by David Dreman
Fama adds in his 1998 paper that market efficiency still survives. He spends considerable time discussing anomalies that challenge the efficacy of EMH, stating that they are chance results. But to do so he must be dismissive of major work, ironically by both other scholars and himself, that has stood for decades. The good professor and a large number of other EMH adherents even tend to deny that anomalies actually exist. We will go into these anomalies in some detail in the chapters ahead.
Since the 1960s, EMH researchers have shown a strong inclination to dismiss anomalies by criticizing the methodology of other investigators or on other grounds, as we’ll see in chapter 6.*22*23
The Power of an Idea
Whether EMH, CAPM, and MPT do a good job of describing markets or are pure blather, they have fired the imagination not only of academia but also of Wall Street. Prior to these theories, investment managers and mutual funds were measured on the rates of return their portfolios generated, usually compared with the S&P 500 or the Dow Jones, with no adjustments made for risk. The development of the CAPM resulted in academics’ and consultants’ putting risk measurements into the formula to determine how well a portfolio performed. If a portfolio earned the market return with higher risk, it was deemed, on a risk-adjusted basis, to have underperformed the market; and if it earned the market return with lower risk, it was deemed to have outperformed the market.
Risk measurement has grown into a multibillion-dollar industry and influences the decisions of countless investors, either directly or through their pension funds. If you buy a mutual fund from Morgan Stanley, Charles Schwab, or virtually any other brokerage firm, as millions do, you might take your cue from a Charles Schwab–recommended list. To rank funds, Schwab and most other mass marketers calculate risk as well as performance. Similar risk measurements are used by consultants who recommend money managers to large pension funds and the large brokerage houses, the latter of which in turn recommend money managers for millions of smaller customers. On the theory that you cannot beat the market over time, more than a trillion dollars has also gone into various forms of index funds.
In the space of twenty pages or so, I have documented the academic dismantlement of the two most important market theories of our day—technical and fundamental analysis—and their replacement, at least intellectually, by a third. The new theory has swept through the universities and then progressively through the financial press, among individual and corporate investors, and among professionals themselves. On the assumption that it is impossible to outdo the market, many professionals have radically altered their techniques and their concept of risk—a fitting tribute to the power of an idea conceived less than five decades ago.
The theory so pervades professional investing and academia that Michael Jensen, one of the important contributors to its development, stated some years back, “It’s dangerously close to the point where no graduate student would dare send off a paper criticizing the hypothesis.”31 At the same time, it is sad, for in accepting the new way, the money manager acknowledges that his or her prime raison d’être—to earn superior returns for the client—is beyond reach.
The spread of the new faith was not unlike the conquest of the vast Inca empire by Pizarro and his 180 conquistadors. Like the conquistadors, the scholars used both faith and the sword to annihilate the pagans’ beliefs in the old marketplace. If the true faith was not accepted, why, then there was the sword—the unleashing of volleys of awesome statistics disproving everything the professionals believed. What amazes in retrospect is that the leaders of the new faith subdued millions of investors with a smaller troop than the original conquistadors.
An Achilles’ Heel
But it’s not time to wave the white flag just yet. The golden age of efficient markets may not be destined to last. If we scrutinize the theory more closely after the chilling market events of more recent times, the elegant hypothesis seems to have more than a few major hitches. The professors assumed that investors were as emotionless and as efficient as the computers they used to generate their theory. They completely omitted any psychology, including the compelling work we looked at in the previous chapters that seems to fuel many of the major investor errors we repeatedly make, from their calculations. This by itself could be a fatal blow to the hypothesis, but, as we shall see in the next two chapters, there are other, even more serious flaws.
Although the efficient-market hypothesis seems to unravel some of the investment knots we have seen, such as why professional investors as a group do not outperform the market, it fails to untie many others. How, for instance, could investors en masse underperform the market for decades? How could the bulk of professional opinion prove so consistently and dramatically wrong at crucial market turning points? Or, if investors are so unfailingly rational, how could euphoria and panic prevail as often as we saw in the past chapters? More specifically, if the market is so efficient, how could the 1996–2002 and 2003–2009 bubble and crashes, two of the most severe in economic history, occur within only a few years of each other, particularly when legions of investment professionals were not only trained in, but carefully followed, efficient-market teachings and invested trillions of dollars according to this contemporary bible?
The truth is that the work of outstanding academics, including several dozen Nobel laureates whose research is the bedrock supporting EMH and MPT, has caused heretofore unheard-of market damage in numerous bubbles during the past twenty-five years.
These revolutionary new ideas that sprouted from financial ivory towers around the world won’t give you the odds to beat the market or for that matter even keep you afloat. Many of the basic teachings of EMH have now been conclusively refuted by advanced forms of the same statistical analysis that devastated the investment heathen. Yet contemporary investment practice is built on the belief in efficient markets. Large numbers of investors, though they believe the theory to be bankrupt, don’t know where else to turn.
The efficient-market hypothesis is the natural extension of the last two hundred years of economic theory. At last a place was found for economists to take a stand that would once and for all establish that people behaved in the rational manner economists have assumed for centuries. Their laboratories are, of course, the stock markets and other financial markets. Demonstrating that people actually behave rationally in these markets would be almost akin to discovering the holy books of economics.
It is not surprising, then, that the original “evidence” by Fama, Blume, Jensen, Scholes, and others, that markets were efficient, was enthusiastically greeted by economists, perhaps nowhere more than at the University of Chicago, one of the renowned bastions of laissez-faire. Equally logical was that Chicago became the intellectual heart of this dynamic new research.
Market economists threw down the gauntlet. As one academic noted, “You can see why the idea [of perfectly knowledgeable investors in the stock market] is intriguing. Where else can the economist find the ideal of the perfect market? Here is a place to take a stand if there is such a place.”32 Take a stand they did, although, as we’ll see, it is beginning to look more and more like that last stand by General Custer.
So deep was their conviction that these theories would usher in the golden age of markets, if not economics, that they were convinced the statistics would bear them out. But as we’ll see next, they do not.
Still, to avoid ensnarement by EMH, you must understand its teachings well. There are no government-required labels to warn you away from the EMH-CAPM-MPT trap; lacking knowledge, you can easily be caught up in it. A flawed investment theory is not market-neutral; it can be destructive to the capital of average and sophisticated investors alike. To find the road to successful investment, we must stay well clear of the theory. That will take something more than looking up imploringly to the heavens.
Where, then, do the real odds of market success lie? Are there any real odds at all? We will examine these questions shortly, but first let’s look at why EMH has failed and how
its failure affects you as an investor.
Chapter 5
It’s Only a Flesh Wound
WHEN I THINK of those defending EMH, a striking image comes to me from the English comedy film Monty Python and the Holy Grail. King Arthur and his squire are riding through the forest—well, we hear the sound of horses’ hooves, but actually the two are on foot, prancing along through the trees and meadows—when they find their path blocked by the Black Knight, who demands that the king fight to the death to pass. In the ensuing swordfight, King Arthur lops off one of the Black Knight’s arms, then the other, but the knight refuses to yield. “You haven’t got any arms left,” the king points out. “Look!”
“What! Just a flesh wound!” the knight retorts. The battle continues, and King Arthur disposes of both of the knight’s legs. Unyielding, reduced to mere head and torso, the knight still won’t give in. “The Black Knight always triumphs!” he bellows bravely. “Come back here and take what’s coming to you. I’ll bite your legs off!”
As this chapter will show, EMH is in a spot not all that dissimilar, refusing to yield no matter how battered.
Interestingly, the historical reality of England’s King Arthur has never been satisfactorily established. It’s just not verifiable history. Yet in grand novels, poems, plays, children’s books—even the satirical deflating by Monty Python—his legend is secure. With EMH we have a plethora of data, and it ought to have been simple enough to establish—or refute—the validity of its “legendary” findings by now. Yet, unlike that of King Arthur’s tales, the historical basis of EMH has undergone considerable revisionism, and with each updating, the base of its statistical observation has become shakier.
In the previous chapter I described how EMH swept through academia in the 1960s and then took Wall Street by storm. Like George Patton’s Third Army roaring through Germany in 1945, the efficient-market hypothesis overwhelmed the obsolescent weapons of Wall Street’s technicians and fundamentalists with its seemingly invincible new weaponry of powerful statistical analysis and mathematics. Because academic findings clearly showed that money managers could not outperform the market, a trillion dollars flowed into funds based on various indexes, from the S&P 500 to the Russell 2000.*24 Owing to the scope of their victory, some academics even expressed concerns that the markets might not continue to be as efficient as the realization spread that money managers and analysts could not beat the market and as a result would probably be laid off. Since these managers and analysts were essential, according to EMH, to keeping markets efficient, too many such layoffs would make them less so. This was a bad dream for those of us in the investment field but, as it turns out, only that. This chapter and the next should demonstrate that it is actually built on sand and will show some of the reasons why. In our journey we will see much of the supposedly powerful statistical documentation of the theory crumble, because either the tools did not do what they claimed or the researchers ignored or downgraded powerful data that refuted their claims.
There is a clear disconnect between real-world results and the predictions of the distinguished academic pioneers who formulated EMH. In this chapter, after we have compiled a solid reference base of major market events that refute EMH’s basic premises, we will turn to fundamental flaws in the analysis used to buttress the theory. As we’ll see, when the EMH blinders come off, the lessons are noteworthy.
Like the Black Knight’s predicament, it isn’t going to be pretty, but it will clear your path to future investing success. Just as the Black Knight loses one arm, then the other, then both legs, yet vows to fight on, EMH is going to lose one support after another yet remain—you guessed it—the academic theory that trumps all others.
Now we’re going to examine in detail three market events that EMH adherents said could not have happened. With all the financial bloodshed, a few lessons should have been learned, but that was not the case. They are:
1. The 1987 stock market crash
2. The 1998 Long-Term Capital Management debacle
3. The 2006–2008 housing bubble and market crash
1. The 1987 Stock Market Crash
The crash of 1987 was to that time the worst market panic since 1929–1932. The seeds were planted in Chicago in the early 1980s. The Chicago commodity exchanges were eager to expand their business away from wheat, soybeans, cattle futures, livestock, and other commodities. Hungriest of all was the Chicago Mercantile Exchange (the Merc), which had a reputation over the years of cornering markets and performing other high-wire acts that fell on the wrong side of the law. Over its history many attempts had been made to close it down. Scandals abounded, particularly in the onion pit. Onions were one of the major commodities traded, and as a result of the corners, squeezes, and other illegal activities, Congress finally legislated the end of trading in onion futures. The exchange limped along, with a seat in the 1960s and ’70s costing only a pittance.
That all changed in the span of a little over a decade. The Chicago exchanges, led by the lowly Merc under its dynamic chairman, Leo Melamed, were transformed from trading grain, cattle futures, and pork bellies to playing a key role in the U.S. stock and bond markets. Behind the radical reorientation of their business activities were a number of major EMH academics. Not coincidentally, most of the professors were at the University of Chicago, one of the strongest bastions of laissez-faire in the country. The academics believed that financial futures gave markets far more liquidity, providing what they thought would be much broader markets and lower trading costs, thereby enhancing markets’ efficiency.
The star of the show was the S&P 500 futures, introduced by the Merc in April 1982. Most commodity traders thought it couldn’t be done, because futures trading was commonly considered to be a form of gambling. Futures trading, because of its speculative nature, had never been allowed to interact with stock trading. Such a reaction, most investors believed, would result in greater volatility in the stock market. Even leaders in the futures industry believed that was the case. Walter E. Auch, then the chaiman and CEO of the the Chicago Board Options Exchange (CBOE), wrote a letter to the Commodity Futures Trading Commission (CFTC), the country’s top commodities regulator, warning of the potential for “sophisticated manipulation and that index futures are a dressed up form of wagering.”1
The danger was very real. We know that a major cause of the 1929 crash was excessive margin trading at razor-thin margins of 10 percent. In the congressional reforms of the early 1930s, Congress gave the Federal Reserve the power to raise margins on stock purchases, so it could never happen again. And the Fed used this power. Stock margins were never under 50 percent and have been raised in more speculative markets to as high as 100 percent on occasion in the post–World War II period. Even so, margins on stock futures today are much lower than stock margins, normally 5 percent prior to the 1987 crash and now about 7 percent.
Commodity margins were about one-tenth as high as stock margins in 1987, well below the low margins blamed for the 1929 crash, more than wiping out a good part of the congressional reforms regulating margin trading after the 1929 crash. The commodity exchanges had strong academic support from the professors because of the latter’s fixation on more liquid markets while entirely disregarding the dangers of very high leverage.
Sharp drops or crashes have often occurred in the past in both commodity and stock markets when margin requirements were too low. So, through the back door of financial futures, aided by powerful believers in EMH, the Merc and the CBOT could buy or short stocks at margins lower than those in effect in 1929. Players on the commodity exchanges—and they included large numbers of Wall Street firms and hedge funds—could leverage their positions almost ten times as high on stock futures as they could when buying stocks themselves. Since stock futures trading was about double the dollar amount of trading on the NYSE, the tail of S&P 500 futures could most definitely wag the dog, the stock market itself. Not to worry, said the professors, ignoring the numerous collapses of commodity markets in th
e past, it can’t happen today. Markets are efficient, and index arbitrage, an offshoot of futures trading, will make them even more so.*25
When the Merc applied to the CFTC for permission to trade S&P 500 futures, the exchange, along with powerful academic backing, made a strong case that movements of S&P 500 futures would not initiate movements of stocks in the index. This was a prediction that would cost investors many hundreds of billions of dollars by linking the speculative culture of the commodity exchanges to the far more conservative floor of the New York Stock Exchange.
The Mercantile Exchange knew it had a huge moneymaker in stock futures. It launched a giant promotional campaign featuring the S&P 500 futures, ran full-page ads in The Wall Street Journal, and hired celebrities such as Louis Rukeyser, the host of the TV show Wall Street Week, to promote the idea, as well as holding heavily attended seminars across the country conducted by some of the best-known EMH theorists to explain the benefit of S&P 500 futures to leading money managers.
The promotion paid off. By the end of 1987, trading in S&P 500 futures alone was over $300 billion a month, about double the $153 billion traded on the NYSE. The CBOE trading of the S&P 100 (a compact version of the S&P 500, limited primarily to the highest market caps in the index) amounted to another $2.4 billion.2
From being a center of trading eggs and pork bellies, Chicago had become one of the world’s largest financial markets. And the Merc controlled 75 percent of the stock index market.3 Reflecting the seemingly endless prosperity in its financial instruments division, the value of seats had climbed from a pittance to $190,000 in eleven years.4