The Fallacy of the Efficient Market Hypothesis (EMH)

A very famous and reasonably intelligent German marketing guy once made the remark, that blogs are the "loo poetries" of the internet. I think that remark is funny and partially correct. And this blog might or might not be any different (actually its intention is not to come to scientifically based conclusion, but rather to scrutinize things on a common sense basis).

Anyways. I love reading "loo poetries", as every now and then they are touching on common sense and contrasting theoretical assumptions and prevailing views that doesn't make any sense at all. One economic assumption I could never get my head around is the Efficient Market Hypothesis (EMH) and its practical implications, which any independently thinking market participant has to seriously quarrel over.

I had my first encounter with the EMH during my degree program at the university in 2001-2002. I had been investing in the markets already for roughly six years and in this short period of time had already encountered several full-fledged financial crises. And here I was, at my first lecture in the corporate finance course of Prof. Lutz Kruschwitz (one of the luminaries in Germany when it comes to classic theory of corporate finance).

What I was being told by my Prof. was really mind-blowing to me, as it stood diametrically to my personal experience in the market. Basically, he told us that we should not even try to analyze and invest in individual companies.  In the 1970's his guru Eugene Fama found out, that the market and its participants not only are highly efficient in gathering all relevant information concerning all individual stocks (and thus the stock market in aggregate) but also incorporate (discount) those information rationally and immediately. Thus, individual stock prices (and the market in aggregate) are always in equilibrium to their intrinsic value. The best advice he could give to us, when it comes to stock market investments, was to buy an ETF on the world stock market, as it was illusionary to expect to do any better (to outperform) by stock picking individual companies.

I was flabbergasted, as my Bayer stock just crashed from 50 Euros last year to 10 Euros in the short period of one year. Was the market for Bayer really "efficient" on both these dates, in the sense that those prices reflected "fully and properly" the knowable facts. Where the changes in the microenvironment and/ or the company's prospects sufficient to slash 80% of a company that was highly profitable, well-managed and strongly financed?

If I had had the knowledge of today, I would have made a run out of the course immediately. Unfortunately I was a greenhorn and didn't have the slightest idea who Benjamin Graham and David L. Dodd was. If I had known, it would have been better to my wealth as well as my health (I did my degree in that course, but it was just like being water boarded for one and a half years with alimentary diarrhea).

So as my gurus are not the French's Fama's, Markovitz's and the rest of this voodoo economists, I was very interested (unfortunately late, but not too late) what my Guru Benjamin Graham had to say about the EMH.

I discovered it in Benjamin Graham's papers with the great title:

Common Sense Investing: The Papers of Benjamin Graham

"(...) market is efficient in the sense that there is no particular point in getting more information than people already have.(...) the idea of saying (...) information is so widely spread that the resulting prices are logical prices-that is all wrong (...) (Proponents) would claim that if they are correct in their basic contentions about the "efficient market", the thing for people to do is to try to study the behavior of stock prices and try to profit from the interpretations. To me, that is not a very encouraging conclusion because if I have noticed anything over 60 years on Wall Street, it is that people do not succeed in forecasting what's going to happen to the stock market."
"(...) "efficient  markets", in its extreme form, makes two declarations:

1) The price of nearly every stock at nearly all times reflects whatever is knowable about the company's affairs; hence no consistent profits can be made by seeking out and using additional information, including that held by "insiders".

2.) Because the market has complete or at least adequate information about each issue, the prices it registers are therefore "correct", "reasonable" or "appropriate". This would imply that it is fruitless, or at least insufficiently rewarding, for security analysts to look for discrepancies between price and value."

"I have no particular quarrel with declaration one, though assuredly there are times when a researcher may unearth significant information about a stock, not generally known and reflected in the price. But I deny emphatically that because the market has all the information it needs to establish a correct price (...)"
"The market may have had all the information it needed...what it has lacked is the right kind of judgment in evaluating its knowledge."

"Descartes summed up the matter more than three centuries ago, when he wrote in his "Discours de la Methode": (...) "It is not enough to have a good intelligence" - and I add, "enough information" - "the principle thing is to apply it well." I can assure the reader that among the 500-odd NYSE issues selling below seven  times earning today, there are plenty to be found for which the prices are not the "correct" ones (...) They are clearly worth more than their current selling prices, and any security analyst worth his salt should be able to make up an attractive portfolio out of this "universe"."

"Let me pass now to the doctrine of the efficient market. I am particularly interested in this because of its negative implications for the work of security analysts generally (...)"

"(...) definition of an "efficient market" (...) an "efficient market" is one in which a large number of buyers and sellers cause the prices to reflect fully what is knowable about the prospects for the companies dealt in." The key phrase for me is "reflect fully". Let us assume first (...) the market has and uses all knowable information about every company's prospects, and hence there is no point for analysts to spend their time to obtain additional information. I dissent from that statement to the extent that it would render meaningless the current controversy and concern on the use of "material information", (...) If in all cases the market already knows and reflects all that is knowable about each enterprise than there should be no such things as "material inside information" (...)".

"But that is not my chief quarrel with the concept of "efficient market". There is a strong implication (...) because the market reflects fully all the knowable facts it thereby establishes correct or reasonably correct prices for common stocks. hence, only the superior security analyst can successfully select the stocks that should be bought or sold. These exceptional people (...) have a quicker and more profound understanding of the economic consequences to individual firms of changes in the economic environment or changes within the firm itself." They have a "rare and valuable talent." I disagree completely with the viewpoint. To establish the right price for a stock the market must have adequate information, but it by no means follow, that if the market has this information it will thereupon establish the right price. The market's evaluation of the same data can vary over a wide range, dependent on bullish enthusiasm, concentrated speculative interest and similar influences, or bearish disillusionment. Knowledge is only one ingredient on arriving at a stock's proper price. The other ingredient, fully as important as information, is sound judgment."

"Take (...) larger group of stocks selling for less than their working capital. Is the market "efficient" in maintaining these fire-sale price levels? Surely it does not lack the essential information about companies. What it does lack is judgment, courage and patience In situation of this kind lie the best opportunities for financial analysts to prove their mettle."

Conclusion

I do recommend japan ETF's to the average investor, as I regard the Japanese stock market in aggregate being significantly undervalued. Furthermore, I think the bulk of investors who have the means to invest in individual Japanese stocks or in capable Japanese portfolio management teams do not have the enterprise in doing so or finding them (as this is hard work too to find capable asset managers) and people who have the enterprise to do so might have not the means.

Having said that, I have to sound a note of caution.

Instead of buying into big indices (Topix and Nikkei), although undervalued as well, concentrate on Mid-/ Small cap ETF's, as the deviation of stock prices to intrinsic value is greater in this market sphere.

More importantly, do you not dare to buy any swap based ETF's, which are so vigorously marketed, especially in Europe. Those products are like a box of candy, e.g. you'll never know what you going to get (definitely no Japanese stocks!!!). If you want to buy an ETF (independently of the underlying country) do always buy "fully replicated" ones. And be aware that even those ETF's have got serious flaws.

And the moral of the story is, that the majority of those well respected economists (many of them noble price winners) are actually a bunch of voodoo economists, that haven't got a clue what is really going on in the world of finance. And the same holds true for the majority of the so called "financial market experts" and "financial analysts", that actually haven't got any passion and intellectual capability for this job, but only are in that business for the fast buck. Those people should come with a warning sign: "Beware; listening to me is detrimental to the wealth of a nation."