Source: Wikipedia.
Dear Diary,
Still nothing much to write home about on Wall Street. No big selloff. No big boom. It’s late summer. US stocks are high and mama’s good lookin’…
When we left off our series yesterday, we had run through the basics of the Efficient Market Hypothesis (EMH)… the reasons it is flawed… and how you can benefit from other investors’ mistakes.
Just do the math. When a stock is worth more than the market price, sell. When it is worth less, buy. When it is in between, just sit tight. There, what could be simpler?
How do you figure out how much a stock is really worth? Read Ben Graham and David Dodd’s 1934 classic, Security Analysis. Everything you need to know is there.
No time for Graham and Dodd’s tome?
Well, our STS (Simplified Trading System) is about as simple as it gets. Buy when the Dow is selling for under 10 times reported earnings. Sell when it trades at over 20 times reported earnings. Otherwise, do nothing. (That’s the hard part.)
Your editor likes STS because he doesn’t have the temperament for detailed stock analysis.
Will it work for you?
No one knows. All we know is that it worked in the past.
Could This Time Be Different?
Following the STS over the last 114 years would have allowed you to participate in the big run-ups in the 1920s… the 1960s… and the 1980s and early 1990s.
Each time, your friends would have told you that you “sold out too soon.” But you would have missed the big drawdowns of the 1930s… the 1970s… and the early- and mid-2000s.
Of course, this time could be different!
Maybe the STS won’t work anymore. Remember, you can never prove a hypothesis; you can only disprove it. And maybe you don’t want to wait 5… 10… or 20 years for the P/E ratio to fall under 10 so you can get into the stock market, anyway.
Everything has a price. And the price you pay for the safety and performance of STS is time.
But today, we want to take up the subject from a slightly different direction. We want to explain a hypothesis of our own…
Is the “Smart Money” Really Smart?
First, as you can see from our discussion of EMH and its critics, the matter was far from decided.
On the one hand, EMH says investors are essentially (but not exclusively) rational, profit-seeking individuals who use publicly available information to determine market prices. And that there’s no use trying to second-guess these prices for profit.
EMH critics – mainly in the behavioral finance camp – say investors are incapable of purely rational calculations and often err in setting prices as a result.
The corollary is that, although some investors are smart enough to take advantage of other investors’ errors, they are not smart enough to eliminate these errors altogether.
There’s the rub: Why not?
Both sides believe stocks have some sort of inherent value. EMH advocates believe the market determines the best price based on what is known about value at the time. EMH critics believe this price is often wildly wrong due to the irrational nature of investors… and that these investors’ mistakes are observable, calculable and correctable (by way of arbitrage).
The critics do not explain how come – assuming you can see these mistakes and bet against them – the “innovations” persist.
Seeing a stock underpriced by the mob should bring forth buying on the part of the “smart money,” thus bringing the price immediately back into line with expected earnings.
Colleague Porter Stansberry attempted to explain this inconsistency by saying errors persisted only in “inefficient” markets and so forth.
But if there were money to be made, you’d think an ignored market would attract interest and become more efficient – fast.
Porter also said that “conflicts of interest” prevented the big players from betting against certain anomalies. But that assumes all the big players are on the same team. They are not.
Our experience of Wall Street tells us that its players are cannibalistic. Given a choice, they would prefer to feast on the carcass of one of their own species than on the flesh of small investors.
Errors of Judgment
It is more likely that the “errors” persist because they are not as visible and redressable as the critics maintain. They are errors of judgment – and thus subject to a substantial amount of error themselves – not errors of calculation.
In short, our hypothesis is this:
The EMH and its critics are wrong. Markets are not truly efficient. But neither are its errors obvious and calculable. The “smart money” is not just observing and correcting mistakes; it is also making its own guesses… and, often, its own mistakes. Often, the smart money succeeds. Sometimes it does not.
This comes from the recognition of the asymmetry of knowledge. We can never know what a stock is worth. All we can do is guess. It stands to reason that people who do their homework take better guesses.
But there are no “correct” answers. The market discovers new prices every second… based on all the inputs to which humankind is receptive. Those include a rational calculation of the present value of a stock’s expected future earnings, discounted according to the perceived risk of holding equity and the available “risk free” rate of return.
Also included are opinions, guesses, rumors, myths and all manner of prejudicial half-truths – some firmly founded on logical thought and observation, others more delusional and whimsical.
There are no “innovations.” Because there is no correct answer to innovate against.
The market merely aggregates opinions – right, wrong, stupid, baffling – and discovers a consensus. Usually, those who do the hard work of valuing an income stream make better predictions about tomorrow’s consensus prices. But not always.
In our view, a market – and life itself – is only somewhat subject to rational calculation. Sometimes, doing the numbers works. Sometimes, yesterday’s numbers give no hint of things that will happen tomorrow.
There’s more to the story… something else going on. Something that often defies your logic… and throws your hard work in your face.
Just what kind of thing are we dealing with?
You’ll find out tomorrow, when this series concludes…
Your very ignorant correspondent,
Bill
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