Friday, January 28, 2011

Information Entropy And The Stock Market II

Recently, FLG wrote:
FLG had never thought about the efficient market hypothesis the same way, but it really does come back to information entropy. Expected information is priced in. This doesn't mean the prices are correct or right. They are simple the product of interaction among the best educated guesses of a large group of people about what the present discounted value of future cash flows are. The sum all the expectations about the future. Information that would change the price is highly entropic and by definition unexpected.

Here's Buttonwood today:
I don't recall anyone (including your blogger) predicting that the market might be vulnerable to riots in Egypt. Yet that's why the market seems to be falling today, as investors fret that the Middle East might get embroiled in war again. [...]

Anyway, it's a timely reminder of the impossibility of stockmarket forecasting. My view tends to be that you look at long-term measures (like the cyclically-adjusted ratio or the dividend yield) and figure out that when valuations are high, future returns are likely to be low. You don't know when the bad news will come, or in what form - pyramids or profits - but you figure something will happen to disturb the rosy consensus. Back when I was on the FT's Lex column in 1990, we were bearish and looked wrong until the market plunged when Saddam invaded Kuwait. Go figure.

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