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March 03, 2014
Nobel laureates Robert Shiller (left) and Eugene Fama (Illustration by HelloVon)
To discuss the EMH one needs an asset valuation model (the valuation is the conduit to the price). If you want to see how investors price equities (the SP500) read my working paper
How Investors Set Equity Prices: "An Endogenous Growth CCAPM (EG-CCAPM) with Low Pricing Error"
The quick answer is that investors efficiently input the pricing data variables into the SP500 price. A future price forecast (not a statistical return forecast) can only be made using the investors forecasts for each of the pricing data variables. Statistical return forecasts are possible because of mean reversion (but typically there are huge errors and the return forecasts are of little use to the investor).
This article proves that economics is an art to which some place mathematical formulations to give the appearance of a science. The Nobel prize in economics is as worthless and meaningless as the Nobel Peace prize.
The hedge fund Long Term Capital Management is an example of what happens when two Nobel laureates attempt to run a business - failure. I am not aware of any successful businesses started and run by economists.
The authors appear to have stumbled over the very Upton Sinclair observation regarding bias that they themselves quote.
Best article I have ever read on the subject, and I've read a lot of them. My only gripe, in so far as I have one, would be the authors' failure to dig a little deeper into the reasons why markets' seem so difficult to beat as evidenced by the paucity of active managers that succeed. Could this be because most are not trying? My major take-away from this article to paraphrase Einstein is, "not everything that counts can be counted".
With respect to just the CAPM and corporate investment decisions, all of us who took finance courses understand the vagaries of deriving a cost of capital in the first place compounded by estimating forward cash flows, particularly the terminal value. Hence, any CFO worth their salt is going to have a range of outcomes in evaluating capital investments.
Perhaps more to the point for this audience, what Fama and others have not only posited, but have in fact demonstrated time and again, is that active managers consistently fail to outperform their benchmarks in developed markets. This reality applies to funds competing against everything in the US from the S&P 500 to the Russell 2000, as well as the FTSE100 and EAFE. In short, this is where the rubber meets the road for most practioners who are managing portfolios whether for large pension plans or individuals. There, the message is clear: utilizing low-cost, passive index investments, particularly ETFs such as the SPY, VO, or EAF is the smart way to invest and using actively managed solutions in these asset classes is consistently a high cost mistake. And, that is the chief value of the work done by Fama, Markowitz, et al.
Market fundamentalism was to blame for the 2008 debacle in that it considered the markets as a self-cleaning oven that should not be regulated. Austrian fantasists refused to recognize that in the event risk-management was a total failure and a stronger government presence was necessary.
"Too big to fail" is an utterly practical, earthbound description of a market with a handful of players who can bring the global economy to its knees. There is no ideological component to it. It recognizes that concentration has gone too far, and threatens more than it benefits. On a risk/reward basis, it's absurd.
As for EMH, all neophyte investors are advised to read Charles MacKay's "Extraordinary Delusions and the Madness of Crowds," but apparently ivory tower EMH proponents have forgotten it. In their Panglossian worship of free markets, they attempt to purify the object of their devotion. Recognizing the irrationality of markets somehow degrades the worth of their religious belief. Behavioral concepts may be difficult to trade, but that doesn't make them untrue.
As for saying that "The markets are batsh*t" is empty, well so is the Universe. Somehow we cope anyway. EMH becomes our Invisible Friend who loves us and will redeem us. In fact, the markets are truly batsh*t, which is why with all the accumulated brains and computer power, people and institutions cr*p out regularly.
I like this article, and I'd offer another common sense argument that markets are quite efficient but not perfectly efficient.
There is a large reward for anticipating the joint distribution of total return for assets each of which one could own or owe in some amount, just like there is a large reward for becoming a pop star. So of course, lots of people will try to do both of these things, and only some of these competitors will truly be able to anticipate total returns or become a pop star. Furthermore, the population at large may lose by spending more on that pursuit than the population at large gains, as American Idol's Simon Cowell reminded many pop star hopefuls.
The real question is what percentage of the participants is "some of them", and what percentage will they experience of the gains and costs. How concentrated will be the winners? Pop stardom was probably less concentrated in the days before recorded audio and video, and investment "alpha" may have been likewise when investment information was less liquid. But investment investment will never be perfectly liquid, so there will always be opportunities not only for massive winners like Renaissance Technologies but also for small winners even among individuals who occasionally have some differentiated insight about business and investment based on their differentiated experience of our world.
The authors are correct that the EMH is a good starting point for thinking about financial markets work. Given how hugely competitive financial markets are these days, the Fama theory is still the best working assumption for most people.
The political attack on 'market fundamentalism', though is not about market efficiency in relation to security markets. It is about the application of this theory to political economy and macro-economic policy.
Yes, security markets are hard to beat. But security markets are not the economy. Judgements over allocation of resources, arguments over wealth disparity and questions about the externalities of hands-off policy-making are quite rightly political questions.
What critics of market fundamentalism are talking about is the extrapolation of market efficiency to all areas of life and the naive faith in theoretical models that that approach involves.
Using taxpayers' money to bail out bankers who obscured the risks they were taking, paying obscene salaries to CEOs who focus on short-term share price movements at the expense of growing long-term wealth, ignoring the environmental impacts of activities that create fat profits for mining companies, treating human beings as raw inputs and the elevation of the financial bottom line over social capital are all valid critiques of the wider application of market efficiency to our lives.
A pretty good article, though I have seen better from AQR. As is (unfortunately) the case, this article only focuses on the tensions between “efficient markets” and “behavioral economics” viewpoints to examine markets, while ignoring theories relating to complex adaptive systems. Spending a little bit of time with complexity would yield insights like (a) studying the behavior and preferences of agents may not be necessarily very helpful for learning about the market and (b) complexity can break down in many specific cases (bubble territory), perhaps most notably when cognitive diversity declines beyond a certain threshold. With respect to (b), it is interesting to note that the authors’ statement “At their core bubbles seemingly are caused by an intense belief in the hypothesis that markets are ridiculously inefficient…” fits this, but so does its opposite (i.e. ‘intense belief that markets are ridiculously efficient’).
Maybe complexity is beyond the scope of the article – and/or beyond the Nobel committee for Econ. But at times it feels like the authors are men with only a hammer and screwdriver in their toolkit, which is a (small) improvement upon traditional ‘man with a hammer’ syndrome.
In a zero-sum set up, where efficiency is always defined in Pareto terms, ‘no one can be made better off without someone being made worse off”, the true test of efficiency lies in the unwinding of this puzzling question that when a rising tide lifts all boats, the very premise on which efficiency is nuanced is lost as there are gains to be made without any one really losing anything. But how could tides be kept rising is when a build-up of a bubble could be co-created and that is the only condition when Pareto optimality loses its significance.
Betwixt reversing positions and arbitrage, between the aids of an index linked investment decision and a pure-play of stocks, alternating between shorts and longs, we are in an infinitely precipitate world of options that change with hordes of people making decisions based on information that even in an inter-connected world could be nuanced in various directions; the least we should expect is an outcome that can be remotely connected to logical structures that influenced the gains or losses in an efficient manner.
It is by chance that an outcome is what it is.
Long way of saying --- as Buffet would say --- the stock market is *often* efficient, but it is not *always* efficient. Also, for what it's worth, Grantham at GMO would argue there have been plenty of major bubbles-- Japan equity in late '80's, Japan land, tech of '00, global mania of '07.
The authors do an effective job explaining that markets are inefficient, but maybe not so much that many can take advantage of the inefficiencies. However, although they gave some disclaimers, they should have also given one before diving into their rec's for the government. These suggestions for the most part help active managers, who as they explain, pretty much just make money for themselves - if they are any good as the authors explain they take out the additional amount in fees or are closed to outside investors.
I disagree with the assertion that high turnover market makers provide necessary liquidity. When the markets are running smoothly, high speed traders make a lot of money. This is not when you need these folks - there was enough liquidity in this environment to facilitate trade already. When markets plunge, such as late '08, these traders pull away from the markets. These people are not there when the market truly needs them. A very tiny transaction tax on what 99.9% of us would classify as very large trades should be enough to stop this. When markets are illiquid, very few large trades like this are executed, so there effectively would be no impact on liquidity.
The term 'market efficiency' is ambiguous and nearly meaningless. There is a difference between economic efficiency and efficiency for the betting on stock market prices, the former being related to the efficient allocation of resources, and the latter more of a psychological betting parlor that is efficient only in the long term.
The securities markets that accept bets are not free markets in any real meaning of the word, as they are heavily subsidized by their being regulated. The role played by Caveat Emptor, which would be healthy and detrimental, in a free market would impose a substantial cost on the producers to alleviate the fears of the consumers in order for a market to be made for their products. These market makers have shifted those costs to the taxpayers through regulations and agencies like the SEC. Caveat emptor is necessary to function for the prevention of bubbles and other manifestations of market hysteria, and when it is socialized and the consumers are seduced into thinking everything is safe, markets tend to become betting parlors rather than longer term investments.
The market efficiency these authors speak of relates to bets on short term emotions and beliefs. These are bets on human behavior, and aren't designed to be held for very long. At any moment in time, the securities markets show exactly what the emotional sentiments of investors are. Essentially, people are trying to make money on each other's stupidity.
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