economics
business
coronavirus
Does Covid-19 Prove the Stock Market Is Inefficient?
Economics, 2013 Nobel Prize
Economics, Princeton University
0
0
Genesis
Response
Penultimate
Finale
May 4th, 2020
Bob’s basic question is whether we should consider altering our portfolio in light of today’s high valuations and uncertainty about the economic outlook. My answer is yes and no. If our capacity for risk has changed because we are less certain about future employment, or if our tolerance for risk is less than we previously thought, then it would be appropriate to reduce risk. But if we want to reduce risk because we think stock prices are too high or because we believe we can accurately forecast future economic conditions, I would say emphatically “no.”
Some historical perspective is useful. Even during one of the most spectacular “bubbles” in stock market history (the dot.com bubble of the late 1990s, considered damning evidence against EMH), most investors who tried to time the market made egregious mistakes. In 1996, Bob (with John Campbell) presented an excellent paper to the Federal Reserve showing that earnings multiples possessed substantial ability to predict future rates of return. Since these multiples were then at all-time highs, the work implied a likelihood of low or even negative returns. This work influenced Federal Reserve Chair Alan Greenspan to make a famous speech questioning whether the stock market was at bubble levels and whether investors were exhibiting “irrational exuberance” in view of the economic outlook. The stock market rallied strongly for four years thereafter, and long-term investors who bought stocks after the speech earned generous rates of return.
We now know (ex post) that market prices were at bubble levels in late 1999 and early 2000. No one was able accurately to identify the timing of the bubble in advance. In fact there is substantial evidence that both individual and institutional investors who try to time the market invariably do the wrong thing. They buy at market tops when optimism reigns, and they sell at market bottoms when pessimism is rampant. And while some investors have made excess returns over certain periods, there is no evidence that such returns persist.
In 2007, legendary investor Warren Buffett offered a $1 million bet that an index fund would outperform a basket of hedge funds over the next decade. Protégé Partners took up the challenge. Result: Their selected basket of hedge funds returned 2.2% per year while the index fund returned 7.1%. The index also beat Buffett’s portfolio. In his will, Buffett has directed that 90% of his estate should be invested in index funds.
It is probably useful to think of the stock market in terms of “relative” rather than absolute efficiency. Andrew Lo suggests that few engineers would contemplate testing whether a given engine is perfectly efficient. But they would attempt to measure the efficiency of that engine relative to a frictionless ideal. Similarly, it is unrealistic to require our financial markets to be perfectly efficient in order to accept EMH. Perhaps the difference between Bob and me is one of degree. I believe that our markets come very close to the EMH ideal. Bob is more skeptical. In any event, I hope his stocks are invested in low-cost index funds.
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