Are Markets Efficient?

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My high school interest in the stock market led me to major in Finance in college.  Hoping to learn juicy insights into beating the stock market, I was instead taught the efficient market hypothesis, or EMH.  The efficient market hypothesis states that markets are largely efficient at assessing risk and dishing out returns.  Over time, equities perform better than other asset classes because equities are riskier than other asset classes.  Returns are a compensation for risk.  Basically, business students pay a lot of money to learn that they don’t have a chance against an index fund.  Fortunately, I went to a state college for this advice.

Eugene Fama and Kenneth French, the architects of EMH, performed research which showed that value investing delivers higher rates of return but attributed this to the increased riskiness of value investing.  Value investors disagree and contend that their approach actually reduces risk because they demand a margin of safety from their investments.

I don’t have  PhD.  I don’t have a Nobel Prize. I’m just a working stiff with a blog and a brokerage account.  My analysis is lacking in sophisticated mathematical modeling, but I agree with the value crowd based on common sense.  Just look at the price ranges from the last year of a few large and stable American companies:

Apple: $118.69 to $89.47 – 24.62% difference

American Express: $75.74 to $50.27 – 33.63% difference

Caterpillar Inc: $56.36 to $97.40 – 43.47% difference

I find it difficult to believe that the underlying value of these business experienced such a wild fluctuation in the last calendar year.

One could also look to the entire market as a whole.  Look at the performance of the S&P 500 over the last 26 years:

1990 – 2000: Up 318.42%

2000-2003: Down 27.66%

2003-2007: Up 47.26%

2008-2010: Down 19.88%

2010-2016: Up 90.43%

Did the actual underlying economic output of the United States experience such wild swings over that time period, as the markets seemed to believe?

Here is the total economic output of the United States since 1990:

U.S. Bureau of Economic Analysis, Gross Domestic Product [GDP], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GDP, December 31, 2016.

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It certainly doesn’t look like the actual economy of the United States experienced anywhere near the wild volatility that the United States markets experienced from 1990 to 2016.

I don’t believe that the markets are efficient.  It seems to me that Ben Graham’s characterization of Mr. Market, the crazy manic depressive shouting prices for businesses based on his mood, is closer to reality than the efficient market popularized by EMH.

I believe that astute investors can find mispriced stocks.  Fortunately, most of the investing community believes in EMH because this is what is written in Finance textbooks.  This a good thing.  The more people that believe that markets are efficient, the less competition there will be for value investors.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.

 

 

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