Field of play
Uncertain and unpredictable
The following is a recent quote from one of the largest and most highly respected Wall Street research firms which shall remain nameless: “There is a science to investing. Though you may not know them by their technical names, chances are you’re familiar with the fruits of Modern Portfolio Theory, the connection between risk and return, the theory of interest, and the efficient market hypothesis. Parts of financial theory are so integral to the practice of investing that most investors have forgotten they originated in academia.” (Emphasis added)
The message is that investment research is sophisticated and based on tried and valid financial theories supported by academic research.
I quote this to underscore that the continuing support and reliance on EMH is broad and insidious.
Warren Buffett’s advice on the subject of the Efficient Market Hypothesis (EMH) is straightforward. “Should you choose, however, to construct your own portfolio, there are a few thoughts worth remembering. Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word ‘selected’: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital. To invest successfully, you do not need to understand beta, efficient markets, modern portfolio theory, option pricing, or emerging markets. You may, in fact, be better off knowing nothing of these.” (Buffett, The Essays of Warren Buffett: Lessons for Corporate America. Lawrence A. Cunningham. 1998, p.93) (Emphasis added)
However: ‘Nullius in verba’ or ‘take nobody’s word for it’. That includes Warren Buffett. If you do not thoroughly understand the evidence for and against the Efficient Market Hypothesis, Modern Portfolio Theory, volatility as a measure of risk and beta, you will not be armed to resist the absolutely pervasive and seductive role of these ideas in the investment industry today. And believe me, they creep in everywhere.
In this post I want to talk about processing of news. To refresh readers memories: in the 1960s a group of academics developed a theory that stock price movements were unpredictable and random and that the stock market was so efficient that all information about a company was rapidly processed by the market so that for all intents and purposes prices reflected fair value.
The investment industry took to this notion in large measure because it purported to explain why it was so hard to beat the market. The explanation is essentially wrong. The real explanation relates more to human psychological foibles.
Reacting to news
Intrinsic to the EMH is the belief that the stock market reacts in a quick and efficient manner to news or new information about companies.
This is what the academics came up with. But, experience is a far better teacher of many things. In some ways the stock market is particularly inefficient even at digesting news.
In his 1958 book Philip Fisher wrote: “There is one factor which all of us can recognize, however, and which can help powerfully in not just following the crowd. This is realization that the financial community is usually slow to recognize a fundamentally changed condition, unless a big name or a colorful single event is publicly associated with that change.” (Fisher, Common Stocks and Uncommon Profits and Other Writings, 1958,1996) p161.
Peter Lynch calls it ‘street lag’. He writes: “Under the current system, a stock isn’t truly attractive until a number of large institutions have recognized its suitability and an equal number of respected Wall Street analysts (the researchers who track the various industries and companies) have put it on the recommended list. With so many people waiting for others to make the first move, it’s amazing that anything gets bought.” (Lynch, One Up on Wall Street, 1989,1990) p41.
In truth there is no telling how the ‘street’ will react to news. At times the ‘street’ can be slow to recognize and react even to major headlines. There is nothing new here. Here is Jesse Livermore’s comment on the San Francisco earthquake: “The Street paid no attention to the earthquake the first day or two. They’ll tell you that it was because the first dispatches were not so alarming, but I think it was because it took so long to change the point of view of the public toward the securities markets. Even the professional traders for the most part were slow and short-sighted.” (Lefevre, Reminiscences of a Stock Market Operator. 1923,1993) p78.
Kindleberger writes: “The theory of rational expectations assumes that investors’ expectations change more or less instantaneously in response to each shock and that investors immediately see through to the impacts of each shock on the long-run equilibrium prices for real estate and stocks and commodities. In contrast, the insight from financial history is that expectations in the real world change slowly at some times and rapidly at others as different groups realize – sometimes at different moments and at other times more or less simultaneously – that the current forecasts of prices and values in the distant future differ from earlier views of the same prices and values.” (Kindleberger, Manias, Panics, and Crashes, A History of Financial Crises. 1978, 2005 Fifth Edition) p.90.
It seems that new information is reflected in stock prices in a variety of ways. Sometime the market reacts quickly and efficiently. Sometimes it reacts very slowly and inefficiently. Sometimes it overreacts with price movements being ‘too big’ and sometimes it underreacts. It is all very uncertain and unpredictable. The bottom line is that it is a mistake to believe the market is efficient at processing information. I leave it to readers to reflect on how the stock market has reacted to the Covid pandemic.
My own impression is that bad news gets discounted in a bull market and good news gets discounted in a bear market. It is said a real bull market climbs a wall of worry. It may be that is because a bull market often begins in an atmosphere of bad economic news. Later, when the bull market is long in the tooth, perhaps the bad news is discounted or even ignored because the street feels the good times are here to stay. But, this is supposition on my part.
In a sense Warren Buffett is right, as quoted above, that “You may, in fact, be better off knowing nothing of these.” Ironically, I suppose it was a stroke of good fortune I never learned about the efficient-market hypothesis and the random walk when I first started investing. It would have put me off pursuing the approach I have followed. In fact, I barely was aware of it. When I did become aware of it, I never read up on it because it never had any intuitive appeal to me. I ultimately decided to find out more about it to see if I was missing something and perhaps learn from it.
I do think investors have to read up on this stuff because of the quote from the ‘highly respected Wall Street research firm’ referred to at the beginning of this post. Over a period of some fifty years EMH became the dominant theory of how markets work and one must understand it if one is to dismiss it, as I hope my readers will.
My earlier post criticising the EMH is The conventional view of market efficiency is badly mistaken
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