The Modern View of the Stock Market

The Middle Ground
Earlier this month, Cliff Asness and John Liew published "The Great Divide over Market Efficiency" in Institutional Investor. The article’s title refers to the half-century-long debate in the academic and institutional-investment communities, between those who advanced the theory in the 1960s that the stock market was very efficiently priced, and those who view pricing errors as commonplace. The 2013 Nobel Prize selections of Eugene Fama and Robert Shiller, members of the first and second camps, respectively, were a nod to the divide.

However, the Nobel selections also suggest the existence of a shared middle group. Had either camp dominated the past 50 years worth of evidence, the Nobels would not have been split. The U.S. stock market is capable of stranger behavior than the theorists originally believed; for example, it’s difficult to couch the 1987 market crash or late-1990s New Era rally in strictly rational terms. On the other hand, the failure of most professional money managers to capitalize on these opportunities supports the theorists' original intuition. To the extent that mispricings exist, they are very difficult to exploit.

The Asness and Liew article neatly summarizes the issues. Although the authors are active investment managers, and thus would be expected to side with Shiller, each has a doctorate and trained under Fama. They are therefore sensitive to the views of both parties.

The Limits of Arbitrage
This concept, promulgated in 1997 by Professors Shleifer and Vishny, describes the friction between theory and practice. According to the model of economic efficiency, the brightest, best-informed market participants will quickly chase down and eliminate stock mispricings. Shleifer and Vishny demonstrate how these arbitragers (to use the lingo) face practical restrictions in this task. Insight alone is not enough. Arbitrage requires capital, and this capital can be withdrawn for a variety of reasons. The arbitrager’s trade does not have an infinite time horizon.

The danger of capital having a shorter life span than the trade is particularly large with stocks. With many other trades, the math is trivial (for example, a slight difference between the spot prices of a commodity on different exchanges) or the security is not perpetual, for example an expiring bond or a merger-arbitrage trade based on the scheduled date of a corporate acquisition. Such trades will quickly be resolved. With stocks, however, perceived mispricings may not only continue for years, but grow.

Adam Smith--the nom de plume of Jerry Goodman, not the 18th century Scottish fellow--relayed the blood-curdling story of a fund manager who circa 1970 correctly identified one of the gaming companies as being severely overvalued. The manager shorted the stock, only to watch it double in price, and then double again. After 18 months of this, his portfolio was shattered, he was facing ongoing margin payments, and family and colleagues were questioning his sanity. He caved for the sake of self-preservation. Sure enough, the stock soon headed straight south, eventually losing 95 cents on the dollar. The markets, as John Maynard Keynes stated, were able to remain irrational longer than the manager could remain solvent.  

The same phenomenon occurred a quarter-century later, only writ even larger. Alan Greenspan famously accused stock prices of perhaps being irrationally exuberant in 1996. After a brief hiccup caused by the doctor's concern, stocks promptly resumed their climb, going up for the rest of 1996, and then in 1997, and then in 1998, and again in 1999, and then again with a blowout beginning to the New Millennium. Pity the portfolio manager of 1996 who correctly was skeptical of JDS Uniphase. Shorting that stock--or indeed, merely avoiding holding long positions in that sector--would have likely led to working in a new profession.

The Joint Hypothesis Problem
One of the difficulties of stock-market research is the so-called joint hypothesis problem. Claims about the stock market’s level of efficiency cannot be made in isolation, because such statements must also be accompanied by a second hypothesis, which is the model that is used to test for the market’s efficiency.

That is, if the market is said to be inefficient, the correct response is, inefficient as measured by what? Perhaps the answer is inefficient according to William Sharpe’s Nobel Prize-winning Capital Asset Pricing Model, which alleges that stock returns are related to stock betas. In reality, that is only loosely the case. But does the failure of the CAPM to predict stock returns mean that the market is inefficient? Or is it that Sharpe’s model is insufficient?

Strategic Betas
Those questions are linked with the issue of so-called smart betas, which Morningstar recently renamed strategic betas. (The term “smart betas” always had a whiff of marketing about it.) Strategic betas are groups of stocks that move together--for example, value stocks or smaller companies or those with high recent stock-price momentum. Some of these, most notably value, which was among the first strategic betas to be identified, clearly seem to be sources of extra return. Over most intermediate-to-long time periods, portfolios of value stocks outgain the overall stock market--often by large amounts. 

This behavior, as Asness and Liew point out, amounts to a rejection of the joint hypothesis of market efficiency and the CAPM--but what is the source of the rejection? Is it that the market is inefficient and value stocks offer the free lunch of higher return without correspondingly higher risk, or is it that the market is efficient, and value stocks carry an extra risk factor that is correctly priced by market participants? The data are not in question, but the answers to those questions remain hotly debated. 

In summary, the efficient market hypothesis did not play out quite as its originators foresaw. The Capital Asset Pricing Model was too simple and has not been adequately replaced. Future stock prices sometimes behaved inexplicably strangely. Tens of thousands of pages of academic literature now document "anomalies" that finance's founding fathers did not foresee. For all that, though, the EMH and its supporting tool of the CAPM remain influential and valuable ways of thinking about stock-market behavior. They continue to serve as useful first-pass approximations of the truth--and as challenges for those who reject their claims.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.