Finding Value in the Efficient Market Theory

by: Eric Falkenstein

I was an official economist for a while, back at KeyCorp, and would sometimes have to give little presentations on the standard macro variables. I remember once in early 1995 having a little 5 minute presentation to the board of a large hardware supply company (a small 'Home Depot' type chain). About 20 suits in a room, and they were all very interested in where interest rates were going. At that time, rates had risen a lot, the yield curve was steep, and they were very concerned. Now, given they had a lot of fixed rate long term debt, they could lose a lot of money if rates fell (rates fall, bond prices rise, and they were short bonds). If rates fell, their liabilities would go the other way. As rates were moving a lot, they were very concerned.

I told them in general, when the yield curve is really flat, rates tend to fall. They did, but that's not the point. Indeed, I should have told them I have no clue, but I knew they wanted a 'view', and I was trying to be helpful (we were a 'full service' bank). They debated back and forth for 20 minutes, and though I left, I had the sense they kept discussing it. I never found out what they actually did. The point is a large amount of management time was spent discussing something where they had no alpha, no comparative advantage, no value as management. They all assumed markets were 'wrong', so the question to them was clearly which way. If instead they thought bond prices incorporated all available information, they would have chosen a neutral position, say by having floating rate debt (it was feasible to swap into this).

A lot of resources are wasted by people who think it is imprudent to act as if markets are rational. They then basically take random gambles that on average lose money via fees paid on various transactions. Most importantly, they lose their focus on where they conceivably have alpha.