Friday, November 22, 2013

Grantham on Efficient Markets, Bubbles, and Ignoble Prizes

The latest GMO quarterly letter was recently released.*

Below, I've highlighted some of Jeremy Grantham's thoughts on efficient markets, bubbles, and the 2013 Nobel Prize in Economics from his section of the letter:

"Economics is a very soft science but it has delusions of hardness or what has been called physics envy. One of my few economic heroes, Kenneth Boulding, said that while mathematics had indeed introduced rigor into economics, it unfortunately also brought mortis. Later in his career he felt that economics had lost sight of its job to be useful to society, having lost its way in a maze of econometric formulas, which placed elegance over accuracy.

At the top of the list of economic theories based on clearly false assumptions is that of Rational Expectations, in which humans are assumed to be machines programmed with rational responses. Although we all know – even economists – that this assumption does not fit the real world, it does allow for relatively simple conclusions, whereas the assumption of complicated, inconsistent, and emotional humanity does not. The folly of Rational Expectations resulted in five, six, or seven decades of economic mainstream work being largely thrown away. It did leave us, though, with perhaps the most laughable of all assumption-based theories, the Efficient Market Hypothesis (EMH).

We are told that investment bubbles have not occurred and, indeed, could never occur, by the iron law of the unproven assumptions used by the proponents of the EMH. Yet, in front of our eyes there have appeared in the last 25 years at least four of the great investment bubbles in all of investment history."

To me, this latest letter is Grantham at his best.
(His section begins on page 6.)

Well worth reading in its entirety.

Grantham goes on to describe the four bubbles that, for many, will hardly be unfamiliar:

1) Japanese equity bubble - By 1989 stocks were selling at 65 times earnings (on what may be not so great accounting). Grantham points out, before that, stocks had never peaked at more than 25 times earnings. Japanese stocks would go on to fall 90%.

2) Japanese land bubble - This bubble peaked a couple of years later in 1991. Grantham describes it this way:

"This was probably the biggest bubble in history and was certainly far worse than the Tulip Bubble and the South Sea Bubble. And, yes, the land under the Emperor's Palace, valued at property prices in downtown Tokyo, really was equal to the value of the land in the state of California. Seems efficient to me..."

3) U.S. equity bubble in 2000 - This one peaked at 35 times earnings but that doesn't even begin to describe how expensive certain stocks had become. For perspective, earnings peaked at 21 times earnings in 1929.

4) U.S. housing bubble - According to Grantham this was the first bubble that was truly global.

Grantham notes that, according to EMH, these annoying real world occurrences should happen something like once every 10,000 years.

He also makes the point that "this efficient market nonsense" certainly didn't hurt value managers like himself.

"...so I should find time to thank all those involved for producing and passionately promoting the idea. During the 1970s and 1980s I am convinced it helped reduce the number of quantitatively-talented individuals entering the money management business."

Warren Buffett has previously made a similar point.

Max Planck understood well the resistance of the human mind, even among those who happen to be very smart, to new ideas. He understood how that tendency impacted scientific advancement.

Buffett has said the same applies to finance.

Well, one of the more disappointing -- even if unfortunately not exactly surprising -- aspects of what has happened over these past decades is this:

"...the proponents of the EMH not only promoted their theory, but via the academic establishment the high priests badgered academic researchers into leaving, resigning themselves to non-tenure, or getting religion, as it were."

Much later in the letter, Grantham talks more specifically about the 2013 Nobel Prize in Economic Sciences:

"So, economics has been more or less threadbare for 50 years. Pity then the plight of the Bank of Sweden with all that money to give away in honor of Alfred Nobel and in envy, perhaps, of the harder sciences. If you had $1.2 million to give away but few worthy recipients, what would you do? I would suggest making it a once-every-three-year event..."

His primary reason?

To make it more likely that only "the Real McCoys" win the prize and to prevent "so many ordinary soldiers" from getting it.

That's unlikely to happen anytime soon, but that doesn't make it any less unfortunate that the Bank of Sweden did the following:

"...to further prove how completely they have lost the plot, they gave two-thirds of the prize to two economists who attempted to prove market inefficiency and one-third to another who claimed it was efficient and seriously efficient at that. What a farce. And to read all these genteel descriptions, or rather rationalizations, as to why this made sense is to realize to what extent the establishment is respected, regardless of its competence level."

The economists he is referring to are Eugene Fama, Robert Shiller, and Lars Peter Hansen.

"Robert Shiller at least served society – Kenneth Boulding would have approved – by loudly warning us of impending doom from the Tech Bubble with his superbly timed book Irrational Exuberance in the spring of 2000. Not bad! He also warned us well in advance of the much more dangerous housing bubble..."

Grantham is, not surprisingly, not quite so complimentary of Fama:

"As for Fama, who conversely provided a rationale for all of us to walk off the cliff with confidence, the less said the better. For believers in market efficiency and all the assumptions that go along with it, the real world really is merely an annoying special case."

Grantham has mentioned this so-called "special case" before.

Now, to get an idea how Eugene Fama looks at bubbles, consider what he said when presented with the following back in 2010:

Interview With Eugene Fama

"Many people would argue that, in this case, the inefficiency was primarily in the credit markets, not the stock market—that there was a credit bubble that inflated and ultimately burst."

He responded this way:

"I don't even know what that means. People who get credit have to get it from somewhere. Does a credit bubble mean that people save too much during that period? I don't know what a credit bubble means. I don't even know what a bubble means. These words have become popular. I don't think they have any meaning."

That comment from Fama just might help begin to explain how such ideas and assumptions have been able to maintain their widespread -- some, including myself, would argue rather more than a little bit damaging -- influence for so long.

From later in the same interview:

"But you are skeptical about the claims about how irrationality affects market prices?"

Fama's response:

"It's a leap. I'm not saying you couldn't do it, but I'm an empiricist. It's got to be shown."**

Naturally, there's nothing inherently wrong with needing it "to be shown", but somehow, at least for Fama, these recent bubbles don't offer much evidence. Also, for certain things "to be shown", we'll probably need several more centuries of data (if not more) for sufficient empirical evidence to exist. In the meantime most of us have to make judgments lacking that evidence.

Other related articles:
-In praise of empiricism: a Nobel prize for everyday economics
-It's the Data, Stupid! Empiricists grab this year's Nobel Prizes.
-Eugene Fama, King of Predictable Markets**

Fama continues to think, more or less, that efficient markets made up of even-tempered and rational participants exist in the real world. This way of thinking at least implies that it's tough to distinguish between what's been mispriced and changes to risk.

Fama seems to generally view any variation in market price as being rational and the reward one gets for taking on risk. In other words, if the market price changes then it must necessarily be a reflection of changes in risk.

Shiller's view seems to be that, at least in the shorter run, less than rational psychological forces may take hold that leads to mispriced assets but, in the longer run, those mispricings tend to be corrected.

Fama does, in fact, seem to have an almost unflappable confidence in things like efficient markets.

Shiller, of course, does not.

Not long after their Nobel Prize was announced Shiller was interviewed on CNBC. In the interview, Shiller called Fama the "father" of efficient markets as a theory and most responsible for popularizing it over the years.

Shiller also said the following about Fama's rather consistent, if nothing else, view that markets are mostly quite efficient and rational:

"When you hatch a theory, you don't easily let go, that's where he [Fama) is. I think he's a -- he's a brilliant man...but he's rather involved in this theory."

CNBC Video: Robert Shiller on Eugene Fama

Maybe, just maybe, the reason Fama doesn't see the empirical evidence relates, in part, to Shiller's explanation.

That doesn't really seem a stretch at all.

Well, in any case, Fama, Shiller, and Hansen have won a big prize.

No doubt winning it involved lots of hard work by what are well-intentioned and smart people.

Still, consider me more than a little bit skeptical of thinking that's built upon the foundation of efficient markets and rational expectations. I happen to be rather convinced that the influence of these theories over time have not been a good thing at all for civilization.

To me, the sooner they lose influence the better.

Naturally, some very capable proponents of these theories (and the many related models) will offer a more favorable view.

In any case, the outcome of this debate has important consequences.

To me, the market isn't terribly efficient. Yet outperforming the market as a whole remains extremely difficult. Some use market efficiency as the explanation for this difficulty. Well, there's no reason why capital markets can't have some inefficiencies AND be difficult to outperform.

To me, these things coexist just fine.

For example, a relatively small proportion of participants might have certain capabilities (both temperamental and intellectual) to consistently benefit from mispricings while the great majority of participants overestimate their ability to do so.

The logical way to go, with this in mind, will continue to be index funds for most market participants.

Adam

Related posts:
-Efficient Markets - Part II
-Risk and Reward Revisited
-Efficient Markets
-Modern Portfolio Theory, Efficient Markets, and the Flat Earth Revisited
-Buffett on Risk and Reward
-Buffett: Why Stocks Beat Bonds
-Beta, Risk, & the Inconvenient Real World Special Case
-Howard Marks: The Two Main Risks in the Investment World
-Black-Scholes and the Flat Earth Society
-Buffett: Indebted to Academics
-Grantham on "The Greatest-Ever Failure of Economic Theory"
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind

* Also published in Barron's.
** Fama is described as "a careful empiricist" in the article.
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