A paper published this week entitled The Death of Common Sense: How elegant theories contributed to the 2008 market collapse has garnered a fair bit of coverage in the financial media, resulting in headlines such as “Modern portfolio theory failing institutional investors” in Investment & Pensions Europe. But is it really true that theory led practitioners up the proverbial garden path?
The efficient market hypothesis states simply that an efficient market prices in the available information and, therefore, is hard to beat. Hard, but not impossible; obviously, there is a process involved. As investors uncover information, they will find that some securities are too cheap and will buy them, bidding up the prices to fair value in the process. They will also find that some securities too expensive, and by selling them, push their prices to fair value.
Therefore, there is a first-mover advantage with regard to new information. The harder and more expensive it is to uncover new information, the greater the rewards for doing so. This, of course, is a key premise behind active management and underlies the considerable R&D investment behind quantitative black boxes and/or teams of fundamental industry and company research analysts.
This week’s paper from the 300 Club is just one of many articles written in the aftermath of the global financial crisis that assert the failure of the efficient market hypothesis. The typical line of argument is that in an efficient market, total market capitalization cannot fall 50% in just a few months—as the markets did in 2008/2009.
This is misguided, in my view. The hypothesis doesn’t claim that markets are correctly valued; it says prices encapsulate the available information. It’s important to understand that information here should be interpreted in its broadest sense to incorporate not just facts, but people’s understanding and perception of the facts, as well as their hunches, biases, fears and aspirations. The market is the clearing mechanism for all this “information.” It is a consensual aggregation of facts and current understanding of and feeling about the facts.
Obviously, the facts can change, as can people’s understanding of those facts. Anyone who can correctly forecast how the facts will change and/or how people’s understanding of those facts might change can make a profit. This isn’t easy. And someone who made one successful forecast won’t necessarily make others. But because the efficient market is a process, there will always be some investors who make correct forecasts and profit from them.
If your research can uncover new information, you can outperform. One example relates to risk. Here again, the capital asset pricing model (CAPM) has come in for a bit of a beating in the aftermath of the global financial crisis—but again, much of the criticism is wide of the mark. CAPM says, sensibly enough, that rational investors demand higher returns for holding riskier investments. As a hypothesis, it’s hard to fault. In practice, of course, it’s notoriously problematic, for the simple reason that we don’t necessarily know what’s going to be riskier until after the event. With the benefit of hindsight, stocks were very volatile during the last decade, with its two recessions and bear markets. Clearly, investors should have demanded a much higher return (i.e., much lower valuations) twelve years ago. Unfortunately, hindsight asset management remains impossible, absent the invention of a time-travel machine.
The good news is that our research demonstrates that investors can make decent forecasts about risk, based on available information. For example, trailing volatility is a good indicator of whether equity risk is likely to be elevated or subdued in the period ahead: generally, high trailing volatility indicates high volatility ahead, and low trailing volatility indicates low volatility ahead—although very low trailing volatility, when coupled with high valuations as in early 2000, suggests very high volatility ahead. To the degree volatility is forecast to be high, investors should, as the theory dictates, demand higher returns for bearing that risk (see Smoothing the Ride, January 2010).
Market movements over the last few years have been traumatic. As psychologists have shown, we react to trauma in predictable ways: first with shock, then denial, then anger. When we’re angry we are quite likely to want to blame someone. In this context, it is understandable that traumatized investors are blaming “ivory-tower” academics for the crash. Nonetheless, the charge is unjustified, in my opinion.
A version of this article was previously published in Investment & Pensions Europe.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Patrick Rudden is Head of Blend Strategies at AllianceBernstein.