Hi Brad,

Your comments inspire several responses.

First, most all of the money invested in almost all assets is from passive strategies. Surely, they are not engaged in an estimate of future cash flows and valuation. Instead, as they receive new monies they simply purchase a proportionate share of them in whatever index they are tracking. The end investor, usually retail, also surely is not engaged in any form of discounting. Most retail investors, a) do not have the time in their lives to evaluate investments in the classical way you describe, b) do not have the skill set to do it. I think it is a pretty safe conclusion that much of passive investment money is a reflection of how people feel about 'the Market' now.

Second, if what I wrote above is true, that most passive money is neutral, ranging to emotional in response to news, then prices, which are set at the margin, are being set by active investors. However, there is not better news there, in my opinion. In a world of 100%+ average turnover among active managers can you really count on investors rolling up their sleeves, putting on their green eye shades and cooly, rationally valuing the future prospects of businesses? There is pretty strong evidence (e.g. in turnover ratios) that most investors are basing their decisions more on momentum or growth factors that valuation.

Third, Tom and I acknowledged that some volatility is adjusting to new information that hits the market. However, I think much of it is emotional, not rational responses to news.

Fourth, you may appreciate the work of Denise Shull of ReThink Group (whom I have featured on EI before). She tracks developments in neuroscience around decision-making. In short, neuroscience demonstrates that all decisions are emotional decisions. Yes, facts weigh in on and affect decisions, but the "to do, or not to do" always involves the emotional portions of the brain. How can we simultaneously grant the power of bias, as enumerated by the behavioral finance community, along with the neuroscience, and then say that volatility predominately is a reflection of differing rational views about the price of an asset?

In summary, I think it is a classic fiction of markets that they are objective. In theory, yes, they are objective, even if the individual participants are subjective. I too have read and understood Adam Smith. Markets are better than trusting a central authority, granted. But that does not mean they are perfect and deserving of unquestioning devotion. As a final point: Adam Smith was not a mathematician, nor a scientist, but a natural philosopher.

Yours, in service,

Jason