At this point, you would have thought the Efficient Market Hypothesis would have died a quite death. But as is its wont on Wall Street, myths, bad theories, and old information linger far longer than one would expect.
Today’s case in point: The WSJ Ahead of the Tape column today (Predicting What’s Next Gets Harder) looks at how much of a future discounting mechanism the markets actually are:
Investors often expect the stock market to behave like a crystal ball. Lately it has made a better rearview mirror.
Conventional wisdom holds that the market efficiently reflects future corporate earnings. This makes sense, as one ostensibly buys stocks in companies to claim bucketfuls of their future profits.
For decades, turns in the stock market typically led earnings by roughly six months. But during the past decade or so, stocks have moved roughly in tandem with, and occasionally lagged, the trajectory of profits, notes Tobias Levkovich, Citigroup’s chief U.S. strategist.
I have several favorite examples of where markets simply get it wrong. When I spoke with the reporter on this, I used the credit crunch as exhibit A. It began in August 2007 (though some had been warning about it long before that). Despite all of the obvious problems that were forthcoming, after a minor wobble, stock markets raced ahead. By October 2007, both the Dow Industrials and the S&P500 had set all time highs. So much for that discounting mechanism.
We’ve seen that sort of extreme mispricing on a fairly regular basis. In March 2000, the market was essentially pricing stocks as if earnings didn’t matter, growth could continue far above historical levels indefinitely, and value was irrelevant. How’d that work out?
Three years later, the market priced tech and telecom in a similarly bizarre fashion. Some of our favorite tech and telecom names — profitable, debt free firms — were trading below their book value. Some were even trading below cash on hand.
The market had "efficiently" priced a dollar at seventy-five cents.
The most fascinating aspect of this is the opportunity for anyone int he market to identify inefficiencies. Discover where the market has a non random error — we’ve called it Variant Perception over the years — and you have a potentially enormous money making opportunity.
This is the reason why everyone doesn’t simply dollar cost average into index funds — its the lure of the big score. And as the recent list of Hedge Fund Winners and Losers makes clear, the winners reap enormous windfalls:
"All of this suggests the stock market may prove less useful as a leading indicator of profits and economic growth. But it also suggests stocks are likely to get out of balance more often, creating opportunities for savvy investors."
Levkovich points to the "proliferation of hedge funds" as making
markets "increasingly focused on breaking news and short-term swings,
rather than longer-term fundamentals." I would add the narrow niche
focuses used to differentiate amongst funds and raise capital also
contribute to this phenomenon. We end up with a case of the six blind men describing the
elephant, with few seeing the big picture.
To an EMH proponent, however, hedge funds should make markets more,
not less efficient. Their long lock period (when investors cannot take
out cash) means they should have a longer time horizon for investment
themes to play out.
One of my favorite quotes on the subject comes from Yale University economist Robert Shiller. He notes the huge mistake EMH proponents have made: "Just because
markets are unpredictable doesn’t mean they are efficient." That false leap of
logic was one of "the most remarkable errors in
the history of economic thought."
Just don’t tell certain Traders that. They hate hearing that markets contain a high degree of random action and inefficiencies.
Except for the really clever ones . . .
Source:
Predicting What’s Next Gets Harder
MARK GONGLOFF
WSJ August 11, 2008
http://online.wsj.com/article/SB121841270391428377.html
the market is a discount mechanism, always has been. I guess we can make a slight argument then that it is a market indicator for the very near term, albeit an unreliable one.
Stocks are irrational, overshooting in good times and undershooting in bad times. Now I dont know where we are right now, but my gut says that stocks have not priced in the possibility of a sever consumer led recession. I recall last October, with so many headwinds out there, stocks were near all time highs. It just didnt make sense. And the rally after Bear Stearns that took us to 13,100, with all the issues in the credit markets before stocks ‘woke up’, so to speak, to a new lower trading range that we are in right now.
While I think the current bear market rally still has some legs, I think the next big downturn will price in the consumer slowdown and wake more people up to reality.
Decades of credit expansion, and all of sudden the spigots are closed, and all we see is a 15% correction? I have a hard time believing the bottom is in!
Barry,
Markets, whether they are labor, flea, oil, stock or futures, are subject to the laws of Supply & Demand.
I always find it odd that we all know this to be true for most markets, but somehow forget this when it comes to the stock and futures markets.
Why is this? Is it a function of the human psyche’s need to prognosticate?
IMHO, before you can even have a logical discussion on whether the markets can be predictive, you would have to have all those involved in the discussion to agree to what time-frame they were discussing.
I think that in the short run, the markets move up because of the predominance of Buy Programs over Sell Programs.
Massive Buy Program trading runs started on the morning of July 17th right at the low from May to June.
At each successive dip, massive Buy Programs kicked on at each low.
You can examples of these recent Buy Programs here:
http://www.transactionlevelanalysis.com/2008/07/go-figure-the-dow-closes-up-26.html
Thus, I guess you could say that if Buy Programs and Sell Programs are future indicators of Price, should we then perhaps be looking at them for future indication?
Barry, dig your blog…
C
My variant perception radar is telling me that the Mall Property REIT’s market is still widely inefficent! Why with all those box stores going out of business and other retailers closing stores. Add in the dismal consumer spending numbers and what do you get?
when the rate of capital accumulation far outstrips the country’s ability to productively absorb it then you must expect that your average hedge fund becomes somewhat irrational. If there were 15 great companies competing for your cash Wall Street would be a far more discerning investor.
Financials markets are exhibiting an abnormal distribution to be read as they are driven through an axiom of dictatorship (for further details see K Arrow).
Since when a dictatorship has shown more merit than a selecting mode with equal weighing (for further details see all references to PPT)
When plotted an a long time scale graph and log normalised they look intelligent when looking with a precise time scale in association with the occurrence of events they are willing and obedient laggards (they call it complacency when it is complicity) .
Markets actors are readers of effects and poor readers of the causes (large time lag)
I think the markets are more like a person, albeit one w/ severe bipolar disorder.
They are manic-depressives, swinging irrationally from one extreme to the other.
Right now, I think the recent rally in the dollar and stocks, seemingly non-sensical, is attributable to the political landscape. Markets hate uncertainty, even if certainty ain’t so good for them, either. IMO, these rallies are due to the markets coming around to the notion that the presidential election is not a foregone conclusion, as recent polls have shown McCain to be running even or better.
Perhaps McCain represents a more predictable (and therefore more certain and more desirable) political landscape for markets than would Obama, a still mostly unknown quantity.
(Caveat: This is NOT an endorsement of either candidate. It’s just an observation that markets, lurching from fear to hope and back again on a dime, might favor ameliorating the fear of the unknown more than suffering an uncertain hope. It’s just a theory. Don’t get your lizard brains going over it.)
Barry,
I suspect that the market has been distorted as an idicator recently because companies have been buying back increasing amounts of their stock in response to Bush’s 2003 tax cut. See our commentary in today’s Enter Stage Right: http://www.enterstageright.com/archive/articles/0808/0808ecgrowth.htm
Howard Richman
http://tradeandtaxes.blogspot.com
It seems Shiller has confused efficiency with perfect foresight. Nobody knows what the future holds, but I think the market is pretty good at reflecting the aggregate view of the various participants. Whatever you want to call it is up to you.
I admit I’m a EMH believer, but it’s been harder to keep my faith during the last year.
My favorite EMH parable is this:
An economic professor and a graduate student are walking through campus when the student sees a $20 bill on the ground.
“Look!” he says to his professor.
The professor says, “That can’t be there, someone else would have picked it up already!”
“Well I’m going to pick it up and spend the rest of the day looking for more!”
The student is right in that any opportunity found should be taken, but the professor is right because spending your day looking for found money is not practical.
Now, I’m starting to think that it might be. Maybe the students on this campus all have holes in their pockets.
Even so, I’m leary of giving up on EMH. I think part of my faith springs from an innate fear of the following:
“Markets can remain irrational longer than you can remain solvent.” (Keynes)
the whole concept of markets predicting the future is a sham.
market participants are human. humans have no innate ability to predict anything.
so getting a bunch of us in a room predicting future events does not reverse that inability, just like pooling thousands of mortgages together into a CDO doesn’t make the mortgages more sound.
if you explain this concept to any common sense layman, they’d consider you a nitwit for explaining the obvious.
to an economist or money manager, this concept is sacrilege.
Stocks are not irrational; Markets are not irrational; HUMANS are irrational!
Without knowing this and without know your self and what it is you are trying to produce as an investor (higher returns, intrinsic value, euphoria) then you will only be a tool used by someone else or some other entity that does have this knowledge.
“A hidden connexion is stronger than an obvious one.” ~ Heraclitus
my nihilistic opinion is that regulation FD has something to do with it.
Everyone so often, someone makes a comment that really makes me wish I had made myself. I have always felt that the market shibboleth of “discounting the future” when it make bizarre moves up or down was absolute horse crap. But people say it all the time, with ZERO evidence of its veracity. So kudos to M3 for the following:
“the whole concept of markets predicting the future is a sham.
market participants are human. humans have no innate ability to predict anything.
so getting a bunch of us in a room predicting future events does not reverse that inability, just like pooling thousands of mortgages together into a CDO doesn’t make the mortgages more sound.
if you explain this concept to any common sense layman, they’d consider you a nitwit for explaining the obvious.
to an economist or money manager, this concept is sacrilege.”
Posted by: m3 | Aug 11, 2008 11:25:11 AM
Remember this, it will save and make you a lot of money in your investing career.
If increasing levels of corruption is all that is left for the US-financial system/Govt., then by all means, the Market is a future indicator and it will go higher-leaving most people poorer.
People can remain in denial far longer than they can remain solvent.
You know,
The indexers have repeatedly said that the vast body of academic research supports their position.
So, you are arguing against a ton of science ( or is that ‘science’?) and the consensus of the financial academic community.
Are you sure about that?
I’m just sayin’
You know,
The traders who have legendary performance and made a ridicious amount of money must have been wrong because the EMH tell them it is impossible for someone to outperform (trade) the market.
So, you are arguing against a ton of practical examples and real facts that the market is indeed inefficient.
Are you sure that humans are perfect beings that always act rationally and is able to receive correct information at all time?
I’m just saying’
Academic studies are pointless, these professors aren’t even rich at all, what makes them to argue against those who have exploited human emotions to made money?
When discussing the EMT, it’s important to distinguish between the idea that market predictions are always correct (which nobody believes) and the idea that they are pretty rational given the limited information about the future (which some people – but not me – believe). So examples where the market got things wrong don’t, by themselves, doom the more sensible versions of the EMT.
IMO, better evidence against the EMT comes from observing the self-reports of various market participants about why they are buying and selling at any given time to see whether they self-report to be based on theories of discounted future earnings, whether the self-reports are consistent with rational valuation schemes (e.g. schemes that don’t leave free money on the table), and whether the evidential connections they describe as the basis for theories of future earnings – in cases where they actually have such – are rational and reliable methods. I’d argue that anyone who goes through this exercise finds that the majority of the most active participants in the market are either a) not paying attention to any direct estimate of future earnings (they are using some form of TA), b) where they pay attention to earnings, they are not using rational means to quantify value (e.g. they are worried about whether earnings in some future period will be a little better or worse than some current estimate and not whether they current valuation is too high or too low in lieu of that adjustment, and c) they typically don’t use sophisticated methods to inform their opinions – e.g. they figure if the shares are rising they will probably beat estimates and if the shares are falling they will probably miss estimates, and they infer backwards from broad market sector price movements to implausible theories about specific securities.
Given all of the above, it would be some kind of grand coincidence if the market was an economically efficient predictor of discounted future earnings, so the onus of proof should fall on people who want to claim the market is efficient. But like a lot of stuff in academic theory, whoever gets to the spot first gets to posit their version as the null hypothesis.
So I believe that EMT is obviously wrong at the level of individual securities. But since most of the price movement for individual securities is determined by the broader market and industry moves in the short to intermediate term, someone who wants to take advantage of this inefficiency in the pricing of individual companies needs patience and a long time horizon.
I believe that industries are also mispriced but the effects are smaller and the irrationality is harder to demostrate.
My favorite Jesse Livermore quote is: “Markets are never wrong. Opinions are.”
I interpret the quote as recognition that a market’s function is price discovery. Price is established when market participants decide to transact. So when does a transaction occur? When a buyer and a seller have different opinions about prospective value.
How can price (i.e., the market) ever be wrong if both parties transact freely?