How Real is Market Efficiency?

Fama, Shiller and Hansen

The 2013 Nobel Prize in economics was awarded to three US economists who have made great contributions to the asset price theory and mechanism, namely in understanding what lies behind price movements. The three Nobel Prize laureates were: Robert Shiller from Yale, and Eugene Fama and Hans Peter Larsen from the University of Chicago.

There is no question about the crucial importance of gaining valuable insights on this topic. Interestingly enough, the points of view and major conclusions from the work of these distinguished scholars are not only different; from certain angles their findings can even seem contradictory.

Dr. Fama’s major work has been about the market efficiency. In general terms, Eugene Fama’s fundamental conclusion is that, on the average, markets tend to behave rationally, since all participants essentially have the same access to the same information in real time; as a result, the rationale goes, it is impossible to outperform the market, on a consistent basis in the long run.

From a different angle, Robert Shiller has concluded that, quite to the contrary, markets are prone to form price bubbles and behave with irrational exuberance, like the in the US subprime bubble. Moreover, Dr. Shiller had been warning since 2005 about the evident house prices bubble, and about its potential to drag prices down by 40%, which not long after proved to be the case. Likewise, Robert Shiller had earlier also timely warned about the internet bubble that culminated in the first quarter of 2000.

“There were a couple of guys in that exchange who couldn’t tell a hide from copper sheeting but they made a lot of money. Why? They weren’t trading a commodity but human nature … and there is something about human nature which is not rational.”

——Alan Greenspan

Lars Peter Hansen developed a method of statistical analysis to evaluate theories about price movements that is now widely used by other social scientists.

The apparent contradictions of Dr. Fama and Dr. Shiller easily fades away when the proper perspective is utilized. The way I see it, being a global investment manager myself with over 30 years of experience, Dr. Fama’s findings are correct most of the time. In fact, it does not even require sophisticated mathematical techniques to prove it; Dr. Fama’s major conclusion is axiomatic, a truism: the market (most market participants) cannot beat itself; that is a practical impossibility —otherwise, there would be no market. From that standpoint, Dr. Fama’s major conclusions are right on target.

Economic theory

The inevitable formations of price market bubbles in a recurrent way, however irregular, is and has been a fact of life throughout mankind’s existence, with no exceptions. Dr. Shiller’s work provides the uncontroversial statistical and mathematical proof thereof. More on this subject in our article Are Bubbles A Product of Economic Cycles?.

By combining both approaches more comprehensive responses can be accomplished. Yes, there is a small perentage of investment strategists that have been able to consistently outperform the major indices throughout time by finding market inefficiencies —in other words market outliers that outperform the market during several years. In fact, market bubbles happen all the time, particularly at the micro level of specific investments, more often than in asset classes. There are literally thousands of unmistakable examples. Let’s elaborate on one of them.

The stock price of Priceline.com [PCLN], now the largest digital travel agency on Earth, once its business model was solidly proven by around 2006, it began to experience an exponential price appreciation that took it from $25 in the summer of 2006 to $144 in May 2008. Once the subprime crisis was manifest, Priceline.com’s stock took a beating along with the market itself, going all the way down to $45.10, in October of the same year. PCLN had experienced an almost sixfold price increase in slightly less than two years, from 2006 to 2008, before going through a temporary price collapse of almost 70% during only five months. Yes, that was in the midst of the subprime parafernalia; and yes, I meant temporary price collapse, because that is what it was. From then on, PCLN’s stock went all the way up to $273.90 in April 2010, an over a sixfold price increase in only 18 months! Only to experience another temporary setback of around 15% during a few weeks –less than 13– before climbing back up to $556.20 in April 2011, an over threefold additional price increase in only 10 months! The current market price is in the neighborhood of $1,074, for a 57% average annual rate of price growth from the summer of 2006 to october 2013.

Was PCLN’s 17 fold price expansion from $45.10 (market low) in October 2008  to $774.90 (market high) in April 2012 a bubble like phenomena? Let’s not get lost in semantics. The truth is that PCLN has developed an ultra reliable business model that virtually exploded during the time frame analyzed. In addition, an appreciation of the multiples at which the stock now trades versus that which was initially commanded has also helped. The major driver behind such a spectacular price rise was an explosive rate of growth in sales and particularly in earnings. There isn’t then that much mystery behind such exponential price appreciations —or market outliers. There are hundreds of examples every year, most of them related to startup companies, and/or new disruptive business models.

Like in most human professional endeavors, there is a lot of hype in the investment world, indeed plenty of it. That seems to be a major reason, a logical one, behind so much reticence to acknowledge that there is a very talented minority of investment managers that is able to consistently outperform the major market indices in the long run. The most conspicuous of those ultra-talented investment strategists is Warren Buffett, the legendary investor. The most remarkable aspect of Buffett’s success is that he has been able to essentially maintain extraordinary average long-term annual growth rates —above 15%, depending on the time frame selected— despite the colossal current size of his holdings —US $458 billion.

Thus, outstanding investment strategists like Warren Buffett have truly been able to consistently outperform the major market indices in the long-run by smartly exploiting market inefficiencies. They are a true minority. They are real, they do exist, and always will.

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About Martin Marmolejo

Global Investment Manager | Founder & Managing Director at MMA Global Investment Management | Proud husband and father | Follow me @globalmarmolejo.

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