Rice Money Managers, Inc.

THE STOCK MARKET - STRATEGY

[Post-Dispatch Introduction:* Since March of 2000, the stock market has lost nearly 45 percent of its value. Though it closed up again Monday, it still has a long way to go to regain lost value and investor confidence. Three analysts examine aspects of the crisis: How did the fall happen? What change in corporate culture could help reverse the trend? What should Washington do?]

Millions of Americans have, know it or not, invested according to the "Random Walk Hypothesis" or the "Efficient Market Hypothesis." These computer-based academic theories and the faith placed in them have been powerful contributors to the stock market bubble and crash.

The Efficient Market Hypothesis assumes (1) All useful information about stocks and the stock market is fully disclosed to investors and (2) Investors deal with the information rationally. If those assumptions are true, one does not have to worry about paying too much for stocks. The efficient market will price stocks fairly. Risk becomes good; the more risk you take, the more money you will make. And the theory is easy. Just write your check.

The Random Walk Hypothesis assumes it is impossible to predict future changes in stock prices, at least in the short run. If true, it is futile to take any action in anticipation of possible future events. Stocks and the stock market don't have trends. Buy and hold, or buy and suffer; it's the best anyone can do.

Ironically, a strange intellectual leap sometimes follows. Though investors are told that one can't predict what will happen tomorrow or next week, "experts" have also claimed that risk and return years or even decades into the future can be predicted.

Unfortunately, "hypothesis" is the key word in both cases. Both theories have compelling factual, common sense and theoretical limitations and flaws. Three examples: (1) Value Line and Standard & Poor's both claim long run records of better-than-market stock selection, an impossibility under Efficient Market. (2) Insiders are required to reveal their stock trades precisely because they are considered better informed than outsiders, not to mention recent accounting revelations! (3) Short-term stock price fluctuations are definitely not random, exhibiting trends and seasonal patterns impossible in random data.

But there is a deeper problem. Markets are about people, not just numbers. What people believe about markets changes how markets behave. The more people came to believe the theories or the sound bites based upon them, the more dangerous and less accurate the theories became. Why? People started throwing money at stocks regardless of value and with no plan for protecting themselves by selling stocks or managing their stock market risk. "Experts" assured them this was the wisest, shrewdest, safest thing they could do!

At first, the new theories seemed to work. In a Ponsi-like effect, new buyers crowded in and bid stocks up to even higher levels, which were, after all, reasonable because "the market is efficient." Because "random walk" proved "market timing doesn't work," there was a convenient excuse to ignore early price declines.

Together the theories anesthetized investors to risk and endorsed couch-potato investing. For most of the 20th century, assumptions about the stock market were much more realistic. The title of a classic book, in print since 1935, tells the story: The Battle for Investment Survival,  with the key words being "Battle" and "Survival."

Tax laws also contributed to the Bubble. They favor stock options over wages as executive compensation and stock buybacks over ordinary cash dividends. Some executives over-focused on stock prices because that makes options valuable. Stock buybacks, arguably a manipulation of stock prices, escalated. The long-term investor lost the risk reduction effect of regular cash dividends, as money, some even borrowed, was directed to buybacks rather than dividends.

The last few years have dramatically proved that people can pay too much for stocks and that markets can trend, carrying most stocks with them. This reveals the stock market for what it has always been, much more a competitive game than a predictable profit machine. Approached with the spirit that investment survival is a battle, it can be productive, but it is never easy. Successful investors need to think and be ready to play both offense and defense all the time.

Charles Rice is president of Rice Money Managers Inc.,231 South Bemiston Ave Ste 800, Clayton, MO 63105 314-854-1388   cmr@ricemoneymanagers.com .  The foregoing is an expression of opinion and should not be construed as investment advice.

Published in the Editorial section of the St. Louis Post-Dispatch on Tuesday, July 30, 2002.
Copyright (C)2002, St. Louis Post-Dispatch  Reprinted by permission.