The Recent History of Market Idiocy

Joel Anderson |

In May of 1970 Eugene Farma published his efficient-market hypothesis in the Journal of Finance. The theory posits that, in a market where everyone has access to all relevant information, there's no way to outperform the market without taking on risk. In essence, when buying a stock, the only way to get ahead is through luck rather than skill because there's nothing you know that everyone else doesn't. Unless you DO know something everyone else doesn't, in which case you probably shouldn't share that with the SEC.

On some level, the take away is that you can't be smarter than the market. And at times it appears that could be true. It can often seem like it's impossible to stay ahead of traders as the moment a piece of news hits, a stock's already moved for the day. However, there are also times when things happen in the investing world that make it difficult to believe there's anything intelligent about the markets. Here's a look at just a few truly head-scratching moments that make it just a little harder to buy into this market as being the one Farma described.

You'd Have to be A Twit

A lot of investors are very excited that Twitter will finally be making its initial public offering later this year. And it's no secret why. With over 215 million users, Twitter boasts the largest audience to hit the market since Facebook (FB) IPOed last year. However, after Twitter released details on the company, along with the proposed ticker symbol (TWTR), at least some investors got just a little over-excited on Friday.

The morning after Twitter announced its new handle (though, it should be noted, probably still at least a month before the stock starts trading), shares in Boston retailer Tweeter Home Entertainment (TWTRQ) hit $0.15 a share. That'sa 1500 percent gain. A return of confidence to brick and mortar retailers? Unlikely, given that Tweeter filed for Chapter 11 and liquidated in 2008. No, the reason why this bankrupt, out-of-business electronics store shot up so fast was because its ticker was mistaken for that of Twitters. Easy mistake to make, right? Except that shares continued to spike, peaking more than an hour after the opening bell.

Panic at the Dow Jones

Unlike last week's Tweeter debacle, which was clearly caused by a handful of idiots, the next two moments describe times when the entire market seemed to display a collective stupidity. As the United States government once again approaches the debt ceiling, many are thinking back to two years ago when Standard & Poors downgraded American debt from AAA to AA+ after the country veered dangerously close to defaulting as Congressional Republicans and the President butted heads. The move rocked world markets. And it's understandble why. American treasury bills have long been viewed as the model of stability, a safe investment that could be relied on no matter how volatile the markets got. The idea that the full faith and credit of the United States could be called into question prompted a massive global sell-off. In a single day, each of the major indices dropped between 5 and 7 percent, with the Dow suffering its 6th worth day ever as it lost almost 635 points.

But amid this news was something very peculiar: yields on 10-year T-notes dropped from 2.34 percent from 2.57 percent. For the uninitiated, lower yields mean that there was higher demand for the bonds, so interest payments were lower, meaning the bonds were more valuable. So, if we're keeping track, Standard & Poors downgraded American debt. Which meant that they believed the debt was less valuable, a belief that prompted a panic on the stock market, which prompted people to look for less risky assets, which got them looking to buy up bonds, which meant that the price of American debt...went up. So, the concern American debt being less valueble led to...American debt becoming more valuable. Just with a massive market crash in the middle.

Credit Default WHAT?!

It may still be too soon to dredge up the housing crash of 2007, but one cannot imagine writing about idiocy in the markets without mentioning it. In this case, seemingly everyone was wrapped up in the same insanity. The entire market was buying and selling debt as fast as it could without giving a second thought to who it was that actually owed the money. However, while one might be able to forgive people losing their heads given how widespread the lunacy was. However, one should also take a step back at times and acknowledge when things have gone completely insane. And complete insanity, credit default swap is they name.

The credit default swap was a financial device invented by J.P. Morgan's (JPM) Blythe Masters in 1994. Essentially, it was insurance against a debtor defaulting. You would pay a fee to a banking institution, not unlike a premium, and then that institution would pay you the money owed by your debtor in the case of a default. Just like insurance. Most of the time, the bank makes money off of the transaction, and on the odd chance that your debtor defaults, you're covered, mitigating your risk. Just like insurance. But credit default swaps are different from insurance in one very essential way. Unlike the insurance market, credit default swaps are unregulated, so the banks writing these swaps didn't need to have actual capital to back their "policies." And that's where it all went horribly wrong.

Without the need to hold capital limiting them, banks and the rest of the credit industry wrote a lot of credit default swaps. A WHOLE lot. By the time the market peaked in 2007, there were $62.2 trillion in credit default swaps. And no, that's not a typo. Trillion. With a T. And if that number seems unreasonably high, it's probably because most estimates of the total amount of money in the world is only about $45 trillion. Ultimately, this caught up to everyone involved, with American International Group ($AIG) getting hit the hardest. And whatever rationalization you might have, anytime the market's extended itself past the point where there's money in the world to back it up, one has to view it as being insane.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
FB Facebook Inc. 119.68 0.77 0.65 17,464,736
JPM JP Morgan Chase 85.49 0.37 0.43 14,567,202
AIG American International Group Inc. New 65.83 0.01 0.02 6,552,997
AFGVY Agfa Gevaert Nv Unsp/Adr 7.64 0.00 0.00 0

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