Efficiency

Poking Holes in a Theory on Markets

...the efficient market hypothesis is ... a theory that ... the stock market can’t be beaten on any consistent basis because all available information is already built into stock prices. The stock market, in other words, is rational.

In the last decade, the efficient market hypothesis, which had been near dogma since the early 1970s, has taken some serious body blows. First came the rise of the behavioral economists ... who convincingly showed that mass psychology, herd behavior and the like can have an enormous effect on stock prices... Then came a bit more tangible proof: the dot-com bubble, quickly followed by the housing bubble...

These days, you would be hard-pressed to find anybody, even on the University of Chicago campus, who would claim that the market is perfectly efficient.

The financial services industry, of course, has a great interest in undermining the efficient market thesis. To the degree it holds true, active fund managers (which is to say all of them) are snake oil salesmen, plain and simple.

Markets should be mostly rational, by the simple syllogism that markets are made up of people, and people, when it comes to their money, are mostly rational. Certainly, as the behavioralists show, people are never entirely rational and so markets are, perhaps, never entirely rational.

That said, the focus on broad behaviorism obscures, I think, a more fundamental irrationality embedded in markets, which is: People, acting rationally within in their individual constraints, do not always produce a rational outcome in aggregate.

More directly: In the current regime, what an investment manager thinks about a company is only a part (perhaps even a small part) of an investing decision. There are all sorts of additional concerns that factor in. For example, a manager has to be concerned about the optics of the investment her own, often under-informed, investors. A manager has to consider the changing regulatory and political environment in which the company operates (its fair to say that the investors the past nine months have been betting more about "what the government will do" than "what a company will do"). There are all sorts of constraints that operate in the name of "Risk Management" that seem to do far more to distort prices then reduce risk. Above all, a manager has to consider the regulatory environment in which she operates. All these considerations alter investment decisions.

In other words, the market is composed of people who are making decisions that only partially reflect economic information and expectations and so market prices only partially reflect that information and expectation. The more these external factors dominate investment decision making, the less rational markets are. And the more irrational markets appear the more likely these external factors are dominating.

Yet ... In Mr. Grantham’s view, the efficient market hypothesis is more or less directly responsible for the financial crisis.

“In their desire for mathematical order and elegant models,” he wrote in his firm’s quarterly letter to clients earlier this year, “the economic establishment played down the role of bad behavior” — not to mention “flat-out bursts of irrationality.”

He continued: “The incredibly inaccurate efficient market theory was believed in totality by many of our financial leaders, and believed in part by almost all. It left our economic and government establishment sitting by confidently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments led to our current plight. ‘Surely, none of this could be happening in a rational, efficient world,’ they seemed to be thinking. And the absolutely worst part of this belief set was that it led to a chronic underestimation of the dangers of asset bubbles breaking.”
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Justin Fox’s ... thesis, essentially, is that the efficient marketeers were originally on to a good idea. But sealed off in their academic cocoons — and writing papers in their mathematical jargon — they developed an internal logic quite divorced from market realities. It took a new group of young economists, the behavioralists, to nudge the profession back toward reality.
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As Mr. Fox describes it, much of the early academic work that led to the efficient market theory was aimed at simply showing that most predictive stock charts were glorified voodoo... Dissertations were written showing how 20 randomly chosen stocks outperformed actively managed mutual funds...

In time, this insight led to the rise of passive index funds that simply matched the market instead of trying to beat it. Unless you’re Warren Buffett, an index fund is where you should put your money. Even people who don’t follow that advice know they should...

As Mr. Grantham sees it, if professional investors had been willing to acknowledge these aberrations — and trade on the fact that the market was out of whack — they should have been able to beat the market. But thanks to the efficient market hypothesis, no one was willing to call a bubble a bubble — because, after all, stock prices were rational...

The notion that no one was willing to call a bubble a bubble is silly. I don't think it would be difficult to find mountains of published quotes from the peak of the respective "booms" calling them "bubbles".

The job of an investment manager is not to avoid bubbles, on the contrary. Bubbles -- which make it very easy to buy low and sell high -- are an investment managers best friend. The job of an investment manager is to time her trades properly.

Finally, again, the notion that "professional investors" were captive to efficient market theory defies reason. If one is captive to efficient market theory, one does not actively trade.

Meanwhile, government officials, starting with Alan Greenspan, were unwilling to burst the bubble precisely because they were unwilling to even judge that it was a bubble...

There is a stronger argument in regards to government officials. For example, regulators have long operated under the "theory" -- one that perhaps ought be revisited -- that introducing externalities into investment making decisions does not reduce the efficiency of markets.

On the other hand, Alan Greenspan -- given his famous "irrational exuberance" speech -- is an ill-fitting posterboy for "government officials unwilling to even judge that it was a bubble". The decision, on the part of government officials, of if, when and how to burst a bubble is a tremendously complicated one. There are many reasons (good and bad) why a government official might recognize a bubble but be unwilling to burst it.

Mr. Fox sees it somewhat differently. On the one hand, he says, the efficient market theoreticians always assumed that smart market participants would force stock prices to become rational. How? By doing exactly what they don’t do in real life: take the other side of trades if prices get out of whack. Their ivory tower view reflected an idealized market that simply doesn’t exist.

The crucial question, to my mind, is why that market does not exist. I don't believe the evidence supports the (behavioralist) assumption that smart market participants were entirely oblivious to the bubble around them. To understand why the efficient market theory failed, one has to understand the many reasons why a smart market participant who recognized the bubble around her might not force stock prices to become rational.