Markets are not (very) efficient

In my years as a college professor, I had more than a passing acquaintance with general investment theory.  I was interested in the subject, and did well with my personal account.  Despite this success, I believed that markets were efficient.  The Efficient Market Hypothesis had gained credence in academic circles, was taught in classrooms, and earned Nobel prizes for the theoreticians.  It made its way into popular literature.  The Wall Street Journal even started a feature comparing the stock picks of experts to the stock picks generated by throwing a dart at a page of stock prices.  The darts did pretty well.  John Bogle was a pioneer with this concept, introducing the first index fund on the S&P 500.  He wrote articles and spoke in front of influential audiences, pointing out the failings of fund managers, most of whom do not beat the market averages.  Thinking that you could beat the averages by picking "hot" fund managers was misleading.  There will always be managers that will do well and managers that will not, but it is a function of randomness.  An excellent book on this subject by Nassim Taleb explained this concept in more detail.  I purchased many copies of the book and sent them to my investors so that they could begin to understand how to distinguish expected performance from past results.  Any investor could profit by reading even a small part of Taleb’s book.  It is well worth the price.

I began work in the investment business providing models and research support for options traders, market makers in the Chicago Board Options Exchange, known in the market as the CBOE (see-bow).   I  began this work for professional traders, trading their own money (and often that of backers) for their own accounts because the traders had an edge.  They bought options on the bid and sold on the offer, conferring an inherent advantage.  The traders needed modeling support and fundamental analysis of the stocks.

As I did this work, I operated with the open mind of an academic researcher.  Gradually I became convinced that there were significant market inefficiencies.  This is extremely important.  The opportunity for the investor comes when others are making mistakes.  If markets are not really efficient, there is opportunity.  The problem comes in determining the sources of the inefficiency and knowing how and when to react.

This concept is crucial to investment management.  If markets are efficient, managers could not show excess returns.  I learned that individual investors made many mistakes, and that their personal accounts showed about half of the gains of the market averages.  They would indeed do better to buy an index fund.  I also learned that the recommendations of analysts at the major firms were a contra-indicator, even though followed by many institutional investors.  The premise was simple:  If the analysts were all in favor of a stock, their followers were already all-in.  The key was to find great stocks that were currently unloved by the analyst community and by individual investors.

I reached this conclusion long before the recent disparging of analyst research, assorted scandals, and the like.  My investors enjoyed great returns from following a contrarian strategy.  The gains did not always happen over night, but they came with time.

I intend to elaborate on this concept, the source of the inefficiencies, why they occur, and what opportunities results.  But first, I need to elaborate on the evidence that markets are not really efficient.  It is a difficult but important concept.

An Interesting Week

Most of the writing I do is on sites exclusively for clients.  This is especially true for the analysis of specific stocks.  Sometimes a theme is also suitable for "A Dash," and tonight is such an occasion.  So here is part of my nightly investor commentary, omitting our daily result and position discussion.

CNBC just reported that the market was up strongly today because of strong corporate earnings. Briefing.com suggests that sense there was no Fed news nor economic news of significance the market could pay more attention to earnings.

Today and yesterday show how little sense there is in most attempts at “explaining” specific trading day results, even moves of 1% or so. Journalists are required to write something, but we do not have to believe it!

There was good earnings news from Morgan Stanley and from FedEx. True enough, but no different from the reports of Merrill, Goldman Sachs, and others in the investment banking space, nor Caterpillar and other cyclical companies.

On May 10th the market focus changed to all Fed, all the time. We got a parade of Fed governors making speeches about their inflation vigilance, plenty of market punditry suggesting that the Fed could not stop inflation nor save the economy. Sector PE multiples were crushed (even further by our lights) for anything related to economic strength — energy, construction, steel, machinery. Many of these stocks declined by 20% or more in about a month. If the economy was to be weak, then technology must also be bad. Since trading and investment banking would be bad, those stocks should also be sold. And what about the yield curve? The fact that it did not matter a few months ago did not deter the same folks from trotting out the same arguments about the economy.

There can be a self-fulfilling prophecy about such stock declines. Analysts started to report that the market was “telling us something” about the economy, and that the Fed should listen. In other words, the market moved lower because of a concern about what might happen. Then some interpreted it as evidence that something would happen.

Over the last few days the sentiment on the economy has changed a bit. Not only are corporations reporting great quarters, but the CEO’s are making more confident statements about global economic strength.

We expect a significant shift in attitudes about the economy, corporate profits, and the relative value of stocks. Market moves like we have seen in the last week illustrate how this might happen.

What’s Going On?

Since the Fed decision to increase interest rates on May 10th, the market has taken a completely different character.  The Fed did not signal that a pause in the rate hike regimen was imminent, leaving the door open for policy flexibility.  Some market participants interpreted this to mean that the Fed was going to kill economic growth.  As a result, they started selling any stock that had a cyclical character.  When this selling started, hedge fund managers on a short-term momentum strategy also started selling.  Individual investors joined the panic.  Even some investment managers now say that it is time to stand back and see where buying emerges.  Technical analysts note that the major averages are in a downtrend and have fallen to critical support levels.

What is wrong with this?

The key point for any investor to grasp is the need to look forward, not backward.  The fact that stocks have declined, and that cyclical stocks have declined the  most, is a backward-looking event.  The key question is whether the "marginal trader" in the market is really looking forward.

How to find the facts?

Our view at "A Dash" is eclectic.  We do not pretend to know the answers, but we are very good at recognizing the experts on each issues.  Partly we do this based upon their past performance, and partly it is based upon the logic of the analysis.

It is important to understand that the markets are not really efficient (more on this in upcoming posts) and that one needs to parse the commentary to learn the facts.

  • The economy.  The facts are that it is very strong.  The economic strength has continued in spite of increased energy prices and a series of interest rate hikes.  The reason is that energy prices are less important than they were thirty years ago.  There has been a drag on the economy, but it is still strong.  The real evidence is from consensus economic predictions and also the predictions from CEO’s in the Business Roundtable.  Both show strong growth.
  • Corporate profits.  The naysayers have been predicting that earnings estimates must decline, and they have been saying this for two years.  They have been wrong, and they are still wrong.  Corporations have strong balance sheets.  Profits have increased at double-digit rates for a record period of time.  Estimates are still rising.  Corporations got lean and mean in 2001 and have expanded cautiously.  They are poised to take action, spending to stimulate growth and buying back stock.
  • Inflation.  This is a widely misunderstood topic.  Hedge fund managers and pundits think that they understand inflation better than the real experts.  There are good indicators of expected inflation.  Things like the spread between TIPS (inflation protected bonds) and regular bonds show modest inflation expectations.  Economists predict the same.  The ten-year note is at a modest 5% yield.  These are the facts.  It is easy to find anecdotal evidence of some higher prices, but more difficult to balance this with the overall picture.
  • The Fed.  The Fed looks at specific inflation indicators, mostly geared to personal consumption (the PCE index) and core inflation rates.  They do this because of the volatility in other inflation measures.  Consider this:  If oil and gas prices remain at current levels, that does not portend additional inflation.  If the economy is slowing a bit, not crashing, but easing to normal strong growth levels, this does not stimulate more inflation.  The Fed’s mission is to kill the expectation of more inflation, so that we do not get a spiral of wage and price increases.  At the moment there is no indication of such a spiral, and the Fed wants to keep it that way.  The new chair, Mr. Bernanke, got off to a slow start with some dovish commentary.  He wants to kill inflationary expectations, as he should.

How Do We Make Money from This?

Let’s start with how one loses money, which is blindly following those who have been wrong and ignoring the real experts on the economy and inflation.  We have the sweet spot of forecasting when economists and CEO’s agree.  There is a disconnect between their read, and that of the average investor and the rookie hedge fund managers.  This is an opportunity.

Our models show the market as a whole to be undervalued by 35% and cyclical stocks, tech stocks, and selected biotechs undervalued by 50%.  Even if we are wrong by a fair margin, it is a great buying opportunity.

Is the Current Market in a Crash Situation?

Those making comparisons with 1987 or 2000 are not looking at fundamentals.  Corporate earnings are strong, much stronger than in 2000.  PE ratios are low, and even lower when compared to interest rates.

Are We Entering Stagflation?

A problem with using the ‘staglfation’ term is that most of the current managers were not following the market in the 70’s when interest rates soared above 15% and growth went to recession levels.  There is no comparison to today’s market.

There is a little more inflation than a few years ago when the problem was global deflation — a serious economic risk.  A little inflation goes with the territory of economic strength.

How Will It Play Out?

The key question is whether the Fed balances interest rate tightening with economic expansion.  Most maket players are following a simple heuristic:  Don’t Fight the Fed.  This is alliterative and makes a lot of sense when the Fed is determined to crush the economy to stop rampant inflation. That is not the current situation.  Most of the Fed tightening simply brought interest rates from an extremely low level, designed to combat deflation, back to a "neutral" range.  We are now in that neutral range.

Looking at every Fed tightening cycle for the last 60 years is not very helpful.  Almost all of these cycles started from much higher levels and faced different inflation situations.  The only circumstances that were vaguely comparable were from the Eisenhower era, when the landscape of derivatives, adjustable mortgages, world trade, and other factors were vastly different.  Despite these obvious problems, one of the major research houses — widely quoted on TV and followed by hedge fund managers and pundits — reports these results as if they were indicative of the current situation.

What to Do?

The current market, as it has been since 2004, remains the opposite of the 1998-99 market.  There is a great opportunity for investors who do not follow the crowd.  The exact timing is difficult.  No one knew exactly when the 2000 "bubble" would burst.  We cannot know with certainty when this "reverse bubble" will play out.

Having said this — sometime pretty soon the Fed will pause, trying to assess the impact of past actions while still talking tough.  Stocks will rise.  Hedge fund managers will jump in to chase performance.  Individual investors will see more opportunity in stocks than in real estate, already showing weakness.  Mutual fund managers will allocate away from emerging markets.  Momentum investors will pile on.

The asset allocation among stocks, bonds, and real estate will reach equilibrium.  More likely, stocks will overshoot.  When this happens, we will shift out of stocks, just as we did in 2000.

Our method has gotten the big cycles just right.  This one is taking longer than expected — torturing us — but the facts have not changed.