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 . . .
Predicting What’s Next Gets Harder
WSJ August 11, 2008