This is a brief post to mark the passing of the Efficient Market Hypothesis (or EMH), to track my personal exposure to the EMH over the last 30 years, and to wonder how we are going to replace the hoary old liar…
Our Finance lecturer was very keen on the Efficient Market Hypothesis. Time and again he would intone that ‘all the information was known,’ that ‘all salient facts had already been impacted into the price of a stock,’ and that ‘if a stock was temporarily mis-priced then clever speculators would buy it, sell it, or short it and make a killing; thereby rapidly returning the stock to it’s true value.’
He must have wondered at the looks of disbelief and passing irritation on our faces. Which only caused him to redouble his efforts at repeating the theory to us.
Our Financial Accounting lecturer was a frequently-imbibing Bulgarian with tenure and only a couple of years left until retirement. So he was not particularly interested in anything very much, but simply pointed to a local producer of woolen goods that had been trading at ten times the nett asset backing on the day that it declared bankruptcy.
So that was one nail in the coffin for the EMH. In this case, all the information was not known. Senior management of the company had clearly been lying to the market and, as it turned out, seriously overvaluing their warehouses full of greasy-wool mittens, which they clearly had had very little chance of selling at any price!
1987: Black Monday
Secondly, in actual fact, clever speculators probably would not act in the way that the EMH expects them too. The theory would only work if everyone believed in it, and really not many people do.
As early as 1987 I was buying and selling shares with a bunch of other young yuppies that I worked with. We all knew that the market was a runaway bull at the time. We all knew that everything was overpriced, and we all knew that it would crash one day. In fact opposition MPs would come on the news and tell everyone just that. But our thinking was not “We should sell short on those overpriced stocks in accordance with the EMH.” It was more “Let’s see how long it will run,” “Lets see how high it will go,” and “We can be in and out with a tidy profit before the crash comes.” So that is nail number two in the coffin. Investors recognise asset bubbles and don’t necessarily think that they are a bad thing that they should act against.
In fact, on the day of the big crash on October 1987, I heard the news from New York on the morning news, and rang my broker as soon as they opened, saying “Sell everything.” The broker, thinking that my voice sounded quite young, said to me, “I should say that your downside risk is less now that it used to be.” Nail number three is that brokers are often disingenuous rogues who try to manipulate the market to get their commissions and don’t necessarily have the client’s best interests at heart (they are legally supposed to, it is called a fiduciary obligation).
Finally, every schoolboy knows that the market is based on sentiment. Greed and fear. On the up people just pile into a good thing on the basis of ‘me too.’ On the down there is a rush for the door and good stocks with nothing wrong with them get hammered along with everything else.
1992: The Lloyds Names Fiasco
I had just arrived in Britain in time for this. It was essentially a pyramid-game (ponzi-scheme?) between all of the syndicates of Lloyds underwriters, where one syndicate packages up a bit of risk as a security and on-sells it to another syndicate who might do something similar. At the end of the day the original risk of a ship sailing into the Bermuda triangle or a building project hitting labour-action, was lost sight of in all of the financial instruments and fun and games.
You probably think I am stating the bleeding obvious at this point. The trouble is that the assumption that ‘The price is correct’ is built into all the spreadsheets and models that banks, fund managers, economists and various Treasuries and Federal Reserves use to predict the future. You can’t really build a model that will accurately predict wild emotion-driven booms and busts.
It gets worse: Jumping ahead now to 1997 when two guys who had won the Nobel Prize for economics, Myron Scholes (of the Black-Scholes option-pricing model) and Robert Merton, formed a hedge-fund company called Long-Term Capital Management (LTCM). This company basically invested your money in derivates for you, and was driven by a hedging computer model that had buried in it somewhere the Value At Risk assumption.
All of portfolio theory is built on the assumption of the correlation, or co-variance of two stocks. You will have heard people talk about counter-cyclical stocks. I don’t really believe that there are such things as counter-cyclical stocks, except maybe publicly-listed companies of receivers. It is often said that newspapers do well in times of depression. But that was in the 1930s before television, the internet etc. They might not do so well in the current depression.
Anyhow, LTCM’s model told them that two counter-cyclical or uncorrelated stocks, if held together, would tend to cancel one-another out and give constant returns no-matter what happened (an excellent defensive position). In risk-management terms LTCM could hold the same financial cushion in cash for both stocks, since they would never drop together. The trouble was that things started to unwind all over the world, starting with the Russian rouble, spreading to become the Asian crisis, and surprise surprise, everything went down. So much for co-variance and portfolio theory. LTCM was hugely exposed and crashed very messily.
These guys, the so-called ‘Smartest Guys in the Room’ employed something called Mark-To-Market accounting. Simply stated the argument goes like this: “How much do you think that a kilowatt-hour of electricity will be worth in San Diego in September of next year? I say it will be worth $10.75. Who says it won’t? I’ll write that valuation into the balance sheet!” Anyone see anything wrong with this idea? Efficient markets not looking so cool as an idea now.
Behavioural Economics: The New King is Only a Child
There is a new branch of economics called Behavioural Economics. It has a theory called the ‘Adaptive Markets Hypothesis’ which is open to the possibility that a individual investor’s behaviour might be influenced by what he thinks that other investors around him are doing, rather than just a slavish adherence to a model.
Well that is very interesting, but how is anyone going to use a theory like that to price a security, or value a business or a portfolio? Before you can say that a theory is dead you have to have something to replace it with.
I hate to say it, but bankers and fund managers are still using the same models that they used to use, because there is currently no useful replacement. Scary? You bet!
Probably the last word deserves to go to Warren Buffet, who famously said, “I’d be a bum on the street with a tin cup if markets were efficient.”