Throwing Out the Efficient Markets Theory

Over the last few months, I've not been surprised to read that recent events have thrown a bit of doubt on the Efficient Markets [EM] theory. As defined in an article this weekend in the Financial Times, EM is "the theory ... that market participants are governed by rational expectations and markets are self-correcting."

If I understand this theory correctly, the correlation in practicality is that the most prudent long-term investment portfolio for the modest, ordinary investor, i.e. the one with the best risk-security ratio, would be something with a lot of Dow-type common stocks, because the collective markets take all factors into account quicker than any individual can do it.

The evidence behind this theory was provided, in part, by Jeremy Siegel of the Wharton School at the University of Pennsylvania in 1994, in a book entitled Stocks for the Long Run. Siegel analyzed data going back to 1802. According to another article this weekend in the Wall Street Journal, he based his statistics on data provided by two other economists, Walter Buckingham Smith and Arthur Harrison Cole.

However, the WSJ article points out two problems with Siegel's argument: (1) the stock samples chosen were "cherry-picked" and not "comprehensive," and (2) as of June of this year "U.S. stocks have underperformed long-term Treasury bonds for the past five, 10, 15, 20 and 25 years."

Oops.

Ever heard Benjamin Disraeli's phrase, "There are three kinds of lies: lies, damned lies, and statistics"?

I've always had a suspicion about the EM theory. It just seems too pat, too profitable to the Wall Street types, and not really adapted to the little guy: the forgotten men and women who just want to hold onto their hard-earned savings and gain a little real income from them.

I observe that Wall Street market players are not long-term thinkers who spend even a nanosecond worrying about the future of Western Civilization. They're the ultimate Instant-Gratification Kids, worried only about their next buck. "To hell with tomorrow," or such esoteric concepts as the "Forgotten Man."

Even more so today, as we slide into this second phase of our current recession, we realize that the Efficient Markets Theory--and even its supposed alternate, the "Treasury Bond Theory" (I'm inventing the name)--may both have failed us. This will be especially true if inflation hits us, as some predict (and I believe it will, when it comes time to put the Federal Reserve and Treasury credit genies back into the bottle).

The truth of the matter is that there is no stasis. No theory works all the time. As we slide up, over, and down the recessional curve, the corresponding statistical charts will prove first one theory and then the other, depending on where you start and where you stop the x axis.

So where does that leave us?

I would be very interested in some research comparing three model portfolios since approximately 1900 (more precisely, a year in which the market can be considered to have been healthy and balanced): an Efficient Markets portfolio, a Treasury bonds portfolio, and a Gold portfolio (one invested primarily in good gold stocks). To be fair, we would allow modification of common stock, bond, or gold stock picks, but only over the longer range to insure diversification, company soundness, and regular dividend issuance, and only according to some strict rule.

But such research is not easy to come by. Current advisers are not thinking in terms of the erosion of the dollar. Most of them take the dollar as the only game in town.

There was a fellow who tried his best to give us good information: Economist Edward C. Harwood. Up until his death in 1980, he took the position that inflation was the most pernicious waster of wealth we had to face, and that any safe investment must insure against excessive business cycle fluctuations and loss of purchasing power through manipulation of the currency by inflationary monetary policy. For the latter part of his life (1950s to 1980), his investment research pointed to recommendations based on a high percentage of gold holdings. (Of course, we have to keep in mind that the world was on a gold standard until 1971, and he was not alone in seeing the then-coming collapse of the dollar.)

Today, the current strength in the "price" of gold (in fact, it's really not the price of gold, but rather the weakened gold-exchange rate of the dollar) demonstrates once more that the world has not forgotten the role of gold as a monetary metal and does not have blind faith in the dollar, in spite of what the central bankers would like us to believe; and that inflation and possible dollar weakness is still very much on our minds.

You've probably noted over the last few months that China and Russia have made quite a show of recommending the return to gold as a store of value in place of the U.S. dollar. (See this Financial Times article, and my previous post about the Russian fellow Sterligov.)

These outbreaks, although embarrassing to the U.S., don't seem to worry anyone just yet. However, it would be a mistake to write off the sentiment behind them, which is probably shared by more Westerners than our politicians would like to believe. Note also that even our central bankers have slowed their gold sales in recent months. (Do you suppose they themselves are aware of its present and future potential "price"?)

There is a risk in holding gold. Roosevelt gave us the precedent: in the 1930s, he simply made it illegal for American citizens to hold any gold and forced them to accept the dollar. Nothing excludes that from happening again, especially with popular sentiment against "the rich" and "the speculators."

The dollar may have a few more years in it; but in the longer run, it may be just such market sentiments that will force our politicians and academic theoreticians to recognize the simplicity and efficacy of gold as a monetary metal, in some future international role.

I would love to believe that this must happen in my lifetime; and if it does, gold will find its true "price," well above what it is today, Efficient Market theory be damned (and along with it Modern portfolio theory).

I could be pipe dreaming. Meantime, my mantra still holds:

You can take gold out of the standard, but you can't take the standard out of gold.

Comments

[conceptwizard:]

I agree with the Gold thesis, in order for the fiat system to function the debt has to have some plausible way to be paid in something that has value, in order to eliminate the potential runs on bonds and other secured investments. Gold is the obvious stable world recongnised equilibrium.

While we are reversing all bubbles that have happened over the last 30 years it makes sense to relook at the Gold Standard. Of course with all the limitless fiat currency out there and the limit of Gold the Gold price would have to be elevated to 10,000 an ounce. Everyone would melt their jewellery pretty quick.

As far as the markets go....I have lost all faith in the way the markets operate, they are being manipulated by giant servers located in the NYSE building owned by those companies that can afford them. Trades are done in milliseconds, billions at a time and have the ability to control the markets. More confirmation on this as Goldmans Sachs this week admitted that an employee had stolen software that has "The ability to manipulate the markets" in their own words, and that is was out there loose presumably to the highest bidder.
Now as a private investor I do NOT find this information consoling. When someone is rolling my marble around the wheel and setting the brake when they want me to lose is just not right.

Back in the old west we used to shoot or hang people committing such atrocities, or at the very least tar and feather on the rail solution. Now the SEC calls it HIGH SPEED SPECULATIVE TRADING, and it is legal. Thats how Goldman can still make money from pension funds and mutual funds companies when everyone else is losing. The game is rigged, so the heck with charts and PE (which dont make any sense anymore) and everything else. I'm just going to pick up my toys and go home until they play fair.

Jul 13 02:19 PM

[Living4Divi...:]

Katy - I like agree with many of your points, I am having a hard time deciding if your post is about a) bashing MPT b) bashing EMH or c) advocating a gold standard.

You do raise an important point: nearly all the big writers in modern finance publish their figures in dollars. Using this logic, in the Zimbabwe stock market, we would all be gazillionaires, because everyone is thinking in terms Zimbabwean currency. I could be a gazillionaire in Zimbabwe, but that may only buy me a cup of coffee.

To get around the "thinking inside the box" mentality, some of the more clever financial thinkers publish their studies in REAL dollars (Siegel, Marsh, Staunton). They are inflation-adjusted dollars, but, then again, they are dollars.

Jul 13 02:31 PM

[Living4Divi...:]

ConceptWizard - I always like the common sense and fact-based insight you put into your posts.

While I agree with you and the OP that a Gold Standard is commendable, as I have written in an earlier article, seekingalpha.com/artic... I firmly believe it is one of those "nice to have, not going to happen" things.


On Jul 13 02:19 PM conceptwizard wrote:

> I agree with the Gold thesis, in order for the fiat system to function
> the debt has to have some plausible way to be paid in something that
> has value, in order to eliminate the potential runs on bonds and
> other secured investments. Gold is the obvious stable world recongnised
> equilibrium.
>
> While we are reversing all bubbles that have happened over the last
> 30 years it makes sense to relook at the Gold Standard. Of course
> with all the limitless fiat currency out there and the limit of Gold
> the Gold price would have to be elevated to 10,000 an ounce. Everyone
> would melt their jewellery pretty quick.
>
> As far as the markets go....I have lost all faith in the way the
> markets operate, they are being manipulated by giant servers located
> in the NYSE building owned by those companies that can afford them.
> Trades are done in milliseconds, billions at a time and have the
> ability to control the markets. More confirmation on this as Goldmans
> Sachs this week admitted that an employee had stolen software that
> has "The ability to manipulate the markets" in their own words, and
> that is was out there loose presumably to the highest bidder. <br/>Now
> as a private investor I do NOT find this information consoling. When
> someone is rolling my marble around the wheel and setting the brake
> when they want me to lose is just not right.
>
> Back in the old west we used to shoot or hang people committing such
> atrocities, or at the very least tar and feather on the rail solution.
> Now the SEC calls it HIGH SPEED SPECULATIVE TRADING, and it is legal.
> Thats how Goldman can still make money from pension funds and mutual
> funds companies when everyone else is losing. The game is rigged,
> so the heck with charts and PE (which dont make any sense anymore)
> and everything else. I'm just going to pick up my toys and go home
> until they play fair.

Jul 13 02:35 PM

[DWStein:]

Very intersting and well written.

I'm concerned, given the sheer size of the markets involved, if there is enought gold to sustain such a system.

I've been begining to wonder if the US currency should be backed by a basket of US residential mortgage debt. The treasury is already long $3ish trillion of the bonds. And the positions are already funded by de facto US treasury bonds. Why not make what is sort of de jure into a defacto policy.

What would be the implications of such a policy?

Just wondering....

Jul 13 03:29 PM