Another good debunking of the efficient market theory, CAPM, and the use of beta to measure risk
From Ned Goodman in the Dundee Corporation 2008 Annual Report (written about a year ago):
Benjamin Graham, the father of modern day security analysis, took time out in his later years to say: “Beta is a more or less useful measure of past price fluctuations of common stocks. What bothers me is that authorities now equate the beta idea with the concepts of risk. Price variability, yes; risk, no. Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earnings power through economic changes or deterioration in management.”
The stock market, like any auction market, is not efficient. Graham used to say, “price is what you pay, value is what you get.” As such, the translation of a bogus model and theory allowing journalists and accountants to easily calculate business valuation because the market knows all means that the market values are likely not to be correct. Markets and auctions have more to do with psychology than the calculation of intrinsic values.
The assumptions behind the CAPM and market efficiency are mostly foolish when studied carefully:
- No transaction costs
- No market movement because of buying or selling
- No taxes
- All investors are risk averse
- All investors share the same time horizon
- Volatility is risk and can be totally controlled by diversification
- All assets can be bought and sold freely
- Investors can all borrow at the best risk free rate
- All investors are aware of and use Markowitz Optimization tool which purports to allow an investor to calculate the required weight to give each stock in order to achieve the greatest return for a given level of risk chosen. Even Harry Markowitz did not totally use his tool for his own portfolio.
To make the whole situation even more ludicrous, Eugene Fama – the original creator of beta – i.e. risk equals volatility, has recently acknowledged its short comings.
So why is it that in spite of the likes of Jeremy Grantham who has recently said in blaming Alan Greenspan for the 2008 financial crisis: “An even bigger villain besides Greenspan was the general concept of rational expectations and the efficient market.” Keynes said “Politicians think they are all independent free thinkers. But it turns out they are invariably slaves to some defunct economic thinkers.” Today, we can add accountants as part of the political slavery to the nonsense of efficient markets.
Grantham went on to rant about Ben Bernanke – “His belief in market efficiency is so profound, that he does not believe that there could be a bubble – and therefore, despite the data before his eyes, he cannot see it. He (Bernanke) went on to say, ‘US house prices have never declined’; that’s why the Fed was so hopelessly wrong.”
So why, you may ask, have the regulators, journalists, and the accounting profession grasped on the efficiency of the markets when they created the Fair Value rule by putting “mark to market” with necessary accounting and regulatory usage.
The standard assumption in economics is that people make such good decisions that our choices are labelled optimal. Conventional investment advice from the Modern Portfolio theory is based on this underlying belief that people and financial markets are rational and sensible. In the real world, however, people are far from rational. We all know that the collective of people produces crazy irrationality.
Investment has not kept up with the cutting edge intellectual developments. While the science of irrational behaviour is quickly growing up, conventional wisdom still provides investment advice based on very outdated, bogus ideas of sensible sane people and rational stock markets. The extremes of human emotion prevent the stock market from spending much time in a rational state of fair valuation. The stock market has multiple personalities: extreme state of happiness to severe depression. The stock market rarely behaves in an average manner.
The creators of the Capital Asset Pricing Model (CAPM), Eugene Fama and Kenneth R. French wrote as recently as 2004 that : “The attraction of CAPM is that it offers powerful and intuitively pleasing predictions about how to measure risk and the relation between expected return and risk. Unfortunately, the empirical record of the model is poor – poor enough to invalidate the way it is used in applications.”
James Montier of Société Général and author of Behavioural Investing perhaps put it best – “that” CAPM is in actual fact Completely Redundant Asset Pricing (CRAP).
Charlie Munger as well said in April 1994, “I have a name for people who went to the extreme efficient market theory, which is “bonkers”. It was an intellectually consistent theory that enabled them to do pretty mathematics. So I understand its seductiveness to people with large mathematical gifts. It just had a difficulty in that the fundamental assumption did not tie properly to reality.”
It was my attitude on this subject that drove me away from the so-called consultants (or drove them away from me) who advise the major pension funds in our society. Consultants who have taken market efficiency to a religion. It is from that religion that we have index benchmarks, risk calculated by volatility (beta), indexing of portfolios. Clearly as the last ten years in the market has ended, the religion of efficient stock markets is more broadly recognized than those of us who agree with the Buffett-Munger agnosticism towards that “bonkers” theory.
Lawrence Summers, President Obama’s special economic advisor, in a prior position was part of the team brought in to unwind and bail out Long Term Capital Management. He stated on several occasions that the Efficient Market Theory is the worst thing that has ever happened to the investment process.
Nonetheless, like all religions, aspects of it take on a life of their own and today we have to live with:
- Regulators who want returns compared to benchmark indices.
- Regulators who want the risk of a mutual fund related to the fund’s beta
- Accountants who want to mark assets to market or if no market exists to a model that would replicate a market. This was the input that nearly took down the entire global banking system.
- Accountants who value option prices using the Black Scholes formula which uses beta as its key ingredient, negatively and unnecessarily reducing corporate earnings with a formula which has been proven incorrect.
With the gradual acceptance of the Efficient Market Theory by the accounting profession it means that as management we have no choice but to sit back and accept the silliness it creates of our financial statements. The bogus Efficient Market Theory has given accountants “negative goodwill”, “mark to market”, ‘impairment”, or “temporary impairment” and earnings and losses impact from equity accounting and share sales by subsidiary companies in excess of book value.
But not only must we accept the usual incomprehensible result, we must then sign a statement that we take full responsibility and agree with the resultant financial statements.
We recognize that accounting disciplines strive to provide information that is both relevant and verifiable. The evolution of accounting to “fair value” rather than “historical cost” means that current market prices have taken on a relevance that is just not acceptable to practiced and knowledgeable investment professionals. Ben Graham, the father of modern security analysis, stated that the stock market is not a “weighing machine”, it is a “voting machine” and the resulting prices that comes from the “voting” process is not likely or necessarily its value.
We have evolved from a system of objectivity and ability to verify to a system in which the market price of an asset is subject to debate between a company and its auditor, particularly during a period, such as recent, of economic stress and panic proportions of market price movements.
As a result, the accounting profession has become overly conservative in order to be prepared for the many instances of criticism that may come from management, shareholders and regulators. To quote Edward Lampert of Sears: “So much time and money ends up spent ensuring that the financial statements are immune from criticism that it can become much more of a distraction than a useful tool for investors and management.”
Link to: Dundee Corporation 2008 Annual Report
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