Poking Holes in a Theory on Markets

12 replies

Jun 6, 2009, 01:19 PM

http://www.nytimes.com/2009/06/06/business/06nocera.html?_r=1&ref=business

For some months now, Jeremy Grantham, a respected market strategist with GMO, an institutional asset management company, has been railing about — of all things — the efficient market hypothesis.
You know what the efficient market hypothesis is, don’t you? It’s a theory that grew out of the University of Chicago’s finance department, and long held sway in academic circles, 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, like Richard H. Thaler at the University of Chicago and Robert J. Shiller at Yale, who convincingly showed that mass psychology, herd behavior and the like can have an enormous effect on stock prices — meaning that perhaps the market isn’t quite so efficient after all. Then came a bit more tangible proof: the dot-com bubble, quickly followed by the housing bubble. Quod erat demonstrandum.

“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.”

“There are incredible aberrations,” he told me over lunch not long ago. “The U.S. housing market in 2007. Japan in the 1980s. Nasdaq. In 2000, growth stocks were three times their fair value. We were quoted in The Economist in 2000 saying that the Nasdaq would drop by 75 percent. In an efficient world, you wouldn’t have that in a lifetime. If the market were truly efficient, it would mean that growth stocks had become permanently more valuable.”
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.
“It helped mold the ‘this time it’s different’ mentality,” he said. Indeed, professional money managers who tried to buck the tide wound up losing their jobs — because everybody else was making money by riding the bubble for all it was worth. 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. “Our default reflex is that the world knows what it is doing, and that is extravagant nonsense,” Mr. Grantham said.

“It’s ridiculous” to blame the financial crisis on the efficient market hypothesis, Mr. Malkiel said. “If you are leveraged 33-1, and you’re holding long-term securities and using short-term indebtedness, and then there’s a run on the bank — which is what happened to Bear Stearns — how can you blame that on efficient market theory?”
But then we started talking about bubbles. “I do think bubbles exist,” he said. “The problem with bubbles is that you cannot recognize them in advance. We now know that stock prices were crazy in March of 2000. We know that condo prices were nuts.”
I thought to myself: if a smart guy like Burton Malkiel had to wait for the Internet bubble to end to realize we had been in one, then maybe Mr. Grantham has a point after all.

jdang307Supporter

Jun 6, 2009, 06:03 PM

Hah! This article is like my investment firm's writings and mantra for the past 10 years. We make fun of the efficient market theory regularly.

I've posted an article by Grantham before, he's a great read and his newsletter is very insightful.

Our strategy is designed to take advantage of the herd mentality. Buying quality companies when they are out of favor (the herd moved on) with an intrinsic value much higher than current share prices, and then waiting for it to normalize.

We were in a huge cash position throughout last year. Our clients were pissed at first (hey why aren't I fully invested) until the bottom of the market fell out.

Thanks for the find DF. I won't blame the efficient markety hypothesis for bubbles, but it has caused a lot of pain. Yes most managers will not be able to beat the market, but an efficient market portfolio will ride bubbles down to the very bottom. And that's not very efficient.

You need some strategic investing.

DevilFin13Supporter

Jun 6, 2009, 10:31 PM

"jdang307 wrote:
Hah! This article is like my investment firm's writings and mantra for the past 10 years. We make fun of the efficient market theory regularly.
I've posted an article by Grantham before, he's a great read and his newsletter is very insightful.
Our strategy is designed to take advantage of the herd mentality. Buying quality companies when they are out of favor (the herd moved on) with an intrinsic value much higher than current share prices, and then waiting for it to normalize.
We were in a huge cash position throughout last year. Our clients were pissed at first (hey why aren't I fully invested) until the bottom of the market fell out.
Thanks for the find DF. I won't blame the efficient markety hypothesis for bubbles, but it has caused a lot of pain. Yes most managers will not be able to beat the market, but an efficient market portfolio will ride bubbles down to the very bottom. And that's not very efficient.
You need some strategic investing.

I'll have to call you when I get a real job some day. :up:

adamprez2003Forum Veteran

Jun 7, 2009, 02:31 AM

"jdang307 wrote:
Hah! This article is like my investment firm's writings and mantra for the past 10 years. We make fun of the efficient market theory regularly.
I've posted an article by Grantham before, he's a great read and his newsletter is very insightful.
Our strategy is designed to take advantage of the herd mentality. Buying quality companies when they are out of favor (the herd moved on) with an intrinsic value much higher than current share prices, and then waiting for it to normalize.
We were in a huge cash position throughout last year. Our clients were pissed at first (hey why aren't I fully invested) until the bottom of the market fell out.
Thanks for the find DF. I won't blame the efficient markety hypothesis for bubbles, but it has caused a lot of pain. Yes most managers will not be able to beat the market, but an efficient market portfolio will ride bubbles down to the very bottom. And that's not very efficient.
You need some strategic investing.

but you and your firm provide the equilibrium to make markets efficient. the efficient market doesnt say that bubbles dont happen or that fools dont lose money. all it says is that eventually and for brief moments equilibrium exists. when it gets skewed it always comes back.

the main thrust of the efficient market theory isnt even that however but rather that a free market will always be more efficient than a state controlled one over the long term and i think that is without question

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jdang307Supporter

Jun 7, 2009, 07:11 AM

That's not what efficient market theory is. Efficient market hypothesis assumes that all information available information on assets are already priced into the stock. Do you see how ridiculous this theory is in light of bubbles?

All information showed that tech stocks were unsustainable in 2000. Real estate was unsustainable in 2005. So on and so forth. The "herd mentality" pushes stock prices further than the price should be, thereby negating efficient market hypothesis. If a stock's price is pushed beyond what the average price should be, the "information" shows that the price should not be that high. But the price is. The fact that such a situation can even exist shows that EMH is invalid. Because information exists that the stock price is too high, yet it remains high. When you have a whole industry overprices, and you have a bubble, you do not have an efficient market.

Believers in EMH have been burned twice in one decade. How is that efficient?

jdang307Supporter

Jun 7, 2009, 07:12 AM

"adamprez2003 wrote:
all it says is that eventually and for brief moments equilibrium exists. when it gets skewed it always comes back.

That is not EMH. EMH says there are never any inefficiencies. Equilibrium is constant. Whatever the price is at any time, that reflects all known information.

And we know this to be false.

padre31Luxury Box

Jun 7, 2009, 08:20 AM

The market is rational?

:lol:

There is an old truism said about Wall Street:

"The market can stay irrational longer then you have money"

What a market is though, is self correcting, eventually, the bubble will burst, eventually a profitible companies stock will come into favor.

adamprez2003Forum Veteran

Jun 7, 2009, 12:57 PM

"jdang307 wrote:
That's not what efficient market theory is. Efficient market hypothesis assumes that all information available information on assets are already priced into the stock. Do you see how ridiculous this theory is in light of bubbles?
All information showed that tech stocks were unsustainable in 2000. Real estate was unsustainable in 2005. So on and so forth. The "herd mentality" pushes stock prices further than the price should be, thereby negating efficient market hypothesis. If a stock's price is pushed beyond what the average price should be, the "information" shows that the price should not be that high. But the price is. The fact that such a situation can even exist shows that EMH is invalid. Because information exists that the stock price is too high, yet it remains high. When you have a whole industry overprices, and you have a bubble, you do not have an efficient market.
Believers in EMH have been burned twice in one decade. How is that efficient?

I understand what you're saying but I think we're arguing apples and oranges here. EMH doesnt predict the future performance. All it says is that the current pricing is correct based on a combination of probabilities and current information. If the next day, new information is introduced that contradicts the current information the price will adjust. I am a much bigger believer in behavorial economics as an indicator of future performance but EMH works for the current price. I was in cash one year before the tech bubble burst because I didnt believe in the pricing anymore. On one hand that's smart, on the other I missed out on a year of profits. Nowadays I try to ride out the excesses a bit longer to try to capture more of the swings. I call it the musical chairs theory. No need to be sitting while the music is still playing but make sure you're in front of a chair at all times because you know its gotta stop eventually

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jdang307Supporter

Jun 7, 2009, 06:23 PM

That's the thing though about the theory. No new information exists the day after a bubble starts to burst than the day before that explains the bubble bursting. The fact that a bubble can exist destroys the theory if you think about it.

EMH Doesn't predict future performance. But it argues that the price at any given time reflects all known information out there. I.e. there are no inefficiencies to exploit unless you are an insider trader (trading on information that is not out there). I find this hypothesis to be false.

adamprez2003Forum Veteran

Jun 7, 2009, 07:04 PM

"jdang307 wrote:
That's the thing though about the theory. No new information exists the day after a bubble starts to burst than the day before that explains the bubble bursting. The fact that a bubble can exist destroys the theory if you think about it.
EMH Doesn't predict future performance. But it argues that the price at any given time reflects all known information out there. I.e. there are no inefficiencies to exploit unless you are an insider trader (trading on information that is not out there). I find this hypothesis to be false.

one of the central tenets of EMH is that the majority of professional investors will fail to beat the market. I have found that to be true in my limited career on Wall Street. Whats your take?

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jdang307Supporter

Jun 8, 2009, 02:07 PM

"adamprez2003 wrote:
one of the central tenets of EMH is that the majority of professional investors will fail to beat the market. I have found that to be true in my limited career on Wall Street. Whats your take?

What is a professional investor anyway, and how are they selected? :pointlol:

My take is that the majority of investors who think they are professional will fail to beat the market.

They say only 1/3 of all fund managers (I guess that's who you can call a professional investor, but as someone who has launched two mutual funds I know that is not a requirement) beat the market. What these pundits fail to say is that according to a study, 2/3 of all money invested in funds are invested in this 1/3.

with proper diligence, screening and monitoring, you will find these managers. It's the reason why the same funds appear in 401ks, pension funds, VA's etc. as options.

If I told you, here are 100 managers. 33 of them will beat the market, 67 will not. Pick one. Of course you have a 33% chance of picking right. If I tell you, you can research them, read other's research, move your money around, monitor them. Your % should go up significantly, no?

That's the problem with EMH. It assumes you have a 33% chance of picking the right investor. Yeah if you throw a dart and then do nothing forever.

adamprez2003Forum Veteran

Jun 8, 2009, 04:55 PM

"jdang307 wrote:
What is a professional investor anyway, and how are they selected? :pointlol:
My take is that the majority of investors who think they are professional will fail to beat the market.
They say only 1/3 of all fund managers (I guess that's who you can call a professional investor, but as someone who has launched two mutual funds I know that is not a requirement) beat the market. What these pundits fail to say is that according to a study, 2/3 of all money invested in funds are invested in this 1/3.
with proper diligence, screening and monitoring, you will find these managers. It's the reason why the same funds appear in 401ks, pension funds, VA's etc. as options.
If I told you, here are 100 managers. 33 of them will beat the market, 67 will not. Pick one. Of course you have a 33% chance of picking right. If I tell you, you can research them, read other's research, move your money around, monitor them. Your % should go up significantly, no?
That's the problem with EMH. It assumes you have a 33% chance of picking the right investor. Yeah if you throw a dart and then do nothing forever.

its funny but i actually agree with miost of what you say. i guess where we differ is simply how we view EMH. To me EMH is not a theory you can trade off. (There is weak and strong EMH but thats another discussion) EMH basically says you as an average or mean investor have no advanatge. It doesnt discount the above average intelligent investor from beating the market but it says the majority wont. So if 66% of fund managers fail to beat the market that kind of validates the theory IMHO.

For trading I use a macro screen and then start using micro screens until i get the right companies( or commodities) in the right sectors. Then I go off of technical analysis. I believe in behavorial economics so that plays a role too

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jdang307Supporter

Jun 9, 2009, 01:29 PM

I guess my problem is that investors will read it and think, 66% of fund managers will not beat the market. I should not invest in active funds. But that to me is a foolish theory. I don't disagree with that statistic, but just disagree with their conclusion.

It's like saying 2% of all NFL players make the pro-bowl. So you have a 98% chance of picking the wrong person you predict will make the pro-bowl. Ignoring the fact you can view history, statistics etc. who would make such a statement. You won't get it right, but you'll be better than 98%.

You find best of breed Fund Managers and this 33% number goes much much higher.