The Inscrutable Stock Market

The strong rally turned in by the Dow Jones Industrial Average in the last two hours of trading today may make it seem as if this is the Chumbawumba market (it gets knocked down, but it gets up again). But the Dow’s rebound was not duplicated by other market averages. In particular, small-cap stocks showed their glass chin once again, being knocked to the canvas early in the day and never really finding their feet again.

What this means for tomorrow is, of course, anyone’s guess, and I mean that quite literally. Perhaps the Dow’s rebound means that all the selling pressure is gone, and buyers can now flood back into the market. Or perhaps the fact that we didn’t have a desperate sell-off means that investors are still too complacent, and that there’s a ways to go on the downside before this “correction” has ended. Perhaps the continued narrowness of the market’s positive indicators–that is, the fact that this year gains have been concentrated among a very small group of companies–bodes ill, as the bear market that has already swamped small-cap stocks catches up to large ones. Or maybe it’s the other way around, and small caps have been beaten down so much that they now represent low-hanging fruit for value investors.

The point is that a convincing case can be made for almost anything the stock market may do in the short term. It’s difficult–I would say impossible, but what do I know?–to argue that this market is not overvalued in light of the fundamental conditions confronting U.S. corporations (slowing earnings growth, the Asian crisis, increasing labor costs, and an inability to raise prices). But over the short haul any number of factors could send the market either higher or lower. And none of those factors is predictable based on what happened in the market today.

So-called “technical analysis,” though, assumes precisely the opposite, insisting that by looking at the market’s internals (trading volume, the number of advancers versus the number of decliners, the 200-day averages of various indices) you can get a good sense of where the market will be going in the future. And the most surprising thing about watching CNBC or CNNfn all day is just how much attention is lavished on the market’s technical conditions. The casualness with which anchors say things like, “The Dow Jones Average has a crucial support level at 8400” or “If the Nasdaq closes below 1750, that could mean big trouble” belies the fact that these statements are, according to all serious analysis, entirely meaningless.

If you spend enough time watching the ticker, it’s hard to believe this. There’s something viscerally appealing about the idea that if the market stays above its previous lows, then it won’t keep going lower. But the essence of the random-walk theory of stock prices is the simple idea that you can’t tell what a stock is going to do next based on what it did before. Random-walk theory may have certain holes in it over the long term–Warren Buffett’s success suggests that–but in the short term it is foolproof. In other words, the Dow’s rally at the end of the day today doesn’t help us figure out whether tomorrow things will be better or worse.

In any case, for all of technical analysis’ visceral appeal, it’s also obviously obtuse. The market dived today because of continued bad news out of Asia, an exogenous factor that technical analysis has no way of accounting for. Markets are very efficient at assimilating information, which means that as information changes, so too do the markets. But technical analysis treats the market as a self-enclosed system, listening only to its own heartbeat. Listening to a heartbeat may be an easy way to get mesmerized. But it’s no way to figure out what’s going on.