we're still not even sure we're in a real recovery. You could almost think of it as a little mini bubble, which brings me to the title of this post. Efficient markets just don't exist. Even when given access to perfect information, people still act irrationally. It's not their fault, they're just trying to make an honest living, but it might be easier if they paid more attention to real fundamentals, and less attention to projected earnings.