The consensus opinion going into last week was that Obamacare  the Patient Protection and Affordable Care Act would be struck down by the Supreme Court in a partisan decision and that the EU summit would end with no substantive agreement on how to address the banking crisis in Europe. As it turns out, both of these consensus positions appear to have been wrong and the market immediately corrected prices to reflect the new information. That’s what is meant by an efficient market – all known information is incorporated into current prices. It is also important to remember – as last week amply demonstrated – that the market prices in probabilities for unknown events. Probabilities, it should be noted, are not certainties.

Benjamin Graham said that in the short term the market acts as a voting machine and in the long term a weighing machine. Anyone who has observed the members of Congress knows that voters get it wrong sometimes. Based on the current approval rating for that august body, one might infer that voters have been getting it wrong quite a bit lately. Of course, most people think it is other voters who have gotten it wrong so we might not see that corrected anytime soon, but one does hope for a cleansing at some point. Anyway, voters at Intrade, a so called prediction market, had driven the odds that the President’s health care plan would be ruled unconstitutional to 70% prior to the decision so it appears the market got this one wrong. Which, believe it or not, isn’t that unusual. A lot of people guessing about the vote of one man – the wrong man it turns out – apparently provides no more predictive value than flipping a coin.

As for the market as a whole, the reaction was initially negative sending the Dow down over 150 points but as hopes for the EU summit rose in the afternoon, the market recovered to close down but not significantly. The point being, I suppose, that the events in Europe are a lot more important to the world economy than what may or may not happen to the now Constitutionally vetted ACA. The only thing predictable about the implementation of ACA is that it won’t work the way it was intended or sold. It will not cover everyone, it won’t reduce costs and you can’t keep your plan if you like it (because it won’t exist or your company won’t pay for it). And oh, yes, it will raise taxes and it won’t reduce the deficit. Obamacare is a pinata for special interests and their lobbyists are already lining up to take a whack and see if they can shake loose some candy for their patrons.

Much was made of the fact that Justice Roberts justified the mandate as a tax but the fact is that the bill already contained a lot of tax increases. Not enough to pay for it mind you, but a lot nonetheless. Investment income tax rates and payroll taxes will increase for those making over $200k. It also places a cap on the amount you can contribute to FSAs and raises the threshold for deducting medical expenses paid out of pocket (because goodness knows we don’t want to encourage that). It also imposes a 2.3% tax on the sale of medical devices. In other words, it further complicates an already incomprehensible tax code. The fiscal cliff just got more complicated to solve.

The other side of the arete on which the US economy balances is the condition of the rest of the global economy and the consensus before last week was that Europe would push us over the edge. Based on the short positions built up in the Euro most market participants believed that the European banks and the Euro were done for. Unfortunately for the consensus, the EU pulled a Monty Python – “I’m not dead yet” – and produced an agreement that appears at least at first blush to make it more likely the Euro will survive. Again the market had to adjust to the new reality and the Euro put on a spirited rally Friday. Stocks and commodities joined the party at least for the day which is already longer than the typical post EU summit rally.

So, back to Mr. Graham’s voting and weighing machine known as the market. We are in the midst of what we at Alhambra believe is a secular bear market. We also believe it is likely not over and won’t be until there is better economic policy somewhere on the globe, preferably the US. At the bottom of a secular bear market one should see ultra cheap valuations and negative sentiment. Ending the bear will involve a change in policy that allows for higher economic growth. When the bear ends, it will not be obvious to most and there will be widespread skepticism about any positive events. While there are surely plenty of optimism skeptics, we don’t think the bear market is over because policy hasn’t changed for the better – yet.

Markets in the throes of a secular bear tend to be more volatile because there are few fundamental, long term buyers. Secular bear markets are made up of people acting almost entirely on emotion. They tend to herd and create opportunities that can be identified by sentiment extremes. But merely identifying these sentiment extremes isn’t enough to be successful in the market. First you have to be sure that the fundamentals aren’t changing in some way you have yet to perceive (assymetric information is a bitch) . Then you have to wait until others start to recognize the same sentiment extreme. And of course you have to have the guts to start establishing positions contrary to the consensus.

To put this in game theory terms, being successful in a secular bear market is about determining when the Nash equilibrium is likely to change. In a Nash equilibrium it makes no sense to change your strategy as long as the rest of the players in the game have no incentive to change theirs. In a volatile market like the one we’ve been in for the last few years these changes happen frequently and sometimes suddenly. Keynes, who despite his economic theories was a pretty bright fellow, identified this behavior long before Nash when he described the market as like a beauty contest. In Keynes beauty contest market you don’t win by picking the prettiest girl. You win by picking the girl that the most other judges believe is the prettiest.

In the Euro example, the dominant strategy at least recently was to be short. Regardless of the reasons, last week’s EU Summit gave at least some of the players a reason to change strategy. It might be nothing more than noise but there could come a point where the noise causes enough other players to change their strategy too (margin calls, etc.) that a new Nash equilibrium is established and the trend changes. Fundamentals have nothing to do with it. It is the perception of the fundamentals by the average market participant that matters. Most of what goes on in the market is based on perception not reality. It doesn’t matter whether you agree with it or not or whether it is right or wrong. The only thing that matters is that enough other people in the market believe it.

In the long term Mr. Graham is certainly correct that fundamentals will win the day but in the meantime investors have to play the hand they’ve been dealt. From 1962 to 1982 there were 3 opportunities to make over 50% on your money in stocks in a relatively short period of time. There were 2 others where the upside was over 30%. If you bought and held the market from the high in 1962 to the low in 1982 your only gain was from dividends and after inflation you were much worse off. 20 years is a long time with no capital gains. The long term can be a very long time and longer than most investors are willing to wait.

I don’t know if the rally last Friday will continue or if the previous downtrend will resume but sentiment is still very negative. Every article I read about the EU summit deal was basically the same; nothing new, nothing to see here, move along. In addition, the sentiment about China is if anything getting more negative with Barron’s making the bear case in its cover story this week. Anything short of an outright crash would be an upside surprise. For now, we’ve reduced our cash position by about a third but still hold a substantial amount in reserve. If we start to see better economic data in the coming weeks – lower gas prices might be a catalyst – consensus voters may get another surprise.

None of this by the way is meant to imply that fundamentals don’t matter. Fundamentals provide us with valuable information about risk but they tell us very little about return except in the very long term. In the short term and particularly in this market, emotion rules the day. To be successful you have to spend some time thinking about how the others in the market are voting and how that might change. In short, sentiment matters and matters a lot.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or 786-249-3773.

Click here to sign up for our free weekly e-newsletter.