By Elliot Turner
Last week I interviewed Justin Fox, editorial director of the Harvard Business Review Group and author of The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street.We discussed topics ranging from the efficient market theory to the dynamic nature of financial journalism.
In part one of this intriguing interview, Justin tackles the present state of economic theory, what went wrong during the Flash Crash, and the importance of Benjamin Graham’s value approach in today’s stock market…
Elliot: I want to talk to you about your book, The Myth of the Rational Market. So in December of this year, you did an interview with Damien and one of the questions he asked you was what you thought about the economic paradigm of the time. At the time, you said that when you ended the book, you were in a little bit of a muddle because you were not really clear as to what the new economic paradigm will be. Since that time, have you gained any new insight? Do you have a better idea of what is or what should be the prevailing economic theory?
Justin: One thing that I’ve seen lately that has kind of clarified my thoughts somewhat was a chapter in a book coming out next month by Amar Bhidé called A Call for Judgment: Sensible Finance for a Dynamic Economy a title which doesn’t give you any sense of how much fun parts of the books are. He has this one chapter where he basically takes my book, Peter Bernstein’s Capital Ideas and this book by a Scottish sociologist, Donald MacKenzie (An Engine, Not a Camera), that covers sort of similar ground, and then just takes apart so much of modern finance. I mean, I don’t know if he’s right about all of it, but it’s just so well done and he is so much more comfortable with a lot of the theoretical arguments than I am.
His argument is that the idea that it’s hard to outsmart the market — the idea of the efficient market, or more the random walk — is fine. It has its limits but, it’s really a useful thing. The idea that the market gets prices right is sort of less meaningful, and it’s obviously wrong sometimes. But what really gets him are any financial models based on past data, be it portfolio allocation models or Black-Scholes option pricing. He just feels that all of that stuff is intellectually bankrupt.
And I think he’s right. Some of it is still useful just because a lot of the times the future is a bit like the past. But as something to build a great theoretical edifice on, it’s kind of ridiculous, because as soon as everybody comes around to believing in your view of how the financial world is going to work, that changes how the financial world is going to work. And it has definitely happened, I think, with a lot of these supposedly risk-spreading mechanisms in the derivatives world that were involved in the most recent financial crises.
Elliot: When you set out to write The Myth of the Rational Market, was your goal to debunk the efficient market theory or were you more just trying to put together the intellectual history of both its supporters and detractors?
Justin: I wasn’t trying to disprove the theory, but it was much more than just running through its history. As somebody who’d been a financial journalist, I sort of thought that this was a useful framework, although it clearly exaggerated and missed things. During the financial crisis, I was just surprised to learn that there had gotten to be a pretty big critical mass of finance scholars, some of them at perfectly respectable business schools, who didn’t buy the whole efficient market worldview. And so, as reporter – I thought, “Oh, that’s a story I didn’t know about and maybe I ought to tell.” That led to an article in Fortune. It was really not out of any sort of ideological thing. It was that there’s much to learn, that it’s an interesting story.
And I think that’s a part of why some people are understandably frustrated with me not telling them what to think at the end of the book. I felt like on the whole, what made the book useful in a way that all the other writings by finance scholars aren’t, is that I just came into it as a reporter — an opinionated one, but not somebody with a huge axe to grind.
Elliot: Let’s talk about the "Flash Crash" for a minute. In the The Myth of the Rational Market you spent some time exploring the idea that “a small ripple can lead to big waves.” Do you have any thoughts or observations about the "Flash Crash" and what may have caused it and how it relates to the changing structure of the market itself?
Justin: Well, yeah. I have a couple of thoughts. It does seem to have had something to do — and this was similar to the ’87 crash — with this one really high-speed part of the market interacting with a slower, different kind of market. Having both the traditional NYSE floor market and the high-frequency trading market brings friction and misunderstandings. That was definitely true in ’87, where it was between NYSE and the futures markets, where they just operated at totally different speeds where something going on in the futures market ended up freaking out everybody in the equity markets. People saw all this activity and they didn’t know what to make of it, so they just freaked out.
The other thing with the "Flash Crash" — I don’t know this has ever been articulated completely — but in general, standard finance theory holds that cheaper transactions would lead to a more efficient market. I think we’re reaching this point where that’s not entirely true. Yeah, high frequency trading is helping to enable increasingly lower commissions in terms of trading stocks. But at the same time, it might be that it brings with it the potential for weird, chaotic fluctuations now and then.
It may be that it was just a case of poor structure and poor interaction between the electronic markets and the NYSE. But I just wonder … and this is something I do talk about in the book. This really interesting simulation experiment that was done at Santa Fe Institute that I think started in late ’80s, where they created these artificial traders and had them trade with each other in order to see what ended up. What they found was that if traders sort of didn’t change — took a while to process new information and waited a reasonable period before changing their opinions about the markets, you ended up with markets that were relatively calm and move towards equilibrium. But the more you sped up that decision-making process and information and everything else, you actually got a market that was more prone to bubbles and crashes.
I think we’re seeing a market that, by the finance academics’ standards of efficiency, is more efficient than it ever has been before. But by the standard of getting prices right in a calm and reasonable way, and doing a good job of allocating capital at all times, it might have actually gotten worse over the past 25 years.
Elliot: Now, do you think that relates back to what you had said about the tendency and the nature of finance as a backwards-looking institution with regard to price history?
Justin: That’s probably part of it, but it’s also that there’s some level at which you increase the frequency and you increase trading. And obviously, a market where commissions are $30 and people are able to trade pretty much whenever they want is going to be better than a market where commissions are $5,000 and you are only allowed to trade once a year. But I think there’s this point of diminishing returns.
And one of the interesting things – I just was out at the new Techonomy conference and I did a panel on financial markets with Doyne Farmer from the Santa Fe Institute, Duncan Niederauer from the NYSE and Barry Silbert who started this new market called SecondMarket—a market that serves as a middle ground between private companies and public markets. SecondMarket on the whole is less efficient and less transparent than our public stock exchanges, but precisely because of that, there are companies willing to have their shares traded on it who don’t feel like they want to be public companies. So, it’s not just this idea that in some ways it’s better for lots of people in terms of raising capital to have this market that people don’t trade all the time. In some cases, you can only trade once every two months or whatever. And that’s actually more useful for certain kinds of assets.
Elliot: So with the recent emergence of ETFs as one of the most popular investment vehicles, do you think that’s given more ammo to the random walkers who assert that it’s hard to generate any sort of alpha over the market’s performance at large?
Justin: Well, it provides lots of new ways to just “buy the market.” I mean my thinking is that – and I think even the random walkers agree with this – if you ever reached a point where most investment is done through passive investment vehicles, then the market will be less efficient because you have fewer people out there trying to figure out whether Coke’s worth more than Pepsi or whatever else.
What’s interesting with ETFs – and I’ve had these conversations with Jack Bogle about it, since he pioneered the index fund – we both don’t really love ETFs even though they’re just cheaper index funds in a lot of ways, because they encourage rapid fire trading that I’m sure for some people in some situations makes a lot of sense, but for most small investors, is just something that sucks up lots of costs.
I don’t have a very clear answer to your question. Obviously, it’s a further triumph of the whole idea that passive investing is a good idea. I don’t believe that lots of people realize passive investing is a good idea, even for those who don’t think the market is efficient, because unless you are really convinced that you have this ticket for beating the market, at least passive investing is cheaper than whatever else you’re going to do. With passive investing, you come out on average better off than you would have if you were just trading around not really having an idea what you’re doing.
Elliot: So let me state an observation and give me your thoughts in response. One of my thoughts is that with ETFs, they force program trading for rebalancing programs that automatically recalibrate fund holdings based on fluctuations in markets. For example, we’ve ended up at a point where a small ripple in the Japanese yen results in an ETF buying or selling a basket of consumer discretionary stocks. And you get what can be considered really remote connections that lead to rapid fire transactions which ripple into other areas very quickly. These forced recalibrations ultimately lead to a higher level of correlation both within sectors and between asset classes. So my observation is that correlation in our economy is on the rise between the combination of the proliferation of ETFs and program trading. Does that make sense?
Justin: Yeah, it does. And it’s funny because at some level the self-rebalancing set up of ETFs is total genius. That’s what makes them so cheap, as you create this situation where other people — you don’t have to have some manager sitting there — constantly rebalance the ETF portfolio. It’s done automatically by a bunch of people trying to take advantage of the tiny arbitrage opportunities.
But I don’t know. It’s chaos theory. I don’t really love that metaphor of the butterfly flapping its wings creating a hurricane somewhere else in the world, but it does seem that this part of market structure makes it more and more possible for those sorts of weird patterns to develop in markets.
Elliot: Now, correct me if I’m wrong but one of the concepts that I took to be a semi-conclusion in The Myth of the Rational Market was the idea that the Benjamin Graham model of value investing has withstood the test of time, that people who are able to take the information and come up with what they think is a fair value and have the ability to ignore what “Mr. Market” is telling them on a daily basis have an edge over time. Do you think that’s a valid interpretation?
Justin: Absolutely – I completely think that’s true. And I think one of the interesting things that is sort of common sense, but that finance scholars have finally started studying and recognizing, is that one of the big reasons for why it’s really hard for a professional investor to stick it out as a value investor is that it requires being unfashionable and going against the crowd. And unless you’ve either built up this incredible reputation — although even that doesn’t really help you that much in investing as people forget your reputation and a year or two if you fail to beat the market — or you get a situation like Berkshire Hathaway (BRK.A), where it’s actually not the investors’ discretionary money that you’re investing, but the cash flow from Berkshire. There’s really no way anybody can discipline Buffett except over maybe a really long period that gives you the freedom to do it.
The flip side of that is that as an investor you have a situation where there’s such little control over the investment decisions. That’s the difficult situation that our investors fear. There’s a reason why people invest in mutual funds. They like the flexibility of being able to take their money out. But the very fact that they do that, and that if you’re some value fund and it’s 1999, everybody wants to take their money out of your fund regardless of your own performance; that’s exactly why it’s hard to be a value investor, and a good economic reason for why value investing works. Beyond that is the individual as a value investor. Obviously, you don’t have to worry about customers but you just need a pretty strong constitution and maybe a different psychological wiring than most people to be able to stick that out.
Elliot: And, do you have any opinion on the value in the market at this present point in time?
Justin: Sort of. If you look at these prices at some point in the next 5 or 10 years, we will look back on today and say “oh, that was a really good time to invest.” In terms of any valuation that I look at, it’s not like the late 1970s yet though. The history is that in a moment when the markets are a really good deal, it comes not because of some further crash but at the very end of it – the end of a bear market is the actual value of the company. The economy is recovering, or at least the companies who share or trade on the exchanges are doing a lot better, and there’s a sense of disbelief among investors. That time is when earnings have improved, but share prices stay in the doldrums. That’s why we bring the values back to a reasonable level. I’ve been seeing a little of that, but it doesn’t feel like we’re quite at the end of the process yet. I do think at some time in the next 10 years, it’s going to have been a very brilliant time to invest – and I mean obviously, the winter of early 2009 was a pretty brilliant time to put money into the market but that was, I think, a more of a medium to short-term type of opportunity.
Disclosure: No positions