Summary:
Barry Ritholz with some thoughts on the Efficient Market Hypothesis, or the idea of markets efficiently reflecting future corporate earnings. Clearly not the case. Some examples: credit crunch; dotcom crash. Note in later case, markets were initially pricing stocks as if earnings didn't matter, whereas three years later some profitable, debt-free tech firms were trading below cash on hand. Stockmarkets now more likely to move in tandem, even lag the trajectory of profits. Blamed on the proliferation of hedge funds. Is making markets increasingly focused on breaking news and short-term swings, rather than longer-term fundamentals. Yet, to an EMH proponent, hedge funds should make markets more, not less efficient. Robert Schiller: 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. (Published: 11/08/08)
Notes:
- Efficient Market Hypothesis:
- the markets constitute a future discounting mechanism
- i.e. efficiently reflects future corporate earnings
- makes sense, as one ostensibly buys stocks in companies to claim bucketfuls of their future profits
- i.e. behaves like a crystal ball
- should have died a quite death
- but on Wall Street, myths, bad theories, and old information linger far longer than one would expect
- WSJ: "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."
- plenty of examples of where markets simply get it wrong
- exhibit A: credit crunch
- 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!
- dotcom crash
- March 2000: the market was essentially pricing stocks as if earnings didn't matter
- growth could continue far above historical levels indefinitely
- value was irrelevant
- How'd that work out?
- 3 years later:
- some of the most profitable, debt free tech and telecom names 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
- most fascinating aspect of this is the opportunity for anyone in t 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
- is the reason why everyone doesn't simply dollar cost average into index funds
- its the lure of the big score
- proliferation of hedge funds
- is making markets increasingly focused on breaking news and short-term swings, rather than longer-term fundamentals.
- contribute to this phenomenon are the narrow niche focuses used to differentiate amongst funds and raise capital
- but: to an EMH proponent, 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.
- Robert Schiller
- "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."
