Cliff Asness, Wall Street sharks and market inefficiency

Field of play

The more things change, the more…

I’m always on the lookout for big picture changes in the investment universe that might adversely affect my investing activity. Cliff Asness has recently written a paper titled ‘The Less-Efficient Market Hypothesis’ in which he offers the observation that the stock market has become less efficient over the last 35 years.

His main conclusion is that he believes that “disciplined, value-based stock picking is both riskier and likely more rewarding over the long term.”

This perked my interest as our family’s entire investible assets are managed by me in a concentrated portfolio in which I attempt to buy shares in superb companies at very attractive prices (less than fair value) and hold them for the long term.

Cliff Asness is managing principal at AQR Capital Management in Greenwich, Connecticut.

Once we understand his thesis, his suggested causes and the evidence he uses to back up his ideas, we can reflect on the strength of his case and what it means for our own investing.

Asness’ paper discusses the EMH, the Efficient Market Hypothesis. The idea of EMH is that if stock prices reflected fair value the stock market would be operating efficiently. He spends a good part of the paper discussing bubbles.

True stock market bubbles

Even the most dedicated EMH enthusiasts agree that in stock market bubbles prices and fair value get out of whack. Asness says that true bubbles are very rare. He feels the word bubble is over used. He says the term should only be used if ‘a large swath of the market’ is in a bubble. A grossly overpriced individual stock or sector just doesn’t cut it. He says he has only seen two true bubbles in his 35-year career – 1999/2000 and 2019/2020. He doesn’t categorize 2008 and the Great Financial Crisis as a bubble. 

I agree with his general view about bubbles. I happen to think 2019/2020 was not a true bubble.

Market efficiency

The issue around market efficiency is not about how quickly and efficiently information gets processed by investors and reflected in stock prices. The issue is about how stock prices and fair values can diverge, and about how sometimes prices can get well ahead of fair value and sometimes prices can fall well below fair value.

Asness’ paper offers a test of market efficiency. He calls it the “value spread”. He describes it as the ratio of the valuation of expensive stocks to cheap stocks. He says that when the “value spread” is high, investors are paying a lot for their favorite stocks versus those they dislike and vice versa.

His measure of market efficiency, the “value spread”, is a proxy. That is, it isn’t measuring market efficiency directly but uses a proxy to indicate inefficiency. If one were to measure market inefficiency directly one would value, let’s say, the S&P 500 stocks in aggregate and compare that value with their prices.

Anyway, his proxy seeks to show the “value spread” using five measures of value much like real-life quants use today. The result is a chart of the “value spread” based on a five-factor model.

His conclusion, shown in a graph, is that during bubbles “value spreads” have surged. As well, “value spreads” have been increasing over the last 35 years. As he puts it: “If these very wide value spreads represent market inefficiencies, they aren’t just more extreme than in the past, but they are lasting longer when they are extreme.”

Before we go further with this, we should make clear what we mean by value investing and value stocks.

Value investing and market inefficiency

There’s a whole lot of confusion around the term ‘value investing’. Many investors who invest in value stock ETFs, factor funds and smart Beta funds, think they are into something derived from Ben Graham’s investing principles. Cliff Asness clarifies this.

His paper notes: “The quant multiple factor has been called the “value” factor for 40 years now. If I could go back in time, I’d rename it something more cumbersome but more accurate like the “low-multiple factor” or similar.”

True value investing as described by Ben Graham involves buying with a margin of safety, at a price less than fair value. It is absolutely intrinsic to that style of investing that the stock market is inefficient and that investors can take advantage of that inefficiency.

I gather from Asness’ paper that he views market inefficiency as useful for quant low-multiple factor investing.

So, it seems both quants and value investors are interested in the subject of market inefficiency.

Less efficient market

Asness’ conclusion is that the stock market is becoming less efficient. He discusses various potential causes but points his main finger at social media. I think there is more to it. Social media are certainly one of the infection vectors, especially when it comes to day trading and other stupidity.

Asness quotes Warren Buffett from 2023: “For whatever reasons, markets now exhibit far more casino-like behavior than they did when I was young. The casino now resides in many homes and daily tempts the occupants.”

In my view, the real culprit behind market inefficiency is human herding behavior, groupthink, social proofing and the madness of crowds.

As Asness points out, the notion of Wisdom of the Crowd doesn’t apply to the stock market.

The crowd is not wise when it comes to the stock market. It is impossible to invest in the stock market without being aware of the views of others. We read the newspaper. We read analysts’ reports of fair value and target prices. Analysts are aware of consensus estimates for future earnings made by other analysts and consensus target prices.  We see prices that others have paid on the stock market. The crowd does not act independently which seems to be an essential prerequisite for the statistical phenomenon of wisdom of crowds to work.

Sharks and minnows

Asness carries out a thought experiment. He imagines market participants made up of three groups. The first are passive investors who are price acceptors. The second are sharks who outperform the market by taking advantage of misguided positions taken by the third group, the minnows. He points out that price discovery occurs through the dollar weighted average of investment buy/sell decisions. He speculates that as more investors move to passive index investing the less skilled minnows’ influence on stock prices has increased. He speculates that this may be contributing to market inefficiency.

Other evidence

A more direct way of looking at market inefficiency is to compare the price of a stock with its fair value. Below is a chart of Apple Inc AAPL from Morningstar. The black line shows market prices over the last ten years. The red line shows Morningstar’s quantitative fair value estimate over the same period. Currently the fair value is some 13% below the price. This suggests the stock is overpriced and that the stock market is about 13% inefficiently pricing the stock. There is one big qualification to this. Estimates of fair value are very subjective even if done quantitatively. That is the reason one wants a Margin of Safety when buying a stock so as not to overpay. Think of it as a margin of error. The key point is that price and fair value are often quite different, intersecting only infrequently.

Asness’ conclusion

He concludes by suggesting that increased market inefficiency has raised the stakes for rational active investing. He thinks: “…the ups and downs will be bigger and last longer, making more money for those who can stick with it long term but making it harder to do so.” He feels that disciplined, value-based stock picking will be both riskier and more likely rewarding long term.

My observation

To quote an old French saying, plus ça change, the more things change, the more they stay the same. Human nature is behind irrational stock market activity, and that has not and will not change. The tulip bulb mania centuries ago, the Dot Com bubble and the GameStop skyrocket and short squeeze are of-a-kind examples of irrational exuberance and the madness of crowds.

You don’t have to get into bubbles and mass hysteria to see human silliness in the stock market. Markets are constantly mispricing stocks. As I note above, the real culprit behind market inefficiency is human herding behavior, groupthink, social proofing and the madness of crowds.

Conclusion

If there is an increase in market inefficiency, I would disagree with Asness on one important point. He thinks it will make investing harder and riskier. I think the opposite. Ups and downs are the friend of the value investor. That is what creates opportunities to buy shares at knockdown prices. It also presents more opportunities to sell overpriced shares at stupidly high prices. A stock available at a knockdown price is less risky than a stock at full price.

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You can reach me by email at rodney@investingmotherlode.com

I’m also on Twitter @rodneylksmith

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