The Efficient Market Hypothesis, propounded by Eugene Fama in 1965, postulated that stock markets are efficient and rational in discounting all available investment information. Not only has this theory in all but its weakest forms been repeatedly disproved by reality, but in the “funny money” period of the last decade its converse appears to have become true: the stock market is not merely inefficient in processing information, but actively incompetent in doing so.

A good short term example of this occurred Monday, when Hurricane Katrina, which had appeared to be of low strength and little importance the previous Friday, proceeded to devastate New Orleans and southern Mississippi, causing at least $40 billion worth of damage and removing 9 percent of U.S. refinery capacity for an indefinite period. The stock market proceeded to ignore this material piece of new information, and closed up for the day, while the oil market, after fluctuating, closed down. Even over the week as a whole, after Katrina’s full devastation had been felt, the U.S. stock market was up around 1 percent. Clearly the EMH process of market adaptation to new information didn’t happen; instead the market processed the new information so badly that it moved in the wrong direction.

Another example is the market for Initial Public Offerings, which has revived recently although it retains but a pale shadow of its exuberance in 1999. Not only have U.S. and Chinese Internet search companies soared to levels previously thought impossible, but no fewer than 36 SEC filings have been made in the past year for “blank check” IPOs, in which money is raised for a company without any idea of what that company is going to do. Over $480 million has so far been raised for such schemes.

For 285 years, historians have mocked the South Sea Bubble of 1720, most particularly its flotation of “A company for carrying on an undertaking of great advantage, but nobody to know what it is.” Haven’t investors learned ANYTHING in almost three centuries?

Needless to say, every time the stock market behaves in a completely loopy, irrational manner, perpetually bullish analysts scurry to explain how it really means that all is well in the best of all possible investment worlds. In Katrina’s case, the stock market’s strength during the week was, according to analysts, caused by a belief that the hurricane would result in the Federal Reserve raising interest rates more slowly than it had previously intended. They failed to explain how a natural disaster that caused destruction and hit oil output could reduce inflation, the main motivation for the Fed’s laggardly and inadequate interest rate increases.

Of course, given the Greenspan Fed’s normal approach, they may well be right about the Fed, in which case the subsequent spike in commodity prices, oil prices and real estate prices will be even more vicious than we are currently seeing, and the post-spike period of correction and bankruptcies correspondingly deepened. Either way, the net long term value of common stocks has been reduced not increased by Katrina.

Studies since the publication of the EMH have pretty definitively proved that, at least in its strong form, it is rubbish. New information from companies moves the market in unexpected ways, while investors such as Warren Buffett can through superior analysis consistently outperform the market for several decades. Seasonal, weekly and business cycle effects produce movements in the market that have been shown to be non-random, and the market also exhibits a degree of leptokurtosis (persistence of existing trends) that cannot be the result of a randomly generated pattern.

However, it is one thing to show that the market is inefficient in processing new information, quite another to suggest that it is incompetent, in other words that its reaction to new information is actively perverse, moving it in the opposite direction to that the new information would rationally suggest.

Incompetence in processing market information is not unusual for an individual. I once had a very senior banking colleague who was an almost perfect negative predictor of the bond markets – if he said bond prices were about to drop, they would almost certainly rise. He was far from ignorant about the market (a completely ignorant person would make decisions at random, and thereby match the market). Indeed, his sources of information were excellent; he was personally well acquainted with top honchos at all the major investment houses whose behavior together moved the market, and spent most of each long day talking to them. Thereby, he was one of the best informed people in the marketplace; there were few new rumors or market activities of which he was unaware.

However, his ability to form a coherent pattern from the mass of information he received was distinctly below average. He would either focus on one particular trivial piece of information to the exclusion of all else, or he would seize on a statement that one of his contacts had made in an attempt to mislead him, and treat it as Gospel truth. Consequently, by having all the information possessed by the top practitioners in the market, but being markedly inferior to his competitors in processing it, he achieved a high level of consistency in calling the market wrong. As such, for those who knew his capabilities, he was very valuable – and far cheaper than someone who was able to call the market correctly.

In an era of cheap money, overvalued markets and falsified statistics, my ex-colleague’s remarkable capability spreads to include the market as a whole. The market takes an optimistic view of each new statistic as it appears, twisting logic in order to present it in its most favorable light. If inflation is rising, business must be good. If economic data come in weak, the Federal Reserve must be likely to drop interest rates. If job creation is weak, a “productivity miracle” must be in progress. If the dollar is rising, foreign money is likely to flow into the market. If the dollar is dropping, the profitability of U.S. corporations is likely to increase. And so on.

The converse applies in a period of deep market depression, such as we had to some degree in the late 1970s, but whose most severe manifestation, in the 1930s, is now almost outside living memory. In that period, if prices were falling, it must mean unemployment would increase. If the Federal Reserve dropped interest rates, they must see a deeper economic depression ahead. If government increased spending, that would crowd private investment out of the market. If inflation increased, businesses would be unable to pass on the increases and profits would be squeezed.

The unnatural pessimism of the 1930s and to a lesser extent the 1970s seems irrational now, but it was no more so than the unjustified self-confidence that now permeates the market. Even when a particular statistic comes in negative, like the Institute of Supply Management’s Purchasing Managers’ Index Thursday, either it is dismissed as a “blip” and ignored or it is used as a rationale for the Federal Reserve to ease monetary policy once more and perpetuate the bubble.

The tendency to interpret all information in a particular way extends beyond market practitioners themselves. During the 1930s, economic commentators ignored the huge growth of new industries such as radio and home appliances, fueled by the universal extension of electric power throughout the United States, and looked instead at the decline of old-line industries such as railroads and textiles. Poverty in the “dustbowl” was dramatized, whereas the remarkable increases in working class living standards in industries such as automobiles and steel were ignored, or credited to labor activism rather than to the overall strength of those industries.

After 1995, the Bureau of Labor Statistics devised a new “hedonic pricing” methodology for calculating price indices, and used it to demonstrate that a new era of much higher productivity growth had dawned, so that market valuations could be permanently higher and increasing wealth disparities could be ignored. A huge building boom in vulgar McMansions was celebrated, while the increasing impoverishment of the less educated, threatened by uncontrolled illegal immigration, was ignored. The $800 billion U.S. trade deficit, which in earlier decades would have seemed a huge problem, was presented as a sign of the strength of the U.S. service sector, with the consequent foreign central bank investment in U.S. Treasury bonds being a natural and providential response to the U.S. budget deficit.

When the market is a “stopped clock” and all data is read in one direction it is not simply imperfect, it is incompetent – at such periods economic reality increasingly follows the direction that the market is refusing to take. At times like the present, the market is not merely “discounting the hereafter” as highly valued markets are said to do, it is discounting the non-existent.

It is only a matter of time before the ebulliently overvalued market comes to match the fairly grim underlying reality.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

This article originally appeared on United Press International.