The Great Divide over Market Efficiency

by on March 10, 2014 at 7:28 am in Economics | Permalink

Clifford Asness and John Liew have an excellent piece in Institutional Investor on Fama, Shiller and The Great Divide over Market Efficiency. Asness and Liew are both students of Fama so you might expect them to come down squarely on the side of market efficiency but they are also co-founders of AQR Capital, an asset management firm ($100 billion under management) with an unusually empirically driven approach to investing. In addition to publishing and using its own research, for example, AQR sponsors the AQR Insight Award which:

…recognizes important, unpublished papers that provide the most significant, new practical insights for tax-exempt institutional or taxable investor portfolios.

The Insight award is worth up to $100,000 so the firm is serious in thinking that research can be profitable.

Asness and Liew argue that just a few anomalies are robust across time, countries, and asset markets, notably momentum and value. On value, they note that a trading strategy of high minus low, that is long a portfolio of cheap stocks (high book value to price) and short a portfolio of expensive stocks (low book value to price) has generated consistently high returns relative to (CAPM) risk over time, albeit not without occasional terrifying episodes.

The efficient market explanation is that book value to price is a stand-in for a non-diversifiable risk factor. The behavioral story is that “a lot of individuals and groups (particularly committees) have a strong tendency to rely on three-to five-year performance evaluation horizons.” As a result, they chase “winners” and flee “losers” over a 3-5 year horizon which generates momentum and the mispricing that makes the value strategy successful. As Asness and Liew put it “investors act like momentum traders over a value time horizon.”

Asness and Liew then follow up with a very astute counter-argument to the risk-factor story:

Also, many practitioners offer value-tilted products and long-short products that go long value stocks and short growth stocks. But if value works because of risk, there should be a market for people who want the opposite. That is, real risk has to hurt. People should want insurance against things like that. Some should desire to give up return to lower their exposure to this risk. However, we know of nobody offering the systematic opposite product (long expensive, short cheap)…the complete lack of such products is  a bit vexing for the pure rational based risk-based story.

Lots of other history and insights.

1 ummm March 10, 2014 at 8:12 am

Lately is has become fashionable to criticize the EMH but the behavior theories are even worse because at least the EMH works 99% of the time. A few exception doesn’t discredit the entire theory. It’s like abandoning newton’s laws because it doesn’t work exactly in the proximity of massive bodies. The left disagrees with the EMH because they want to believe in the conspiracies that the market is rigged or a bubble inflated by irrational speculators. I also disagree that market participants can behave irrationally real-time. Irrationality can only be determined retrospectively. In retrospect, buying gold at $1800 an once was irrational but at the time it wasn’t.

2 john personna March 10, 2014 at 10:13 am

Did you read the article? It “has become fashionable to criticize the EMH” because that is what the data demands.

I personally go even further than mild criticism for strong forms, I think the whole idea was a logical error, an argument that a behavior proved an arbitrary causation. Absolutely prices in traded markets follow something like a random walk. The impact of random news on that is absolutely a factor. The strange and unsupported assertion of the original EMH was that such news -> price link was the ONLY driver, and that emotion or attention were NOT factors.

Likely that randomish walk is driven by all three .. rational responses to news, plus emotional responses, plus turns of attention.

And as I’ve said, that complex mix is probably even harder to “predict” than a simpler model.

3 ummm March 10, 2014 at 10:32 am

in my defense the article is 10 pages…

4 Brian Donohue March 10, 2014 at 10:43 am

I invite you to explore your “true value atheism” position. AFAICT, you say we can only talk about price, not what something is ‘intrinsically worth’. To be clear, I will use US dollars as the measure of value.

Let’s start with this crisp $1 bill in my hand. Surely we agree that this is ‘worth’ $1, right?

Now imagine the $1 is payable in six months time by the government. Now we have some scope for valuation differences. Maybe this promise is worth 98 cents, maybe 99 cents, maybe 99.99 cents. But valuing it at 70 cents or $1.20 is wrong.

Extend the period to 30 years. Now there is substantial scope for differences in valuation, but to me, it is still obvious that these valuations clump around an unknown ‘true value’.

Now let’s say it’s a company and not the government will pay the $1 dollar. More uncertainty, more scope for different valuations. But I see no basis for abandoning the idea that there is an ‘intrinsic value’ to the promise, even if we don’t know exactly what it is and reasonable people value the promise differently.

Finally, imagine that the company promises you not $1, but a share of its earnings in year 30. Lots more uncertainty here, but I don’t see why this can’t fit into a valuation framework.

There are random elements to spot stock prices, but, over the long run, they are tethered to some underlying reality.

I think when Shiller speaks of bubbles, he is saying “The price is too damn high!” and this statement is made in reference to his idea of the (unknowable) ‘intrinsic value’ of the asset. Maybe I’m wrong though.

5 john personna March 10, 2014 at 10:55 am

The example you chose is actually well-covered by experiment. A few variations of the theme are covered in Thaller’s “Winner’s Curse” book.

Basically what they find in “I can pay you now, or I can pay you later” studies is that people take less than they should (by present value calculations) when offered money up front.

I suspect that the psychology is pretty simple, a bird in the hand is worth two in the bush. Sure, you may tell me that you’ll pay me $100 in six months, but will you move, forget, die? Even in a contractual situation can we shake off that evolutionary understanding of risk?

(Bubbles are less a fear/risk thing and more a greed thing, right? Amply demonstrated by people who go into what *they* think are bubbles, just planning not to be the last one out.)

6 Alex K. March 10, 2014 at 11:37 am

“I suspect that the psychology is pretty simple, a bird in the hand is worth two in the bush. Sure, you may tell me that you’ll pay me $100 in six months, but will you move, forget, die?”

How is that irrational?

The real world is in fact full of unmodeled and unmodelable uncertainty and it’s the naive (in fact, stupid) belief in simple and clear models that is irrational. Or perhaps a better way to put it is that adding untractable uncertainty to some simple model is more rational than believing in the simple model — this does not necessarily commit me to the claim that everyone is rational.

7 john personna March 10, 2014 at 11:48 am

I should give two answers. First is that the more I read on this the less I feel “rational” and “irrational” are clear territories, even less that one is a good territory and one is a bad one. A bias towards cooperation, for instance, may not be rational, but is good.

Now, on your question and this payment risk, it much be about the deviation from true risk, right? If I go into a test group at a local uni, and sign up for a econ study, I should believe their promise and use a quick mental pdv calculation, right? If they are offering me better than bank interest, I should take the deferred payment.

Most don’t, preferring “cheeseburger today.”

8 john personna March 10, 2014 at 11:50 am

BTW, are the however many billions sitting in simple US savings accounts demonstration of this effect? Is money available today enjoying excess preference?

9 john personna March 10, 2014 at 11:52 am

A general belief that “life is uncertain” undermines any rational expectations model.

10 Alex K. March 10, 2014 at 12:20 pm

“[ If I ] sign up for a econ study, I should believe their promise and use a quick mental pdv calculation, right? ”

People have various heuristics, which tend to be more adapted to the complex environment in which they live relative to the heuristics derived from simple models. So, yes, in artificially simplified environments those heuristics fail — but that’s not a very momentous fact.

“A general belief that “life is uncertain” undermines any rational expectations model. ”

There are many possible uses of a rational expectations model. Some such models are just a way of saying that people do in fact see a little bit more than the length of their nose, that they take into account the value of some relevant variables and that they have relatively sophisticated behavior depending on the value of such a variable. Many Old Keynesian models denied even this kind of rationality (their agents behaved in a very robotic manner, and the correctness of the Keynesian models depended on agents having such robotic behavior). So such an interpretation of rational expectation models is not undermined by the addition of uncertainty.

On the other hand, you are right that there is a stupid interpretation of rational expectation models (that agents take every detail into account and devise perfect strategies in response) which is indeed undermined by untractable uncertainty.

The solution is to make economists be more sensitive to the separation of models that assume just the first, robust kind of rationality and the models in which hyper-rationality is crucial for their conclusions to hold.

11 john personna March 10, 2014 at 1:20 pm

I gather that one big “what a minute” in behavioral studies is confusion about what is finding and what is artifact in such experiments. Of course, if the results are confused, that might be one more indication that the real world is confused.

Perhaps the caricature of EMH thinking was the nightly news reduction … “X corp moved up on news that Y happened.”

I’d say we know from behavioral studies that “X corp moved up, and Y happened, which might be rationally connected, irrationally connected, or totally unconnected.”

12 Brian Donohue March 10, 2014 at 1:54 pm

“Bubbles are less a fear/risk thing and more a greed thing, right?”

I dunno. Are people more prone to undue optimism/greed or undue pessimism/fear?

Certainly, what gets talked about almost exclusively are the “greed things”.

http://www.themoneyillusion.com/?p=26332#comments

13 john personna March 10, 2014 at 2:04 pm

FWIW, I often “think” it is smart to buy after a crash, but “fear” that it is not.

My dad was a tough guy, going in big on the Tuesday after Black Monday.

14 Brian Donohue March 10, 2014 at 2:09 pm

One thing I know for sure is that if you buy the day after a crash, you get a better deal than buying the day before.

People are funny- in most markets, a lower price means a sale and buyers flood in. When it comes to stock markets, though, people often behave opposite to this.

15 Finch March 10, 2014 at 2:10 pm

> AFAICT, you say we can only talk about price, not what something is ‘intrinsically worth’.

My understanding is that economists sometimes distinguish between price and value when the security might be put to different uses. For example, a buy-and-hold investment implies no concern about liquidity premium, but an available-for-sale investment implies concern. Prices are only available including the effect of illiquidity.

16 Brian Donohue March 10, 2014 at 2:15 pm

I completely agree. Which is to say that different people value the same things differently, right? This is hardly unique to stocks.

However, it would be silly to value an asset at less than the price you could sell it for, even if the asset has no ‘intrinsic value’ to you.

17 Finch March 10, 2014 at 2:25 pm

Buy-and-holders typically would value it at more than they could sell it for. The price is sort of a floor on the value. Consider, for example, MBS in the immediate aftermath of the financial crisis. If you had to sell, you would sell at a significant discount to the expected discounted cash flows because the market was illiquid. I could imagine a reversal of this, but it would be weird.

And it’s not exactly the same as saying different people value things differently. It’s that when economists say “price” they are thinking about trading, and when they say “value” they are not.

Practitioners use tools that make this price/intrinsic value distinction in fixed income, so it’s not just ivory tower pedantry.

18 john personna March 10, 2014 at 2:40 pm

Well, the concept of value is tied to risk. And all risk in the real world is vague. Any models for volatility or default are based on past performance. The MBS were rated AAA for this very reason. Now, in the time frame you mention, days after the crash, people were trying to guess at some future risk. A complete unknown, including calculations of bailout potential and etc.

19 john personna March 10, 2014 at 2:42 pm

(The AAA rating was indeed made by “practitioners using tools that make this price/intrinsic value distinction” … to all our detriment.)

20 Finch March 10, 2014 at 2:54 pm

JP, I’m not sure I understand your comment. All sorts of risks (like market risk) are thought of as being part of value. The ability to trade the darn thing is part of price. It’s possible (and entirely reasonable for some people) to be worried about the cash flows a security will throw off and not what they can get for it today.

So for many securities in the immediate aftermath of the financial crisis, prices were depressed beyond what was warranted due to uncertainty in their expected cash flows (which might have been a significant discount all on its own) because for various reasons there were few buyers and those few who remained could demand great bargains.

It’s not necessary for you to think the people who create bonds or the people who buy them are saints or geniuses or anything like that to believe this.

21 john personna March 10, 2014 at 3:49 pm

I guess my point is that people who think they can calculate a future value for a security do so by suspending disbelief about some risk story.

22 Brian Donohue March 10, 2014 at 3:57 pm

jp, it’s not so hard to estimate such a value- people do it every day in the presence of uncertainty. Uncertainty tells you something about the quality of the estimate and possible distribution of outcomes around that estimate.

23 john personna March 10, 2014 at 4:27 pm

Nassim Taleb says no, that’s not what people do. Instead they make a stab at prediction, and then when conditions change they call a do-over. In this way, those guesses are never accountable or due.

I mean what was the aftermath of the MBS crash? Just new price models based on a new prediction.

24 Finch March 10, 2014 at 5:01 pm

I’ll rephrase: it’s not necessary to believe people are any good at valuation to understand the words they use and to think that there might be a difference between the value of a stream of cash flows to someone who’s going to hold the security and what you can get for the same security in a market.

25 Ray Lopez March 10, 2014 at 8:18 am

Warren Buffett is the counterexample of the EMH. You could argue he’s the exception to at last the strong form of EMH, that there’s no inside trading advantage, by noting that by sitting on so many boards, Buffett essentially gets “legal” inside information and thus an advantage over other traders who don’t have such information.

26 Andrew' March 10, 2014 at 8:38 am

And he also says to get an index card and a hole puncher and when you’ve made 12 punches you are done with your investment decisions. This is another way of saying that EMH usually wins. You have to know what it is to recognize what it isn’t. And I don’t think he has much of a legal insider advantage you are saying. He just figured out 99% of the way investing really works.

27 john personna March 10, 2014 at 10:15 am

What do you mean by “EMH actually wins?”

Are you mistaking the behavior (unpredictable markets) with the causation? Because “EMH” is not short for “unpredictability,” it is an argument about aggregate market rationality.

28 Andrew' March 10, 2014 at 12:01 pm

I don’t think I’m mistaking anything.

29 john personna March 10, 2014 at 1:17 pm

But neither did you answer any of the questions.

30 Andrew' March 10, 2014 at 3:37 pm

In a way I answered all the questions.

31 john personna March 10, 2014 at 3:50 pm

lol, Andrew’, if there is anyone who as over-answered, with great detail, in this thread, it is me.

32 ummm March 10, 2014 at 9:08 am

EMH doesn’t preclude some people form being more skilled than others. The EMH reflects how the market seems to digest new information quickly. Lately, Buffett’s performance hasn’t been that great, so it looks like mean reversion is creeping up on him.

33 john personna March 10, 2014 at 10:16 am

No, that is not the EMH either.

34 ummm March 10, 2014 at 10:34 am

according to wikipedia the weak form allows some fundamental strategies to provide excess returns

35 john personna March 10, 2014 at 10:48 am

My criticism of that is that “weak form” is nothing but a roll back to the naked observation. People say “weak form EMH” when they just mean unpredictable markets. This creates a linkage, and a life after death, for the original (strong form).

It is a zombie theory in “weak form.”

36 bluto March 10, 2014 at 4:35 pm

Buffett made most of his money because his costs of capital are lower than other investors not because his return on assets is substantially higher. Running insurance companies produces a huge amount of float which he invests in equities.

37 Ironman March 10, 2014 at 8:19 am

The way the markets would actually appear to work is more complicated than either the fans of Fama or Shiller’s takes on how the markets work would believe.

I’m surprised about the apparent lack of a long expensive/short cheap stock portfolio though – that would seem to be exactly the sort of thing that would have been implemented in a hedge fund. I wonder how the strategy would fare in back-testing compared to other hedging strategies (if it doesn’t provide enough insurance against large losses compared to other strategies, that could be an explanation for why the approach would not have been adopted anywhere.)

38 Andrew' March 10, 2014 at 8:34 am

Me too…except is that backwards?

39 john personna March 10, 2014 at 11:15 am

From that article:

In practice, this is an example of the market being inefficient, where the rational response of investors to risks associated with the Fed’s QE tapering policy, something that Shiller’s Nobel prize-winning theory says could never happen, actually created an inefficiency in the market, something that Fama’s Nobel prize-winning theory says could never happen.

I think they author twisted himself in a bit of a loop there. Didn’t investors attempt rational response to a rumor of tapering? And attempting to respond to a rumor might indeed cause excess volatility a la Keynes and Shiller.

40 Ironman March 10, 2014 at 6:34 pm

The point is that Shiller would consider the activity to be “irrational” (while Keynes would attribute the activity to “animal spirits”). Neither view stands up to scrutiny in this situation, as investors were really behaving very rationally during that particular noise event.

41 J March 10, 2014 at 8:38 am

Tyler did you watch Cosmos?!?!?!

42 J March 10, 2014 at 8:40 am

Ack I’m sorry, I should have checked to make sure this wasn’t an Alex post before commenting. I gotta say this post felt like a Tyler one. Maybe he’s rubbing off on you. Alex did you watch it?

43 Alex Tabarrok March 10, 2014 at 9:13 am

It’s on the DVR, will watch this week!

44 john personna March 10, 2014 at 10:42 am

I wasn’t really planning to watch, but was by the tv at 9, and so turned it on. My reaction was “this really isn’t the 1970s anymore.”

In 1978 we all watched it in my house, in good part because as a science kid of that era I was incredibly starved for content. That was what made it a huge event. We had patience for the theatrics. Now is different.

And so I turned it off and read something about body clocks on my Nexus5.

45 prior_approval March 10, 2014 at 10:02 am

Makes one wonder where the CFROI framework fits into this, and whether endowing academic chairs after pursuing a successful investment career is more efficient than searching for unpublished work and attempting to make money from it.

46 john personna March 10, 2014 at 10:21 am

It is probably important to note that when Mandelbrot looked at financial markets, he did not find a random walk, that’s where he found chaos. A new mathematical concept.

47 david March 10, 2014 at 10:39 am

urgh. he found a levy flight, which is a random walk

48 john personna March 10, 2014 at 10:46 am

“The term “Lévy flight” was coined by Benoît Mandelbrot,[1] who used this for one specific definition of the distribution of step sizes” … in it “D is a parameter related to the fractal dimension and the distribution is a particular case of the Pareto distribution”

So we are hardly removed from chaos/fractal math.

49 J March 10, 2014 at 12:19 pm

What difference does it even make. World events are not literally random but are probably chaotic, so the stock market should be too. But for us mere mortals it might as well be random, epistemologically speaking.

50 john personna March 10, 2014 at 1:14 pm

Yeah, though some detail on the “big days” of up or down movement is helpful. Black Mondays happen, but so do chaotic upward movements. As I understand it, exposing oneself to a long term market position (a la a random walk down wall street) is still best, because in attempting to avoid downside you also avoid “excess volatility” to the upside.

51 Andrew' March 10, 2014 at 12:55 pm

I always wonder “a random walk around what?” Sometimes I take a random walk, but I always end up back at home.

52 Donald Pretari March 10, 2014 at 11:03 am

Has anyone ever tried investing based upon Backward Political Slurs? I thought this was an excellent piece. I wish I could figure out how to keep it and quote from it.

53 JasonL March 10, 2014 at 12:20 pm

I find myself frustrated with behavioral explanations that are always after the fact. If behaviorists aren’t relying on EMH as a basis for reasonable expectations, they descend into navel gazing.

54 Squarely Rooted March 10, 2014 at 1:39 pm

JP Koning had a fantastic post last Friday where he argued that the returns to HML are basically just returns to providing the market with liquidity:

http://jpkoning.blogspot.com/2014/03/is-value-premium-liquidity-premium.html

55 ohwilleke March 10, 2014 at 1:55 pm

People who want to avoid risk favor government backed securities, cash, cash substitutes, and bonds from institutions with credit ratings almost as good as the government. Those who want par for the course risk buy index funds.

Any undertaking that relies upon beating the market’s valuation is inherently risky, because the track record of funds that do so successfully is small. Also, aren’t hedge funds more direct ways of achieving what their anti-growth portfolio claims to?

56 Jason March 10, 2014 at 2:00 pm

One way to understand the “anomalies” of momentum and value is to think that prices in efficient markets are maximally uninformative, but not necessarily completely uninformative:

http://informationtransfereconomics.blogspot.com/2014/02/ii-entropy-and-microfoundations.html

57 Andrew' March 10, 2014 at 3:39 pm

Are we that bored of common sense?

58 Donald Pretari March 10, 2014 at 2:33 pm

Squarely Rooted and Jason…Both of the Blogs Referenced look interesting…Thanks…

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