Student to his Economics Professor: “Look, Sir, there’s a $10 bill on the floor!” Economics Professor: “That’s impossible – if it were really a $10 bill, someone would have picked it up by now.”
“Theory is there to inform our decisions, not to dominate them.”
Academia itself has found plenty of “investment anomalies“ which suggest that markets are not (always) efficient. However, in many disciplines and economic models, the efficient market hypothesis (EMH) still plays a role as a key assumption. The very fact that observations of profitable momentum strategies, the earnings announcements drift or the size effect are called “anomalies“ or “phenomena“ implies that the EMH is believed to be the normal state of a market, and inefficiency thus represents the deviation from normal.
Understanding Market Efficiency
Before looking at Marks’s view on efficient markets, it is important to understand what is actually proposed by the supporters of the EMH. The fact that there are three forms of efficiency (weak, semi-strong, strong), is widely known these days and has been covered previously. One misconception, however, that still seems to be believed by some is that Fama’s famous theory deems long-term positive returns in stock markets impossible. This, however, is not what the EMH is about. Instead, the EMH suggests that:
- It is impossible to consistently beat the market (i.e. achieve “abnormal returns“) because all existing shares (i.e. the market) are always priced to accurately reflect all available information. It is perfectly possible to make positive returns;
- As prices are always precisely reflective of the intrinsic value of a stock, it is not possible to purchase undervalued or sell overvalued stocks;
- Hence, it should be impossible to outperform the overall market through stock selection or market timing skills;
- Therefore, the only way an investor can possibly obtain higher (than normal) returns is by purchasing riskier investments;
- Thus, in efficient markets, fundamental analysis is pointless, and the consistent success of investors like Warren Buffet is due to luck. If just enough people try to beat the market, one in a million will be lucky enough to actually do so consistently, wrongly crediting this success to their investment skill.
Joint Hypothesis Test
Having understood what the EMH actually proposes, one more thing needs to considered; when proponents of the EMH suggest that it is impossible to consistently achieve “abnormal“ returns, what do they define as “normal“ returns in the first place? Normal returns would be calculated by using a pricing model, like the capital asset pricing model (CAPM), which itself has many assumptions that are debatable.
Hence, any test of market efficiency is, as academics call it, a “joint hypothesis test“. This is just a complicated way of saying that any evidence of abnormal returns could also be due to the CAPM (or whichever model is used) being a flawed model to determine “normal“ returns. In other words, any evidence of abnormal market returns could reflect an actual market inefficiency, a flawed pricing model, or both, as it assumes that the used pricing model (for example, the CAPM) is the correct model to measure normal returns.
This leads some people (especially proponents of the EMH) to claim that market efficiency by nature is not testable. In sum, there is plenty of evidence that contradicts the EMH and its own proponents say that it can never be proven. Does that mean the concept of market efficiency is irrelevant in its entirety?
Marks’ Understanding of the EMH – A Matter of Degree
- EMH Proposition I: Shares Are Always Fairly Valued
Howard Marks’ view is that despite its shortcomings, one should not reject the EMH entirely. For him, the EMH can be split into two main propositions, one of which is rather uninteresting to investors, while the other one is of some relevance. The “uninteresting bit“ is the assertion that all prices always reflect a stock’s intrinsic value. If one looks at the market, say, in 2001, when some stocks were worth $240 on one day, and $25 the next day, the market cannot be right(ly priced) both times about the intrinsic value of that stock. Clearly, other factors than the intrinsic value play a role in such extreme scenarios. Bubbles, or on a smaller scale, flash crashes and other phenomena that lead to extreme valuation changes within a short period of time, provide further evidence for why the proposition of ever-accurate pricing is doubtful. They are a clear proof of the fact that prices can strongly deviate from their fair values.
- EMH Proposition II: New Information Is Priced Into the Market Instantly
However, the interesting part in Marks’ view is the claim that new information is priced in immediately by the market. Especially in today’s marketplace, with the huge amount of closely watching participants and algorithms reacting instantly to new information, this assertion is much more defendable than the first proposition. Marks goes on to argue that there are differences across asset classes with regard to the degree of their efficiency. For example, FX markets can be argued to possess a relatively high degree of efficiency due to their drivers being rates, growth and inflation. Who could possibly have an information advantage on those macro drivers? On the other hand, looking at credit markets, which tend to be less liquid and more news driven, one can see how an information advantage on a specific company can allow a trader to benefit from this advantage. Overall, in Marks’s opinion no market is entirely efficient or inefficient, “it is always a matter of degree“. This is an important takeaway when thinking about market efficiency and its implications. Efficiency does not only differ across asset classes but also across time. Markets are sometimes more efficient, and sometimes less efficient, depending on how much they are driven by sentiment rather than fundamentals at the time.
Market Inefficiency and Investment Performance
So what are the implications of the view that market efficiency is a matter of degree, rather than of absolutes? In a later section of his chapter on market efficiency, Marks asserts that “inefficiency is a necessary, but not a satisfying, condition for outperformance“. Trying to outperform an efficient market, obviously, is a waste of time and Marks recalls that this realisation made him focus on rather inefficient markets “where analysis and hard work pay off best“.
This becomes evident when looking at the range of investment strategies his fund, Oaktree Capital, pursues today, among which there are investments in distressed and high yield credit and special situations. Marks shows an important point here, which is that theory is there to inform, not to dominate, decisions. Despite the many flaws one can find within the framework of the EMH, there is still a lot one can take away to make more informed investment decisions, as Marks’s example shows.
EMH does not say one cannot earn positive returns in the market. It only says one cannot make “abnormal“ returns in the long run. Despite many “puzzles“ and the “joint hypothesis problem“ which both seem to disapprove the assertions made by proponents of efficient markets, the theory is still relevant to investors, for example in choosing which markets they should look to invest in.