232 THE INTUITIVE INVESTOR
lasers). Similarly, in Vaga’s view, the stock market can exist in
different states—random and efficient or concentrated and “mo-
mentum-like.” The former is the conventional efficient market
described in textbooks. It prices securities accurately on the basis
of all known information. The risk-reward tradeoff for efficient
markets is described by Sharpe’s Capital Asset Pricing Model (i.e.,
more return for more risk). The latter state—called “coherent” by
Vaga—is seen in bull and bear markets, where the market averages
move powerfully in a given direction, disregarding conventional
valuation measures.
In this state, the traditional risk-return tradeoff is inverted and
investors can earn above-average returns with below-average risk—
a heretical idea to efficient market proponents. In fact, it’s an idea
that only an “open” mind could entertain. Vaga postulates a third
state as well, “chaotic,” which represents the worst of all worlds:
low return for above-average risk.
Vaga explains these different market states in terms of the in-
teraction between fundamental and technical factors. Fundamen-
tal factors, including such variables as interest rates, company
earnings, and GNP, can be bullish or bearish depending on exter-
nal world events. In contrast, technical factors are sensitive to
investor sentiment, which ranges between two extremes: indepen-
dent, traditional thinking and “groupthink.” As long as investor
behavior is characterized by the former state, the market is ratio-
nal and efficient. As investors become frenzied and move toward
groupthink, the market state changes to coherent (if fundamentals
are strongly positive or negative) or chaotic (if fundamentals are
neutral).
In the coherent groupthink state, the technician’s advice—“the
trend is your friend”—is correct. The energy of the market has
become laser-like, concentrated and powerful, and it is unwise to
stand in its way. As Zweig says, “don’t fight the tape.” When the
fundamental news is neither positive nor negative, but investors
are behaving in a groupthink fashion, the market is chaotic, lung-26-29 ware 232 1/19/01, 1:19 PM