Is the market efficient, always?

Is the market efficient, always?

But these conditions do not always exist. Market pricing and volatility of the late 1990s give reason to believe that these conditions did not exist. Some companies trade at prices bearing a discount from their intrinsic value – the key claim of value investing. Numerous other flaws infect beta, widely documented in a burgeoning literature over the past decade showing its declining utility.

General faith in beta requires general faith in efficient markets. But belief in efficient markets means the equity risk premium in the late 1990s was negative, zero, or very close to zero – that is the only way to make sense of the high stock prices prevalent in the late 1990s if markets are efficient. Under CAPM, a zero-market-risk premium implies a discount rate equal to the risk-free rate. But this is a strange result, defying common sense that common stocks are riskier than U.S. Treasuries.

We are back to where we started: Estimating appropriate discount rates for equity securities requires judgment about how much riskier a particular business is compared to risk-free benchmarks of U.S. Treasuries. Modern finance theory assumes return is correlated to risk (you get what you pay for); value investing understands return as correlated to effort (you get what you deserve).



Also read:

1. Understanding Discount Rates
2. Risk-free rate
3. Traditional Method: Discount rate or WACC (I)
4. Traditional Method: Discount rate or WACC (II)
5. Modern Portfolio Theory
6. Portfolio Theory: Market Risk Premiums
7. Portfolio Theory: Beta
8. Is the market efficient, always?
9. Discount Rate Determinations: Summary