Many value investors have heard of, and subsequently ignored, the efficient market theory. This is mainly because there are so many obviously mispriced stocks in the markets. For example, the share price of large companies may fluctuate by 30%, 50% or more in one year, even though the companies plug along at the same pace.
In his book, “Inefficient Market Theory: An Investment Framework Based on the Foolishness of the Crowd,” author Jeffrey C. Hood wanted to go further and challenge its intellectual underpinnings.
He laid out the rationale for the theory this way:
- Participants in the stock market are all rational actors.
- Who have access to all information about a business.
- This information is immediately incorporated into stock prices.
- This makes stock prices always correct, or nearly correct.
In this case, “correct” refers to the intrinsic value of a business, or the price at which a well-informed and rational private buyer would supposedly buy a business from a well-informed and rational private seller.
Hood called the efficient market theory an interesting theory, but, “Unfortunately, the theory is simply not correct, or perhaps more generously is only partially correct. The stock market certainly does not always produce correct prices, and it also does not always produce better prices than any individual could provide.”
He went on to cite the words of Warren Buffett (Trades, Portfolio): “Observing correctly that the market was frequently efficient, they [academics] went on to conclude incorrectly that it was always efficient. The difference between these two propositions is night and day.”
According to Hood, the theory became widely accepted by academics in the 1970s, “and a substantial number of investment professionals also fell under its spell. To this day, the EMT continues to hold sway in most business schools across the country.”
Benjamin Graham was the next authority Hood enlisted to challenge the efficient market theory, referring to Graham’s famous statement, “In the short run the stock market is a voting machine, and in the long run the stock market is a weighing machine.” For Hood, that statement meant short-run stock prices are determined by the crowd’s votes, but “there is no intelligence test required to vote.” Rather, those votes are subject to multiple emotions and errors in judgment, allowing them to be well off the mark of “correct” prices.
However, in the long run, the market does get the pricing right:
“One can also imagine the stock market operating as a slowly reacting weighing machine, whereby individual stocks are placed on the scale, and eventually, given enough time for irrationality and emotion to play itself out, the scale registers the correct value of the stock. Thus if an individual stock is currently mispriced due to irrationality, misjudgment, or systemic forces, eventually the stock market will correct this mispricing, and the stock price will ultimately return to a more correct value which better approximates the intrinsic value of the underlying business.”
Another challenge to the efficient market theory comes from Howard Marks (Trades, Portfolio) and his book, “The Most Important Thing.” In the book, he compared the stock market to a pendulum that continually swings between depression and euphoria. While in the middle, the wisdom of the crowd may produce correct prices, but the pendulum spends most of its time near the extremes. That push toward the extremes is driven mainly by investor irrationality.
The consensus among the experts Hood has cited comes to this:
“Hence the reality is that the stock market is often efficient and stock market prices do quite often reflect the appropriate values of their underlying businesses. However, in many instances, and sometimes for lengthy periods of time, the market simply does not produce correct prices, and oftentimes individual securities are wildly mispriced.”
From that, he concludes that some underlying assumptions of the efficient market theory are wrong, and they can be seen more easily when one is analyzing the criteria used to identify a wise crowd.
Hood suggested we might consider how much the value of a public company fluctuates between a 52-week high and a 52-week low. Often, that’s a very wide variation, even though the intrinsic value of the company changed very little. If a knowledgeable buyer and a knowledgeable seller negotiated for 52 weeks, would the negotiated prices vary so wildly?Â
According to him, this example proves there is market inefficiency during normal years. Beyond the normal years, when fear or greed is running high, the market becomes extremely inefficient and offers more mispriced opportunities.
Part of the reason for wild swings is that irrational buyers are trading in large, liquid market exchanges:
“The liquidity aspect of markets as a contributing factor to market inefficiency cannot be overstated. A privately negotiated transaction between a buyer and a seller requires much time and effort, and is not entered into lightly. In contrast, in the stock market a piece of a business can be sold in a second with the mere click of a button. The ease with which pieces of a business can be bought and sold in the stock market provides a huge temptation for irrational participants to make thoughtless and often emotional buy and sell decisions that are divorced from reality.”
What about proponents of the efficient market theory who say the truth of the concept is in the fact that so few investors consistently beat the market over time? Hood responded by saying, “as we will see, the poor investment performance of the majority of the market crowd is largely due to irrationality, incorrect incentives, various systemic constraints (mostly short-term mindsets and overdiversification), and herd mentality present in the market.”
Finally, he noted that investors who maintain a long-term perspective, avoid irrationality (as well as the herd mentality) and take a fundamentals-based approach are more likely to beat the market. “In other words, if an investor harkens from the intellectual village of Graham and Doddsville, or Buffettville, he is much more likely to consistently and reliably beat the market averages than if he hails from Wall Street.”
Conclusion
Hood has argued, with the support of Buffett, Graham and Marks, that the efficient market theory is flawed. While it may be mostly correct in the long run, it fizzles in explaining the pricing of stocks in the short run.
That short-run failure can be attributed primarily to irrational behavior by market participants. Much of that irrationality can be slowly eliminated over time; in Graham’s words, “enough time for irrationality and emotion to play itself out.”
Read more here:
- Inefficient Market Theory: The Wisdom of Crowds
- Inefficient Market Theory: The Foolishness of the Crowd
- Ratio Analysis: The Payout Ratio
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