The Globe and Mail

  Efficient Markets?


Monday October 24, 2016

Back when Benj was doing his MBA at Dalhousie University, his views conflicted with a professor who was a believer in the “efficient market hypothesis (EMH),” also known as “perfectly efficient markets.”

Benj was more obstreperous then, and since he had been investing successfully for a number of years and read scads of literature on the subject, he chose to argue rather forcefully with his teacher. At the end of class, after the fireworks had subsided, a wizened student who had worked the currency markets for a number of years before returning to university asked Benj, “Why do you bother?”

The EMH argues that stocks always trade at their fair value because they reflect all available information — it is impossible to beat the market over the long term unless one has insider information or takes on excessive risk. Whoa, have we been wasting our lives in Contra Land?

The theory is credited to Eugene Fama, who is surely no lightweight. This American gent won a Nobel prize in economics and in some circles is considered “the father of finance.” We are disagreeing with eminence, so to speak, while we're known more for being two guys in a garage. Nice garage, mind you.

So let us see about taking this apart. First, the market is composed of thousands — make that millions — of inputs. The major one, of course, is investors themselves. Why would shareholders be perfectly attuned, whether individually or as a collective? If the result is flawless pricing, the ingredients must, at the end of the day, tally perfection. Investors are not. In fact, how many unblemished things are there in the world, if any?

The theory becomes far more questionable when one considers days where the stock market has major moves. October 19, 1987, was a classic, when the Dow dropped 22.6 percent. That was a helluva plummet.

Hypothetically, we suppose, one could argue that proves how efficient markets are, but a nosedive of that proportion is not perfection, but panic. It was not based on valuations in any way, shape or form; people decided to sprint to the sidelines, plain and simple.

The second-largest drop was October 28, 1929, at 12.8 percent. The year 2008 had three plunges of better than 7 percent. Worth noting is that all of these time periods featured very different technological contexts. It seems difficult to fathom that, irrespective of the means of conducting trades, all the time frames would allow for perfection. Our belief is that none of them does.

One outstanding example of imperfection was May 6, 2010, the infamous “flash crash.” The Dow dropped about 9 percent, around two-thirds of that in a span of five minutes. Almost all of the 600 points were regained in about 20 minutes. Believers could argue that it was the most perfectly efficient day ever. Poppycock!

We like to think that when we analyze companies, depth is our hallmark. From financial statements to financial ratios, macro and micro factors, technical and fundamental analysis, management and many other aspects, there is a multitude of parts at play. Other investors often just work from tips from family or friends. “Like, Uncle Toby heard at the bar that XYZ is a great buy!” Would a combo of these methodologies lead to perfection?

It is a fact that many investors have outperformed markets over long periods of time. Heck, we are delighted to be included in that group, which is why Benj was featured first in Robin Speziale's best-seller Market Masters. Being probability guys, we're comfortable that the proof is in the pudding.

Back to 1981 and Benj in the classroom. If the same situation arose today, he might not bother to debate. Rather, he might kick back and scrutinize the clock until the irrational yak was finished. Then again, as is commonly stated today, “One never knows.” Or does one?