Markets ARE Efficient; The Focus Is Wrong

Markets Are Efficient But The Focus Is Wrong
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By Kevin Bailey | 23 May 2002

There seems to be confusion as to the definition of Efficient Market Theory (EMT). This was a term coined by Professor Eugene Fama in his doctoral thesis in 1962. The theory holds that stocks are always correctly priced since everything that is publicly known about the stock is reflected in its market price. Fama describes this in a review for the Journal of Finance in December 1969 where he details that the primary role of the capital market is the allocation of ownership of the economy's capital stock.

In general terms, the ideal is a market in which prices provide accurate signals for resource allocation. That is, a market in which firms can make production / investment decisions, and investors can choose among the securities that represent ownership of firms— under the assumption that security prices at any time 'fully reflect' available information. This is what is meant as (and is called) 'efficient'— EMT is not about perfect pricing but rather about imperfect pricing in a random (aka, 'stochastic' or 'statistical') manner. The point of capitalism is that capital markets work and that risk is rewarded.

Therefore, the market is the sum total of all participants estimations and all known information. One manager or one investor cannot consistently outpredict or outforecast every other participant [[but note: it can take as long as 20 years to distinguish Nassim Taleb's "lucky fool" from someone who is actually showing a real ability to "predict" (or "anticipate") the markets! : normxxx]]. There are indeed times when with the benefit of hindsight we see that the sum total of investors are behaving in a manner which seems hard to justify. The example of the NASDAQ trading at the PE of 150 was stupid just as when it was trading at 100 or 50. Should one have stood aside when the NASDAQ PE rose to over 30 times earnings in the early nineties and should one continue to stand aside now because, despite a seventy percent fall, NASDAQ is still trading at crazy PE's?

In 1992, Professors Fama and French (F&F) developed a dramatic paper that helped to explain the relative outperformance of some managers by defining the different dimensions of risk. They documented the three factor model which explained the smaller companies' effect and the value effect which is evident in all markets around the world. Value and size are dimensions of risk and in a logically efficient market, over time, those investors willing to take on the increased risk of small companies or of distressed, out of favour [[ie, 'large value': normxxx]], companies should be rewarded with a higher rate of return.

[ Normxxx Here:  But why should the market trade at all? It has been suggested that F&F predicts that the market will reach some 'equilibrium' point and, thereafter, trading should be minimal, if at all! But this shows a profound ignorance of EMT and stochastic models. In the first place, EMT is NOT a 'static' model; it recognizes that at every instant, new information is entering the market and old information is becoming 'stale', so at every moment, the market must reevaluate! Second, it says that the market is 'efficient'— NOT 'true'! That is, it merely 'approaches' the "true" value, stochastically, only over a long period of time— and we have already conceded that that "true" value is changing from moment to moment!  ]

It should cost more for a riskier company to raise capital, via a higher interest rate on borrowing and/or a lower share price on equity capital. Thus, it is a cost of capital argument not an inefficiency argument at all. Some managers taking greater small company or distressed company risk get a higher return, whilst others pay the price of this risk and lose out, ending up with a lower return than the broader market. The returns of all managers or participants in the market can be charted and you find the normal bell curve distribution of results with most managers falling close to the index with a few outliers at the extreme good and bad ends.

We all know who the good outliers are. They get massive inflows after they have achieved their "outstanding" performance and have the cash flows to swamp us with advertising spend about their past performance. The bad outliers disappear or are quietly taken over so we end up with survivorship bias. The trouble is that none of us can predict in advance who the next batch of good outliers are [[since, according to F&F, all of the current outliers are simply "lucky fools": normxxx]].

For the last five years it was Colonial First State and the five years before that it was Bankers Trust. Who will it be over the next five years? The examples that have been used to prove the theory that some managers can predict the future, happen to be instances of extremely disciplined managers who stick to their strategy and capture the small company and value risk premium. Mentioned are Warren Buffett, Kerr Nielson and Robert Maple Brown because they are outperforming their peers at the moment. But, all were underperforming their peers four or five years ago, and virtually all 'EMT debunkers' neglect to tell us whom they have masterfully chosen to outperform their peers over the next five years.

In my view, it requires an abandonment of commonsense to believe that in spite of overwhelming scientific evidence to the contrary[!?!] the markets with millions of participants are not more efficient at allocating resources in a risk adjusted manner than ANY one individual is on his own, or even with the help of a team of, 'smarter than the rest of us', researchers.

For example:

• During the tech boom those investors speculating and driving prices to extremes and expecting extreme returns were indeed rewarded with extreme risk returns. The trouble was finding the guru who would be able to predict the day or even the year when the time of reckoning would come. Certainly the fund managers involved in that sector did not seem to have this power.


• On 30th June 2001, if there was a swing of 70 points in the ASX 200 index in the fifteen minutes after the market closed— was anyone able to predict this ramping and profit from it as the efficient market corrected it within a few minutes of opening the next day?


• On 20th October 1987, if our market was 25 percent lower at the end of the day than the beginning was our active friend able to short the market and profit? If so, was he or any fund manager able to repeat the performance by systematically gaining this market intelligence in advance of any other dramatic change in collective sentiment which drives markets in the short term?

EMT's view is that all of these were the result of temporary market mania and all were unable to be profited from as all were unpredictable in advance [[or even as they were occuring: normxxx]]. They were the rapid revaluation of circumstance by millions of investors reacting independently to new and evolving information and no one individual was able to consistently predict when the sum total of other participants (the market) had over reacted or under reacted.

In 1987, the total of all participants in the US market collectively over reacted to known information. [[And, to this day, no one knows what that 'information' was! : normxxx]]. As a result of this 'overreaction', the prices quickly recovered after the share market crash[[, stabilizing by the end of that year: normxxx]]. In the previous great crash in 1929, the total of all participants underreacted to the information and another bigger crash was required and occurred in 1930. The EMF postulates that around half the crashes should be too little and half should be too big [[ie, with "coin toss" accuracy: normxxx]] for markets to be operating efficiently in the long term. Unpredictable economic outcomes generate price changes. The distribution is around the mean— the expected return that people require to hold stocks. That distribution has outliers, sometimes too much adjustment to new information, sometimes too little but always unpredictable in advance.

It has been asserted that Morningstar data shows that (net of fees) the average 'local equity trust' [[ie, in the US, an average 'investment fund': normxxx]] has beaten the All Ords Accumulation Index [[ie, in the US, either the Dow or the S&P 'average': normxxx]] since 1980 by twenty one percent. I take that to mean one percent p.a. over twenty one years and this can be entirely explained by survivorship bias. Not stated is that only the above average (lucky?) managers would survive the twenty one years and all the other horror managers drop out. This would so grossly distort the figures as to make one percent p.a. an appalling result. I can guarantee no one would have been able to predict in 1980 the managers who would survive and those who would fall by the wayside. Talk about torturing the facts until they confess. Even if it were true that the average manager did outperformed by one percent, it is an awful lot of extra risk and cost and churning to justify it. I bet none of the managers promised to outperform by only one percent per year.

The reason the average investor consistently makes poor buy/sell timing decisions is they are constantly being advised to get into a fund that is outperforming its peers just before it regresses to the mean. There is an entire advice and research industry receiving big commissions to change investments that is perpetuating this phenomenon. Saying markets are efficient is not saying managers are stupid or lazy. Far from it. It is precisely because they are so good at processing all known information that there is no room to profit in advance from glaring inconsistencies. There is a capital market rate of return and that return over time will be greater with more exposure to the risk of small stocks or distressed stocks in a portfolio. It is the cost of capital argument that has been disguised as undervalued or overvalued stocks.

Over ninety-four percent of the return achieved by all managers and market participants can be explained by their exposure to the risk factors of market risk, small company risk and value stock risk for which the cost of capital premise demands they be paid a premium. Despite this, as long as there is a buck to be made in marketing the golden goose the focus and expense will be poured into the minor factors of stock picking and market timing, (which account for only six percent of return), and scorn will be poured on anyone daring to shout the truth in the tradition of Copernicus.

[ Normxxx Here:  Ah, but as seemingly iron-clad as this argument is, this is NOT the last word, as I shall attempt to show in future such articles!  ]

Normxxx    
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