Chapter 11. Potshots at the Efficient-Market Theory and Why they Miss
Robert Shiller concluded from a longer history of stock market fluctuations that stock prices show far “too much variability” to be explained by an efficient-market theory of pricing and that one must look to behavioral considerations and to crowd psychology to explain the actual process of price determination in the stock market.
The author reviewed all the recent research proclaiming the demise of the efficient-market theory and purporting to show that market prices are, in fact, predictable. His conclusion is that such obituaries are greatly exaggerated and that the extent to which the stock market is usefully predictable has been vastly overstated. He shows that following the tenets of the efficient-market theory – that is, buying and holding a broad-based market index fund – is still the only game in town. Although market may not always be rational in the short run, it always is over the long haul.
I. What do we mean by saying markets are efficient?
1. Markets can be efficient even if they sometimes make egregious errors in valuation. Markets can be efficient even if stock prices exhibit greater volatility than can apparently be explained by fundamentals such as earnings and dividends.
2. Economists view markets as amazingly successful devices for reflecting new info rapidly and, for the most part, accurately. Above all, we believe that financial markets are efficient because they don’t allow investors to earn above average returns without accepting above-average risks.
3. No one can consistently predict either the direction of the stock market or the relative attractiveness of individual stocks and thus no one can consistently obtain better overall returns than the market. And while there are undoubtedly profitable trading opportunities that occasionally appear, there are quickly wiped out once they become known. No one person or institution has yet to produce a long-term, consistent record of finding money-making, risk-adjusted individual stock-trading opportunities, particularly if they pay taxes and incur transactions costs.
II. Potshots that completely miss the target
1. Dogs of the Dow: out-of-favor stocks eventually tend to reverse direction. The strategy entailed buying each year the ten stocks in the DJ that had the highest dividend yields. The idea was that these ten stocks were the most out of favor, so they typically had low price-earnings multiples and low price-to-book-value
ratios as well. This strategy consistently underperformed the overall market during the last half of the 1990s. “The strategy became too popular” and ultimately self-destructed.
2. January Effect: stock-market returns have tended to be especially high during the first two weeks of January. The effect appears to be particularly strong for smaller firms. One possible explanation for it is that tax effects are at work. Some investors may sell securities at the end of the calendar year to establish
short-term capital losses for income tax purposes. Although this effect could be applicable for all stocks. It would be larger for small firms because stocks of small companies are more volatile and less likely to be in the portfolios of taxexempt institutional investors and pension funds. However, the transaction costs of trading in the stocks of small companies are substantially higher than for larger companies (because of the higher bid-asked spreads) and there appears to be no way a commission-paying ordinary investor could exploit this anomaly.
3. Hot news response: some academics believe that stock prices underreact to news events and, therefore, purchasing (selling) stocks where good (bad) news comes out will produce abnormal returns. Fama found that apparent underreaction to info is about as common as overreaction, and post-event continuation of abnormal returns is as frequent as post-event reversal.
4. It is obvious that any truly repetitive and exploitable pattern that can be discovered in the stock market and can be arbitraged away will self-destruct. Indeed, the January effect became undependable after it received considerable publicity.
III. Potshots that get close but still miss the target
1. Short-term momentum: Lo and Mackinlay found that for two decades broad portfolio stock returns for weekly and monthly holding periods showed positive serial correlation. Moreover, Lo and others have suggested that some of the stock-price pattern used by so-called technical analysis may actually have some
modest predictive power. Behavioral economists find such short-run momentum to be consistent with psychological feedback mechanisms. Individuals see a stock price rising and are drawn into the market in a kind of “bandwagon effect.”
However, two factors prevent us from believing markets are inefficient:
a. It is important to distinguish statistical significance from economic significance. The statistical dependencies giving rise to momentum, in fact, are extremely small and are not likely to permit investors to realize excess returns.
b. We should ask whether such patterns of serial correlation are consistent over time.
2. The dividend jackpot approach: Depending on the forecast horizon involved, as much as 40% of the variability in future market returns can be predicted on the basis of the initial dividend yield of the market as a whole. Investors have earned higher total rates of return from the stock market when the initial dividend yield of the market portfolio was relatively high. These findings are not necessarily inconsistent with efficiency. Dividend yields of stocks tend to be high (low) when interest rates are high (low). Consequently, the ability of initial yields to predict returns may simply reflect the adjustment of the stock market to general economic conditions. Moreover, the dividend behavior of US corporations may have changed over time. Companies in 21st century may be more likely to institute a share repurchase program rather than increase their dividends. Thus dividend yield may not be as meaningful as in the past. Finally, this phenomenon does not work consistently with individual stocks. Investors who simply purchase a portfolio of individual stocks with the highest dividend yields in the market will not earn a particularly high rate of return.
3. The Initial P/E predictor: Campbell and Shiller report that over 40% of the variability in long-horizon returns can be predicted on the basis of the initial market P/E.
4. Long-run return reversals: buying stocks that performed poorly during the past three years or so is likely to give you above-average returns over the next three years. However, return reversals over different time periods are often rooted in solid economic facts rather than psychological swings. The volatility of interest rates constitutes a prime economic influence on share prices. Because bonds – the front-line reflectors of interest-rate direction – compete with stocks for the investor’s dollars, one should logically expect systematic relationships between interest rates and stock prices. When interest rates go up, share prices should fall, other things being the same, so as to provide larger expected stock returns in the future. Only if this happens will stocks be competitive with higher yielding bonds. Similarly, when interest rates fall, stocks should tend to rise because they can promise a lower total return and still be competitive with lower yielding bonds.
5. The small firm effect: since 1926, small firms have produced returns over 1.5% points larger than the returns from large stocks. But, small stocks may be riskier than larger stocks and deserve to give investors a higher rate of return. Thus, even if this effect was to persist in the future, it’s not at all clear that such a finding would violate market efficiency. Moreover, this effect may due to “survivorship bias”. And in most world markets it was the larger cap stocks that produced larger rates of return.
IV. Why even close shots miss
1. Regarding to internet bubble, when we know ex post that major errors were made, there were certainly no clear ex ante arbitrage opportunities available to rational investors. And even when clear mispricing arbitrage opportunities seem to have existed, there was no way to exploit them.
2. To me, the most direct and most convincing tests of market efficiency are direct tests of the ability of professional fund managers to outperform the market as a whole. But the fact is that professional investment managers are not able to outperform index funds that simply buy and hold the broad stock-market portfolio. During the past 30 years, about two-thirds of the funds proved inferior to the market as a whole. The same result also holds for professional pension fund managers. There are some funds which beat index. But the problem for investors is that at the beginning of any period they can’t be sure which funds will be successful and survive.
V. A Summing Up
1. Market valuation rest on both logical and psychological factors.
2. Stock prices display a remarkable degree of efficiency. Info contained in past prices or any publicly available fundamental info is rapidly assimilated into market prices. Prices adjust so well to reflect all-important info that a randomly selected and passively managed portfolio of stocks performs as well as or better than the portfolios selected by the experts.
3. With respect to the evidence indicating that future returns are, in fact, somewhat predictable, there are several points to make.
a. There are considerable questions regarding the long-run dependability of these effects. Many could be the result of “data snooping”.
b. Even if there is a dependable predictable relationship, it may not be exploitable by investors (e.g. high transaction costs).
A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel
http://people.brandeis.edu/~yanzp/Study%20Notes/A%20Random%20Walk%20down%20Wall%20Street.pdf
Robert Shiller concluded from a longer history of stock market fluctuations that stock prices show far “too much variability” to be explained by an efficient-market theory of pricing and that one must look to behavioral considerations and to crowd psychology to explain the actual process of price determination in the stock market.
The author reviewed all the recent research proclaiming the demise of the efficient-market theory and purporting to show that market prices are, in fact, predictable. His conclusion is that such obituaries are greatly exaggerated and that the extent to which the stock market is usefully predictable has been vastly overstated. He shows that following the tenets of the efficient-market theory – that is, buying and holding a broad-based market index fund – is still the only game in town. Although market may not always be rational in the short run, it always is over the long haul.
I. What do we mean by saying markets are efficient?
1. Markets can be efficient even if they sometimes make egregious errors in valuation. Markets can be efficient even if stock prices exhibit greater volatility than can apparently be explained by fundamentals such as earnings and dividends.
2. Economists view markets as amazingly successful devices for reflecting new info rapidly and, for the most part, accurately. Above all, we believe that financial markets are efficient because they don’t allow investors to earn above average returns without accepting above-average risks.
3. No one can consistently predict either the direction of the stock market or the relative attractiveness of individual stocks and thus no one can consistently obtain better overall returns than the market. And while there are undoubtedly profitable trading opportunities that occasionally appear, there are quickly wiped out once they become known. No one person or institution has yet to produce a long-term, consistent record of finding money-making, risk-adjusted individual stock-trading opportunities, particularly if they pay taxes and incur transactions costs.
II. Potshots that completely miss the target
1. Dogs of the Dow: out-of-favor stocks eventually tend to reverse direction. The strategy entailed buying each year the ten stocks in the DJ that had the highest dividend yields. The idea was that these ten stocks were the most out of favor, so they typically had low price-earnings multiples and low price-to-book-value
ratios as well. This strategy consistently underperformed the overall market during the last half of the 1990s. “The strategy became too popular” and ultimately self-destructed.
2. January Effect: stock-market returns have tended to be especially high during the first two weeks of January. The effect appears to be particularly strong for smaller firms. One possible explanation for it is that tax effects are at work. Some investors may sell securities at the end of the calendar year to establish
short-term capital losses for income tax purposes. Although this effect could be applicable for all stocks. It would be larger for small firms because stocks of small companies are more volatile and less likely to be in the portfolios of taxexempt institutional investors and pension funds. However, the transaction costs of trading in the stocks of small companies are substantially higher than for larger companies (because of the higher bid-asked spreads) and there appears to be no way a commission-paying ordinary investor could exploit this anomaly.
3. Hot news response: some academics believe that stock prices underreact to news events and, therefore, purchasing (selling) stocks where good (bad) news comes out will produce abnormal returns. Fama found that apparent underreaction to info is about as common as overreaction, and post-event continuation of abnormal returns is as frequent as post-event reversal.
4. It is obvious that any truly repetitive and exploitable pattern that can be discovered in the stock market and can be arbitraged away will self-destruct. Indeed, the January effect became undependable after it received considerable publicity.
III. Potshots that get close but still miss the target
1. Short-term momentum: Lo and Mackinlay found that for two decades broad portfolio stock returns for weekly and monthly holding periods showed positive serial correlation. Moreover, Lo and others have suggested that some of the stock-price pattern used by so-called technical analysis may actually have some
modest predictive power. Behavioral economists find such short-run momentum to be consistent with psychological feedback mechanisms. Individuals see a stock price rising and are drawn into the market in a kind of “bandwagon effect.”
However, two factors prevent us from believing markets are inefficient:
a. It is important to distinguish statistical significance from economic significance. The statistical dependencies giving rise to momentum, in fact, are extremely small and are not likely to permit investors to realize excess returns.
b. We should ask whether such patterns of serial correlation are consistent over time.
2. The dividend jackpot approach: Depending on the forecast horizon involved, as much as 40% of the variability in future market returns can be predicted on the basis of the initial dividend yield of the market as a whole. Investors have earned higher total rates of return from the stock market when the initial dividend yield of the market portfolio was relatively high. These findings are not necessarily inconsistent with efficiency. Dividend yields of stocks tend to be high (low) when interest rates are high (low). Consequently, the ability of initial yields to predict returns may simply reflect the adjustment of the stock market to general economic conditions. Moreover, the dividend behavior of US corporations may have changed over time. Companies in 21st century may be more likely to institute a share repurchase program rather than increase their dividends. Thus dividend yield may not be as meaningful as in the past. Finally, this phenomenon does not work consistently with individual stocks. Investors who simply purchase a portfolio of individual stocks with the highest dividend yields in the market will not earn a particularly high rate of return.
3. The Initial P/E predictor: Campbell and Shiller report that over 40% of the variability in long-horizon returns can be predicted on the basis of the initial market P/E.
4. Long-run return reversals: buying stocks that performed poorly during the past three years or so is likely to give you above-average returns over the next three years. However, return reversals over different time periods are often rooted in solid economic facts rather than psychological swings. The volatility of interest rates constitutes a prime economic influence on share prices. Because bonds – the front-line reflectors of interest-rate direction – compete with stocks for the investor’s dollars, one should logically expect systematic relationships between interest rates and stock prices. When interest rates go up, share prices should fall, other things being the same, so as to provide larger expected stock returns in the future. Only if this happens will stocks be competitive with higher yielding bonds. Similarly, when interest rates fall, stocks should tend to rise because they can promise a lower total return and still be competitive with lower yielding bonds.
5. The small firm effect: since 1926, small firms have produced returns over 1.5% points larger than the returns from large stocks. But, small stocks may be riskier than larger stocks and deserve to give investors a higher rate of return. Thus, even if this effect was to persist in the future, it’s not at all clear that such a finding would violate market efficiency. Moreover, this effect may due to “survivorship bias”. And in most world markets it was the larger cap stocks that produced larger rates of return.
IV. Why even close shots miss
1. Regarding to internet bubble, when we know ex post that major errors were made, there were certainly no clear ex ante arbitrage opportunities available to rational investors. And even when clear mispricing arbitrage opportunities seem to have existed, there was no way to exploit them.
2. To me, the most direct and most convincing tests of market efficiency are direct tests of the ability of professional fund managers to outperform the market as a whole. But the fact is that professional investment managers are not able to outperform index funds that simply buy and hold the broad stock-market portfolio. During the past 30 years, about two-thirds of the funds proved inferior to the market as a whole. The same result also holds for professional pension fund managers. There are some funds which beat index. But the problem for investors is that at the beginning of any period they can’t be sure which funds will be successful and survive.
V. A Summing Up
1. Market valuation rest on both logical and psychological factors.
2. Stock prices display a remarkable degree of efficiency. Info contained in past prices or any publicly available fundamental info is rapidly assimilated into market prices. Prices adjust so well to reflect all-important info that a randomly selected and passively managed portfolio of stocks performs as well as or better than the portfolios selected by the experts.
3. With respect to the evidence indicating that future returns are, in fact, somewhat predictable, there are several points to make.
a. There are considerable questions regarding the long-run dependability of these effects. Many could be the result of “data snooping”.
b. Even if there is a dependable predictable relationship, it may not be exploitable by investors (e.g. high transaction costs).
A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel
http://people.brandeis.edu/~yanzp/Study%20Notes/A%20Random%20Walk%20down%20Wall%20Street.pdf
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