SYNOPSIS: Dislikes the view that stock prices are necessarily rational.

Economists have a rather Zen-like view of stocks. They believe that investors are rational, and that stock prices are therefore unpredictable. It sounds peculiar, but the logic is ironclad. Rational investors would take into account everything they know -- all the information available about where profits, interest rates, technology and so on are going -- when buying or selling stock. So stock prices would already reflect all available knowledge, and would change only when new information came in. And new information is, by definition, unpredictable -- otherwise it wouldn't be new -- which means that changes in stock prices would be unpredictable too. Q.E.D.

Except, of course, that real investors aren't entirely rational. Being human, they are driven by fear, greed and the madness of crowds. In principle this should create patterns in stock prices, and in principle you can use those patterns to outperform the market. Good luck. But while it may be very hard to tell whether the market is overvalued or undervalued (remember that Alan Greenspan warned of "irrational exuberance" when the Dow was at about 6,500), one thing is for sure: It fluctuates more than it should. That is, instead of rising or falling only when there is real news about the future, stocks surge and plunge for no good reason. People sell because other people are selling, or buy because other people are buying. (It's called "momentum investing" when the market is rising; it's called "panic" when the market is falling.) And as a result it's more a series of random leaps than a random walk.

And yesterday, of course, was a case in point. On what was basically a slow news day, markets suddenly dived, with the Dow falling more than 3 percent and the Nasdaq more than 5. It didn't rate some of the headlines it generated -- when a market that has risen around 90 percent over the previous year falls 6 percent, this is not exactly a "meltdown" -- but it was a pretty big movement to occur without anything happening to change your fundamental view about what is going on in the U.S. economy. (O.K., one group of investment analysts released a report predicting higher interest rates over the next year -- but there was no particular reason to think that these analysts knew anything that the rest of us don't.)

Why was the market so easily spooked? Presumably because everyone -- me included -- is even more confused than usual about what stocks are really worth these days. On one side, the U.S. economy has been practically wallowing in good news for the last few years: productivity has been soaring, allowing the economy to grow far faster than seemed possible without running out of labor, and anyway we seem to have mysteriously acquired the ability to employ people previously regarded as marginal without setting off a bidding war for the more obviously qualified workers. And with clever new applications of silicon chips coming out every day, it is easy to become, well, exuberant about the future.

On the other hand, as any financial theorist could tell you, good news that you already expect to hear isn't news. Five years ago, a 2 percent annual increase in worker productivity would have been regarded as excellent, and stocks would have risen sharply on the report; today it would be regarded as a disappointing performance, and would drive stocks down. In fact, current stock prices already have built in the expectation of economic performance that not long ago we would have considered incredible; performance that is merely terrific would be seen as a big letdown.

So which will it be -- terrific or incredible? We all have our opinions -- being a pessimist by nature, I think that things will be merely terrific -- but nobody, and I mean nobody, really knows. And a rational market would accept this ignorance, and wait for some actual evidence in favor of one side or the other.

Of course, it doesn't work that way. Yesterday, something -- if I knew what, I would be a lot richer -- caused investors to become slightly less convinced than they had been the day before that we are living in the best of all possible worlds. And the result was a huge destruction of paper -- um, I mean virtual -- wealth.

But hey, it's still a terrific economy. Or do I mean incredible?

Originally published in The New York Times, 1.5.00