Is The Market All-Knowing?

“The tape tells all” is a Wall Street bromide we’re all familiar with. It neatly summarizes the belief that the major averages discount everything pertaining to the business outlook. It’s also a basic tenet of Dow Theory.

Writing a century ago, Richard Wyckoff was one of the very first market pundits to put this belief in writing. “The tape tells the news minutes, hours and days before the news tickers or newspapers and before it can become current gossip,” he wrote. “Everything from a foreign war to the passing of a dividend; from a Supreme Court decision to the ravages of the boll-weevil is reflected primarily upon the tape.”

This sentiment was also eloquently summarized by author Robert Rhea over 80 years ago. Writing in his classic book, The Dow Theory, Rhea observed:

“The fluctuations of the daily closing prices of the Dow-Jones rail and industrial averages afford a composite index of all the hopes, disappointments, and knowledge of everyone who knows anything of financial matters, and for that reason the effects of coming events (excluding acts of God) are always properly anticipated in their movement. The averages quickly appraise such calamities as fire and earthquakes.”

The late Joe Granville took this a step further by suggesting that the stock market represents the sum total of a nation’s intelligence across many different fields. He maintained that the market knows virtually everything worth knowing about the short-to-intermediate-term outlook.

Writing in September 2004, just after a devastating series of Florida hurricanes, Granville observed: “When the stock market turns down it is warning of trouble ahead. It doesn’t matter what the trouble turns out to be…For a look at the future it was only necessary to follow the market instead of hurricane reports.” In view of the vulnerable state of the market prior to the major hurricanes of 2005 and 2012 (Katrina and Sand), perhaps Granville was on to something.

Not all investors believe that Mr. Market reflects the sum of all wisdom as it pertains to the future outlook, however. Proponents of Random Walk Theory in particular dismiss this notion with scorn. But are they right to reject this proposition?

Experience has shown that Granville’s proposition is essentially correct, if overly simplistic. To assume that the market always declines at the first scent of trouble would be the height of folly. The collective wisdom of informed investors does tend to trace out its foresight in the charts, but it isn’t always blatantly obvious at first and sometimes is evident only in retrospect. The market action of the year 2007 is instructive. Consider that beginning in February that year the market commenced a series of volatility plunges as insiders first began to manifest their advance knowledge of the coming credit storm.

In between, and immediately after, the market plunges in February and August ’07, however, the S&P made new highs. This was either a consequence of the recoil rallies going too far, or was the result of manipulation to disguise insider selling. The lesson here is that while Mr. Market will usually provide advance warning signals for trouble on the horizon you must often pay close attention to discern those signals, for it isn’t always obvious.

If the tape does indeed tell all, what is it telling us now? The major indices and the NYSE breadth indicators have been in good shape for most of the year. By the same token, cumulative trading volume has been subdued because of diminished participation among individual traders as passive ETF investing has gained popularity. The major averages have been buoyant, but not lively, in recent months. This has been reflected in the economic news for most of the year, and there have been no crisis events to speak of. The market, in short, has been dull and listless in reflection of the lack of bad news news. You could even say that the market has predicted the lethargic U.S. political/economic scene of recent months by its own lack of excitement.

If the tape indeed tells all (and I believe it does), then it’s telling us that there are currently no major worries among informed investors and insiders about anything that might torpedo the U.S. ship of state and disturb the country’s equanimity. Developments of this magnitude take time to develop and the traces of these dangers always eventually manifest in the stock market long before making an announcement anywhere else.

This is not to say that the market will necessarily continue to experience smooth sailing for the balance of the year, as short-term volatility tends to be erratic and isn’t always predictable. But the tape doesn’t suggest anything calamitous on the horizon, contrary to the warnings of the perpetual alarmists. The secular bull market which began in 2009 is still very much intact with lots of room to run before entering those tumultuous shoals which always mark the end of the line. By the time that point has arrived, however, the tape will have long since whispered the danger to those who bother to listen.

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