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The reasoning behind the market's rise

The most recent unemployment rate was certainly good news, and the stock market reflected that. The January employment report showed a surprising increase in employment of 243,000, and the unemployment rate fell to an equally shocking 8.3 percent. With that news, the major averages start the week at post-crisis highs. Dow Jones Industrial Average is at highest level since May 2008. The Nasdaq stands at a level last seen in December 2000.

These positive results in the unemployment situation were much better than the market had expected, as no forecaster I'm aware of was close. The most optimistic forecasts I had saw were in the range of about 175,000 new jobs and an unemployment rate of 8.6 percent. And many forecasters were looking for significantly lower numbers.

There were a few other bits of good news last week unrelated to the employment report:

-- The Institute for Supply Management's index of non-manufacturing industries, which account for almost 90 percent of the economy, rose to 56.8 in January. Economists, on average, projected the index to climb to 53.2. Readings above 50 signal growth.

-- Internationally, the European composite purchasing managers index rose to 50.4. Like the ISM's index, readings above 50 signal expansion.

The surprising news and subsequent jump in the global equity markets provides an important lesson for investors in this news. One of the major tenets of the Efficient Market Hypothesis is that markets incorporate all knowable information into securities prices. This means that it doesn't matter if new events are good or bad, but rather how they compare to expectations.

If there are no surprises in terms of new information, then the market will have already incorporated those expectations into prices. On the other hand, if news is bad, but better-than-expected, you can expect the markets to jump. (The reverse is also true.) The unemployment figures provide a great example. An unemployment rate of 8.3 percent, by itself, is a bad number in most people's minds. Yet the stock markets jumped because the figure was better than expected.

This is why it's so difficult to predict stock market returns. If a major determinant of investment returns is the unknowable (new and surprising information), just how likely is it that active investment managers will be able to add value (outperform) after expenses?

Unless you believe that you can forecast the unforecastable (surprises), the logic is inescapable -- active management is a loser's game. This is why much of what you hear from Wall Street is more appropriately called information pornography -- information that is meant to tempt you into action, when inaction is the best course.

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