Is The Market Always Right?

George Soros likes to joke that market has predicted seven of the past two recessions. And he is right. Since the market is forward looking, it will sometimes discount fundamentals that will never become a reality.

Prices reflect people’s expectations about the future, mostly about the near-term future. To say that the market is always right means to assume that people’s expectations about the future always come true. We all know that this is not the case. No one has a crystal ball. People are often wrong.

Is the market always right?

No, but this does not stop people who follow price trends to make a lot of money. The market could remain “wrong” (irrational) for a very long period of time and even become “wronger”.

Is the market always right is not even the right question to ask. As Stanley Druckenmiller says in the book Market Wizards: “It is not important whether you are right or wrong, but how much money you make when you are right and how much money you lose when you are wrong.” And yes. You will be wrong. In this business, being wrong is not a choice, staying wrong is.

Josh Brown has an interesting observation on why trends exist. Here’s what I think on the subject:

Trends exist because discounting the future is a process, not an event. Different people buy for different reasons at the different stages of the price cycle. Some buy, when a company is still losing money, but it has great potential. Another group buys when this company reports its first profitable quarter. A third group buys when this company has had several years of outstanding growth and beats analysts’ estimates. A fourth group buys just because the company’s stock has been outperforming and at all-time highs. Another group, buys because it needs to cover its shorts.

The market is forward looking and it often discounts events that have not happened yet. The market is also constantly looking for feedback – in the short-term perspective from price, in the long-term perspective – from fundamentals. When expectations are met and exceeded, the trend continues.