If you’re reading this chapter on the Net, you’re already a full-fledged member of the information revolution. You know how quickly information can spread worldwide, and you are aware how thoroughly our lives are being changed as a result. We can all plug into unimaginable wells of information, much of it constantly updated in real time. If we choose, many of us can work effectively from home, or on an island in the South Pacific. Our clients and associates may neither know nor care where we are located. I’m no longer surprised when I see prominent Miami attorneys negotiating deals and settlements on their cellular phones, faxing and receiving contracts and pleadings, setting court calendars, and checking their email while simultaneously trolling for giant tuna off Bimini! Anybody, anywhere can be plugged into almost anything.
How quickly and effectively information spreads is at the heart of the debate over just how efficient markets are. The question, far from being one of just academic interest, directly impacts every investor. Even if investors have never heard the term “efficient market,” they form strategies and view their alternatives based on opinions about the efficiency of various markets.
In order for markets to properly set prices and values, two conditions are necessary: willing buyers and sellers (neither being under particular pressure to buy or sell), and those same participants’ possessing perfect knowledge. Should one side possess more information than the other, then we must expect that that side has a tremendous advantage. We must then expect the holder to utilize this additional knowledge to extract “undeserved profits” or “economic rents.”
Markets are the very heart and soul of the capitalistic system. The system’s invisible hand not only sets prices, but determines how goods and services are distributed, and encourages further growth of the system with benefits for all. For markets to work at all, there must be a general feeling that they are fair.
In organized markets, governments and regulators go to a great deal of trouble to ensure that both sides operate on a level playing field. Ideally, no one should have an advantage. Consequently, governments require mountains of disclosure, set accounting and financial reporting standards, monitor for compliance, prohibit certain insider trading, and license brokerages, dealers, representatives, investment advisors, salespeople, and even the markets themselves.
Let’s look at a perfect market: lots of buyers and sellers, homogeneous products, perfect knowledge, and instantaneous spread of new information. In this market, prices are determined by the independent judgment of thousands of buyers and sellers. New information reaches buyers and sellers instantly, prices adjust instantly, and neither side can expect an advantage or anticipate economic rents. The market is perfectly efficient.
In this perfect market, no amount of additional research will improve an investor’s position. All information about each security and its economic prospects is already known. Prices settle into equilibrium at a level that reflects both the market rate of return and the additional risk each security carries. All that is necessary for an individual investor to attain an appropriate rate of return is for her to buy and hold a diversified portfolio. The individual investor need not exhibit superior skill or cunning in order to match the most sophisticated institution. Furthermore, an individual’s portfolio cannot possibly underperform, no matter how brain-dead the investor is! The market has set the appropriate price for each security.
How the market accomplishes the miracle of setting the proper price for each security is still the subject of lively debate. Various models have been proposed that should lead to appropriate pricing. Buyers and sellers are attempting to discount all future benefits of owning a security to a present value that is equal to the price.
When arriving at a price that will “clear the market,” buyers and sellers must also assess the risk in a particular asset, and compare that risk to the market as a whole. The most widely known model, the Capital Asset Pricing Model (CAP-M), examines the volatility of an individual stock in relation to the market as a whole, assigns the additional volatility (a factor called Beta), and assumes that stocks will be priced to reflect both market risk and the particular risk of the individual stock. CAP-M and Beta are brilliant and elegant concepts that have a certain charm and intuitive appeal, but they suffer from real-world flaws. There is a lively cottage industry devoted to either bashing or defending the concept. Professor William F. Sharpe, who won the Nobel Prize for proposing CAP-M, thinks the concept was a pretty good first effort, modestly admits its flaws, enjoys the debate, and is happy that no one can take back his prize.
Asset pricing and expected returns are directly related. Risky assets have lower costs and higher expected returns than less-risky assets. In a later chapter, we will discuss some improvements to the theory of asset pricing which can assist investors when plotting their own investment strategy.
No market is perfectly efficient, but our securities markets are pretty close. Today, as we have all observed, information spreads worldwide at the speed of light. Millions of people have access to the same information simultaneously. Millions of traders constantly monitor data for pricing aberrations around the world. Where such pricing discrepancies exist, they are almost instantly closed by normal arbitrage. Thousands of computers continuously screen prices against multiple criteria, formulas, and models to detect mispricing. Hundreds of analysts may follow a single stock. There are very few secrets.
With all this activity going on, investors must ask themselves what the chances are that they will be able to develop a single investment idea that hundreds or thousands of others haven’t considered already. If others have already acted on a similar concept, then their knowledge must be factored into the price of the stock. Is it ever possible to get an edge, and if so, can we get it reliably enough to make a difference? In the real world, transaction and tax costs are high, and we would have to be right a rather dauntingly large percentage of the time to overcome our trading costs. The cost of research is also high.
In a real way, the very skill, quality, access and number of people doing research limits the value of the process. If nobody did research, then giant market discrepancies would occur. Simple research should lead to giant gains, but with so many players, the point of diminishing returns may be far behind us. The hundreds of thousands of often-brilliant researchers and analysts make the market efficient. I’m not saying that you can never win, only that it is unlikely that you can consistently win enough times to overcome the costs of trying.
Degrees of Efficiency
Debate about the efficient market boils down to the consideration of one of three models. At one end of the spectrum, the “strong” market theory, no one can ever get information that isn’t known to the market. Even insiders cannot benefit from their position. Supporters point to studies of price movements before significant public announcements to prove that there are inside information leaks. The “weak” market theory acknowledges that insiders may occasionally profit from their information. The “semi-strong” theory cuts down the middle.
It would be hard for me to argue that markets are always perfect — insiders do occasionally score big gains. For a fascinating view of the ’80s insider trading scandal, see Den of Thieves by James B. Stewart. For generations, insider trading, market manipulation, and other unsavory scams were considered clean sport for Wall Street’s barons. JFK, Reckless Youth, by Nigel Hamilton, offers some interesting insight into the role Joseph P. Kennedy played as a master manipulator of stock and bond pricing during Wall Street’s darker times. In what appeared to be a classic case of appointing the fox to watch the henhouse, Kennedy was named first chairman of the SEC by FDR, and served with some distinction in the post. Later, he returned to his old seamy tricks as a market manipulator in London while serving as ambassador to England.
Only the most naive would think that insider trading has been eliminated. But as information spreads more quickly and further, it becomes more difficult to profit from insider trading, and harder to conceal it from regulators. While occasional violations will continue to occur, the impact on the markets is probably minimal. Some economists today argue that the prohibition of insider trading is unnecessary and counterproductive. In view of past abuses, it’s a little hard for me to believe that lifting the law would be a good idea. To continue to inspire confidence, markets must appear to be even more chaste than Caesar’s wife.
The more important issue is whether research and active management can add value to a portfolio. As we have noted, if markets are efficient, then all the research in the world will not improve an investor’s results. If research is a factor, then it can be a valuable addition. If we can set up an appropriate benchmark for a market or portion of it, we can then measure the impact of management. Fortunately, today we have hundreds of indexes that measure the performance of various markets and parts of them. If we don’t like the available indexes, it’s easy enough to generate others that capture a more specific portion of the target market. Indexes have no transaction, management, or other real-world costs, and are always fully invested. They offer the perfect “investment style” to use as a comparison.
Management offers not only style, but selection of individual securities, and perhaps market timing. Management costs money, both in management fees and transaction costs. In addition, it is difficult for managers to stay fully invested even if that is their goal. Not counting taxes, management is generally assumed to cost at least 2% per year. If the investor pays taxes, the constant buying and selling will create substantial tax liability, which becomes a heavy drag on performance.
Index funds are mutual funds that mimic an index. In the real world, they will have some transaction costs and other expenses. These expenses average between .2% and .5%, depending on the market and the sponsor of the fund. Index funds do not constantly buy and sell, so the tax drag will not be nearly so heavy. This can be a substantial benefit for taxpayers, and occurs as a fortunate by-product. If markets are efficient, index funds do not have to bother with all that pesky research. Is this a free lunch? Not really. Other, less-wise investors are paying for all the research that makes the market so efficient!
In theory, if markets are inefficient, good managers will overcome all the direct and indirect costs they generate and add value; they will exploit market inefficiencies to produce superior results. These managers rely on research, experience, intuition, or superior skill and cunning to decide what and when to buy and sell.
Types of Research
Market research is divided into two categories: technical and fundamental.
Technical analysis starts with the assumption that everything one needs to know about a stock or market can be learned from studying its price and past movements. By plotting or charting past movements, technicians believe that they can discover repetitive patterns that will suggest valid buy and sell “signals.” Discovery of the right signals will lead to effective market timing. Some of the “pure” technicians insist on studying charts without the name of the firm attached so that they will not be “confused” or “distracted” by their knowledge of the firm! Technicians use all sorts of data and combinations of data to generate their signals. They will study insider trading, consumer confidence, interest rates, yield curves, market volume, short sales, odd lot volume, ratios of new highs to new lows, and hundreds of other “indicators” to generate their signals. They tend to speak in terms of resistance levels, floors, breakouts, proprietary trading strategies, periods of increased market risk, and other mysterious babble. Often they attempt to add a layer of legitimacy to their work by having the data fed into computers for number crunching and analysis.
Technical analysis persists in spite of the total lack of any creditable evidence of its effectiveness. One might as well examine the entrails of animals, chart the stars, or worship the Tooth Fairy. Looking back, one can always find the patterns that led to market events. The only little problem you have is that when looking forward, those patterns are no help. Many technicians constantly revise their indicators as they fail in real life, then “backcast” using the new indicators and publish the theoretical results. To give the backcast greater validity, it was once common to have a CPA firm certify that had you used these techniques, you would have had the stated result. The fact that real, live investors never obtained those results was seldom disclosed. Today there are several landmark cases winding their way through the courts concerning backcasting, and the SEC has taken a lively interest in the subject.
Wall Street loves technicians and continues to pay them lip service. Right or wrong, technicians generate huge trading volume. And whether the investor wins or loses, the house always gets their slice. The media gives the technicians undue attention in their unending quest for simple answers to complex questions and pithy, quotable, seven-second sound bites. Investors often desperately want to believe that someone can protect them from market forces that they do not understand. Technicians prey on the risk aversion we all feel by offering protection against the market’s downside. By offering an illusion of risk reduction, market timers and technicians appeal to conservative and fearful investors. They paint themselves as “concerned” and “responsible,” while giving the impression that a buy-and-hold strategy is somehow wild and crazy.
Fundamental analysis is far more rational. It concerns itself with examination of the firm and the economy. Fundamental research looks at financial data, sales forecasts, market share, quality of management, expansion plans, new products, competitive position, economic forecasts, and other data to search out the “real” value of companies and the prospects that they face. From the investor’s point of view, so much fundamental research is done, and the results so widely and quickly distributed, that you must decide if available information will provide a unique edge. One must always assume that a million or more people already know what you have just discovered.
Fundamental research also has a fundamental problem: forecasting. The market and economic environment is far to complex to allow for accurate forecasting even if we have perfect data and insight. At best we have a very poor understanding of how the economy and the world’s markets work. Even worse, noneconomic events pop up randomly to confuse us further. One well-placed bullet, typhoon, coup, drought, or earthquake can make a shambles out of the best forecast. As a result, earnings and interest-rate forecasts are so laughably bad that anyone with a 40% success rate can qualify as an expert.
Conflicts of Interest
There is a darker side of the research problem that investors must also consider: The motives of research departments may not always be pure. Wall Street has its fingers in many pies. As a result, conflicts of interest can easily creep into analyses. In one famous case, an analyst observed publicly that Donald Trump was in big trouble with his Atlantic City project. Covering the debt was likely to be a big problem, the analyst claimed. Trump complained, and the analyst was fired. Apparently, his employers had hopes of assisting Trump with yet another bond offering! So much for honest research. Trump’s later problems in Atlantic City are well documented, and the story is only unusual in that it became public when the analyst sued over his wrongful termination.
Few things gladden the hearts of Wall Street’s barons like a big juicy underwriting or takeover. The fees a big takeover can generate are unimaginable for mere mortals like us. Wall Street knows that sell recommendations hurt the feelings of the very managers who control underwriting and takeover business. Hurt feelings often translate into diminished prospects for further business. So it shouldn’t surprise us that the ratio of buy to sell recommendations is skewed, and that a sell recommendation often comes far too late to be of any use.
Wall Street continues to hype their research — partly to generate trading volume, partly to justify their full service fees, and for another important self-serving reason: Brokers who rely on research for recommendations shed a good deal of their liability if a recommendation doesn’t work out. In fact, some brokerages publish both technical and fundamental research, often with directly conflicting recommendations! Now, how much help is that?
An Alternative Point of View
Detractors of the efficient market theory point to the often-strange behavior of markets. For instance, they argue that the market couldn’t have been right both before and after the crash of 1987, when we lost 500 points in one day. They miss the point. Nobody is saying that the market is always right, or even rational. The real point is that if markets are efficient, it is very unlikely that you, or anybody else, will be able to consistently “beat” the market.
Another problem with the efficient market theory is that clearly not all markets are operating by the same standards. Very small companies have fewer analysts, and some issues are thinly traded. Foreign and emerging markets have different disclosure and financial reporting criteria, enforcement may be lax, or corruption endemic. Some markets do not even have insider trading restrictions. All of these complaints are valid, and all give comfort to managers who argue that they can exploit inefficiencies to obtain above-benchmark returns.
So much for theory. The lines are clearly drawn. If markets are not efficient, then managers should have an easy time beating their benchmark. If markets are efficient, then we should consider firing the managers and hiring the index. The proof is in the pudding!
In the next chapter, we will examine the real-world performance of managers. We will also consider whether overperformance is the result of skill and cunning or just dumb luck. Finally, we’ll examine whether performance really does matter and if managers can repeat past performance. Will last year’s heroes be back, or fall into well-deserved obscurity after their 15 minutes of fame?
As always, I have borrowed heavily from the ideas of giants. In-depth discussion of efficient markets and fundamental and technical research can be found and painlessly enjoyed in both Capital Ideas and A Random Walk Down Wall Street. For a brilliant and also absorbing analysis of the problems of making decisions in complex environments, see Chaos and Complexity. All books can be obtained or ordered in any major bookstore. Do yourself a favor – read them all!