Efficient Markets Hypothesis

I occasionally read The Big Picture, a Blog with interesting posts about the economy and financial markets. I recently came across an article on the efficient market hypothesis titled ``Random Walk and Outperforming Fund Managers." While I agree with some statements at the beginning, for example that one should use a variety of tools for stock selection, I find myself in much disagreement about the analysis of the Efficient Market Hypothesis, EMH, and its relation to mutual fund performance and the ``random walk" hypothesis. Before attacking the EMH one should at least make sure of what the EMH says and implies, and what it does not say or imply. This is what I intend to do in this Blog, plus I will try to clarify some other misconceptions that I have read in the mentioned article and related comments.

There are three forms of the EMH:
(i) Weak form: current prices incorporate the information content of past prices. That is, it is not possible to make abnormal returns (in excess of what the market expects from the stock) by predicting future stock prices based on current and past prices alone. This is the form that is related to the ``random walk" hypothesis.
(ii) Semi-Strong Form: current prices incorporate the information content of all publicly available information. This means that it is not possible for mutual funds to outperform an index strategy.
(iii) Strong-Form: current prices incorporate the information content of all, public plus private, available information. This means that even insiders cannot make abnormal returns.

The fact that there are 3 forms and that they can hold in special situations, it does not mean that economists, even proponents of the EMH believe the hypotheses are a good representation of actual financial markets. No one believes (iii), there is debate on (ii), and almost every academic economist believes (i). There are a lot of carefully executed analyses that show that mutual funds do not statistically outperform indexing, so (ii) is not rejected. But since valuing a stock is a very hard task, collecting and processing information is costly, and there is a big element of learning involved in the process, it's hard to believe that no investor can spot a value stock and profit from it. Some may be better than others and may earn superior returns. That is why I say (ii) is debated. But once you have paid the skilled manager (value finder), there is nothing left for the average investor, that is why indexing is just as good for most people.

1. EMH does not imply that prices necessarily follow a random walk process. It implies that you cannot make abnormal returns, on a risk adjusted basis, based on past prices alone. Prices may deviate from the random walk, but these deviation are not profitable, on a risk adjusted basis. Prices are very close to a random walk, and so (i) is not rejected in the data, that is what we mean when we say that the ``random walk" is a good representation of stock prices. The word martingale sometimes replaces ``random walk."

2. Malkiel is not the father of the EMH, Eugene Fama of the University of Chicago defined it as I have done above.

3. That some managers cosistently outperformed the S&P 500 does not prove EMH is rejected. One needs more than that. Just out of luck some one is going to do it. EMH does not say no one is going to do it.

4. The Weak version is not ``just a version that is less wrong". It has a precise definition, and there is overwhelming evidence that it is not rejected. This implies that technical analysis alone is useless. But I agree with the Big Picture that it can be part of a toolbox for stock selection.

5. Behavioral economics (BE) is not one of the reasons why EMH fails, or at least nobody has proven that. BE may explain the behavior of individuals under some circumstances. But to say that they act irrationally depends on what you mean by rational. BE does not say much about aggregation among individuals and the prices that would result after aggregation of these ``irrational" choices. This especially in a world of heterogeneous investors some of whom might not (I think many) be irrational. I also want to add that if you look closely at much of the evidence for ``irrationality" and behavioral biases, most of it comes from lab experiments with subjects making choices that most observers of financial markets would find far from reality (to say the least).

6. 2 Behavioral economists shared 1 Nobel prize. This is because of advancements in decision theory. But may or may not be a signal that BE explains most movements in stock prices.

7. The Big Picture rejects the weak form EMH by looking at the NASDAQ level in March 2000. Again, the weak form says that you cannot make a better prediction than the market, based on historical prices alone, about future stock prices. Whatever was embodied in the NASDAQ in March 2000 it could not be used to make abnormal returns. Even if you thought prices where not representing fundamentals, and therefore expected the bubble to burst at some point in the future, you could not use the fact that the NASDAQ was at 5100 to say when the crash was going to come. People had been predicting a crash since 1996. Even f the price is a ``bubble", EMH can still hold. Such bubbles are called ``rational bubbles." Even if you think that the price is above fundamental, a rational investor may still buy the stock, rationally expecting that with some probability the price will be even higher.

8. While many rational economic models that try to explain stock prices are rejected in the data, it does not mean that EMH alone is rejected. Tests of economic models are joint tests of the model plus EMH. It maybe that these models are rejected because they do not correctly capture risks faced by investors, not because there are inefficiencies. I haven not seen a careful study that rejects the weak form EMH alone.

9. EMH does not say that better track records than the S&P 500 cannot exist. It says that on a risk adjusted basis, there should not be a statistically significant number of investors that can do so. To reject the hypothesis, one should show that there are enough funds (a statistically significant amount) that can do that, after adjusting for risk. EMH is perfectly consistent with the fact that, by taking more risk, you can outperform the S&P. It is also perfectly consistent with the fact that some investors, even on a risk adjusted basis, can outperform the S&P. It says though, that there are relatively few of these, say no more than 5-10%.

Fed lets the monetary throttle go in the midst of uncertainty about the economy

On August 8, the Fed decided to stop increasing the target for the federal funds rate, now at 5.25%. Futures markets gave the pause a 50/50 chance against a further quarter point increase, highlighting the high degree of uncertainty about the economy. Wall Stree Journal reporter Greg Ip put it clearly in today's column:

``The Fed is entering what has traditionally been one of the most delicate phases of the business cycle. The economy has reached full strength and inflation pressures have built.

There are signs that higher interest rates are slowing the economy, but it remains unclear if they have slowed it enough -- or too much. The Fed paused at a similar point in February 1995, and in May 2000. The first time, the economy had a "soft landing" -- slow growth followed by five more years of expansion. The second time, it fell into recession."

In the August 8 press release, the Fed states that

``...the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information."

Given the high degree of uncertainty about where the economy is and about the effect of previous monetary policy actions, the option of waiting for some of the uncertainty to clear is very valuable to the Fed. But where does this uncertainty come from?

Economic growth has moderated in the second quarter as a result of (i) the cooling housing market; (ii) higher prices overall, and energy in particular, that have decreased households' real incomes; and (iii) increasing interest rates. With the economy at full capacity and increasing prices, there is a risk of inflation, and an increase in expected inflation, if the effect of prices is transmitted to wages. If wages rise, with a slowing aggregate demand, the economy could fall into a recession.

Although labor markets appear tight in some sectors, particularly for skill intensive jobs, there does not seem to be a worrying effect on wages (to the Fed at least). In fact, the Fed deleted a statement about labor markets from the June's press release.

Thus the picture that the Fed seems to have is one with moderating aggregate demand and inflation, so that it does not need to increase rates further at this point. A further rate increase can be expected if labor markets and aggregate demand do not paint the same picture in the near future.

The option to wait that the Fed is exercising is also not as passive as some may think. Because the Fed is open to raise interest rates at the next meeting, long term rates remain relatively high and thus should help contain aggregate demand.

Burton Malkiel on "More than you know"

Read Malkiel's interesting review of the book "More than you know" by Michael Mauboussin in today's WSJ at http://online.wsj.com/article/SB115023749936579384.html

I think by now, we all know how to pick stocks: just buy stocks with growth potential that is not yet reflected in the market price. But the advice to pick funds that charge lower expenses and have low stock turnover seems much clearer to me.

Uncertainty, inflation data, and financial markets

We now have new data on inflation, both PPI and CPI indexes have been released by the BLS. The PPI, producer price index, is a measure of price changes from the prospective of the seller, whereas the CPI, consumer price index, is a measure of price changes from the prospective of households. What should we gather from the large amount of information released by the BLS?

Let's start from the PPI, released yesterday. The PPI increased by 0.2% in May after a 0.9% increase in April and a 0.5% in March. What does this mean? A 0.2% is not a big increase, but it is the series of increases that may worry the Fed. From May 2005 to May 2006 the PPI increased by 4.5%. This is a value outside the confort zone of the Fed. But, does a 0.2% reading means that inflation is slowing down, possibly due to contractionary monetary policy finally kicking in? This is not so sure. If we focus on PPI of intermediate goods used in manufacturing, the index increased by 1.1% in May, after a 0.9% increase in April, and a -0.1% in March. To the extent that increased prices of intermediate goods are passed on to prices of final goods, this increase implies a future increase in inflation.

Now the CPI, released today. The CPI increased by 0.4% in May and by 4.3% from May 2005. During the first 5 months of 2005 the CPI has increased at an annualized rate of 5.2%. Contrast this number with a 3.4% increase in the CPI in all of 2005. Excluding food and energy, the index increased at an annualized rate of 3.1% in the first 5 months; this is core inflation. The main drivers seem to be transportation (caused by increasing energy prices), medical care costs, apparel, and, perhaps more importantly, housing rentals. Both rents and owner equivalent rents have increased in May, by 0.3% and 0.6% respectively.

The data on inflation confirms some of the fears Mr. Bernanke had expressed: inflation is moving within bands that we have experienced in the recent past, but it's getting outside the Fed's confort zone. At the same time, spending and economic growth seem strong, both in the US and globally. It seems almost certain, as futures on the federal funds rate show, that the Fed will increase interest rates.

How have stock market reacted? On one hand you have strong growth, on the other rising inflation. This is an environment of uncertainty. If inflation rises, it means that high levels of growth cannot be sustained any longer, the economy is near or at full capacity. The fact that markets have dropped in the last week or so means that valuations are adjusting to a new, lower, level of growth. As the same kind of data is emerging more or less globally, and most noticeably, Japan and Europe, global financial markets are reacting in a similar fashion. Emerging markets indexes have also declined, and by more than the DJIA. This fact should not surprise. Growth in these markets is clearly related to growth in major countries such as the US, Japan, and Europe. In addition, these are riskier markets, so we should not be so surprised that benchmark indexes are down 9% in Russia and Colombia, or 5% in Turkey.

The climate of uncertainty has hit commodities too, with gold futures down 7% yesterday and 22% in the last month. Incidentally, commodity prices going down should indicate that expectations of inflation are not rising.

In conclusion, it seems that financial markets are not uncertain about what the Fed will do and about the Fed's ability to control inflation. Markets are uncertain about what's happening to growth, and what growth rate can be sustained in the near future.

What's Happening to Stocks?

The Dow Jones Industrial Average closed below the 11,000 threshold for the first time in three month yesterday, June 7, when it hit 10,930.90. According to many in the news business, the drop is due to continued adjustments to bad news about inflation and the U.S. economy after Mr. Bernanke's speech, echoed yesterday by Atlanta FRB President Jack Guynn. Fears of inflation, and forthcoming interest rates increases by the Fed, the story goes, will slow down the economy, and that is driving down stocks (see for example today's commentary of wednesday's markets in the WSJ).

There is something wrong with this analysis. First, as low inflation promotes economic stability and long run performance, investors should greet positively actions taken by the Fed to curb inflation: further rate rises, if needed, would only benefit the economy. So stocks should react positively.

Second, is it really fear of inflation that is driving markets down? How have bonds reacted? Long term bond yields have barely changed in the last two days. The 10-yr note yield closed at 5.02%, and even the three month T-bill closed at 4.81% on monday, from Friday's 4.80%, and at 4.85% yesterday.

So, if we are to find something in Mr. Bernanke's speech that has shaken the markets, what is it? I think stock markets reacted, rationally, to his clear economic analysis of the current state of aggregate supply ---read my previous blog about the analysis. Mr. Bernanke said that there is little doubt that the economy is approaching full capacity utilization, and although productivity will continue to grow, it is unlikely that it will continue to do so at the pace we have observed in the last few years.

If stock prices before the announcement were based on longer lasting sustained growth of the kind we have experienced so far, then adjustment of growth expectations can very well explain the drop in prices. Stock prices are taking Mr. Bernanke's analysis seriously. Now, Mr. Bernanke's warning that we maybe seeing a growth slowdown soon does not mean that the economy is about to experience bad times. It just means that growth may be stabilizing closer to long run levels experienced by the U.S. (think 3% rather than 4% or more). This seems hardly bad news. So it's possible that stock markets did overreact by taking the analysis more negatively than intended by the Fed Chairman. Here I am just speculating though.

One final thought about inflation. With the economy stabilizing at a lower growth rate, it is natural that money supply should grow less rapidly, otherwise there would be to many dollar bills chasing to few goods to buy, which would spur inflation. Thus the need to raise rates a little. It seems investors should be confident about future Fed policy, as bond traders seem to be showing.

What's your take?

What's your take on interest rates?

In a public appearance on Monday, Fed chairman Ben Bernanke highlighted the state of the economy and, according to the media, sent down the DJIA by 1.77%.

What did he say about the economy? And what's the relevance of his comments for future interest rate policy? I am going to review his comments and take a stand on the next target for the federal funds rate.

Bernanke aknowledged the robust (i.e. above trend) growth of the U.S. economy during the past three years and attibuted it mostly to advances in productivity and increase in the labor force ---underlying fundamentals. But then he stated:

" While we cannot ascertain the precise rate of resource utilization that the economy can sustain, we have little doubt that after three years of above trend growth, slack has been substantially reduced."

This is a statement that the economy, given current resources and technology, is approaching full production capacity. In my macro class, I call this region of the aggregate supply function the "danger zone", an area in which the Fed start to worry about inflation. This is because further increases in production, due to increased aggregate demand, can come only at higher prices.

Bernanke says there is little doubt about it, we are in the danger zone!

Increasing prices, inflation, tend to reduce excess demand, demand that is not sustainable in the short run because the economy is near full capacity. Bernanke is not sure that this is already happening, here is why.

He says that personal consumption expenditures, which make two thirds of US output, has shown slowing growth in the past quarter. High energy prices affected income and expenditure of an increasing number of households. Fuel prices have increased more than 30% in the past year (from 2.11 to 2.86 a gallon nationwide), and households are starting to feel the effect of this increase. The housing market is cooling, which might induce household to take out less home equity loans to finance their consumption. Payroll data shows signs of employment slowdown, and the number of initial jobless claims is up.

On the other hand, unemployment rates are still low and investment is rising at a good pace. In particular, while residential housing is slowing down, non-residential construction is picking up, which might take some of the slack from residential housing. Other business investment, like IT and equipment, is also increasing. Corporate bond spreads remain low, showing little signs of increasing risk, and global growth seem high this year.

And now inflation, what's happening to inflation? Core inflation, exluding volatile energy and food prices, has been at 3.2% in the past 3 months, and at 2.8% in the past six months. This is an unwelcome development according to Mr. Bernanke. What about inflation expectations? Measures of expected inflation and inflation risk indicate that expected inflation is on the rise, and while the current level is whithin values experienced in the last year or so, it bears closed watching. Mr. Bernanke also said that anectodal reports show that firms are having difficulty attracting workers in some sectors.

To summarize, we have an economy close to full capacity, in which inflation is already at reasonably high levels, and in which it is not clear that price increases have slowed down the "robust growth" ---above trend--- we have been experiencing in the past three years.

Before jumping to conclusions about the future course of monetary policy, we should think about policy so far. The Fed has been increasing rates for a while, and given the lags with which monetary policy affects aggregate demand, it's not so obvious that further increases are needed. One has to weigh two risks: (i) slowing down the economy by increasing rates if they are not needed vs. (ii) letting inflation increase by not raising rates. Even disregarding speculations about credibility, a new chairman, and similar arguments advanced by the press, with the unemployment rate so low, the Fed can afford raising the target federal funds rate by a quarter point (to 5.25%) at the next meeting and my guess it's that this is what they will do.

Business Cycles and Large vs. Small Cap Performance

In the past 5 years, the Russel 2000, a yardstick for small-stock performance, is up more than 40%, while the Dow Jones, which tracks 30 of the nation's biggest public companies, has been about flat (read Diya Gullapalli's article on the June 5 WSJ Mutual Funds Report).

There appears to be cycles of performances between the two classes of stocks in the data. Large cap stocks tend to outperform small caps during periods of slow growth or recessions, and small caps outperform large caps when the economy is rebounding from a recession and its growth is greater than usual.

The argument for these cycles seems to be based on the fact that prices and revenues of small cap companies are more susceptible to business cycles than prices and revenues of large companies. A cited reason for this is that large companies enjoy economies of scale.

Another reason for this apparent performance is that small cap companies are usually companies with potentially fast growing profits and revenues. But growth prospects are uncertain and hard to estimate, and changes in growth prospects have large effects on stock prices. Thus, during economic contractions, when uncertainty about economic prospects is higher, small caps may take a bigger hit.

How can this be useful to investors? Given these cycles, the answer is obvious, one should invest in small cap funds or companies in expansions and in large cap funds or companies in contractions. Investors can take advantage of this strategy to the extent that we can predict expansions/contractions. Notice though the market would try to undo this profitable strategy with price changes: Prices of small caps would increase right at the beginning of an expansion, thus eliminating future capital gains. Under this hypothesis then, only unpredictable components of business cycles are responsible for the performance cycles. Thus, there is no way to take advantage of the performance cycles: small caps are simply a riskier investment opportunity.

According to this view, small caps should earn a greater long-run return relative to large caps, in compensation for the extra risk. This is indeed the case in the US, where in the last 80 years or so small caps have outperformed large caps.

Notice this type of "efficient market" type of analysis is based on two testable implications: that small companies profits are more strongly procyclical, and that their prices react to changes in expected growth prospects of the company. I am not sure we have direct and convincing evidence on these.

Backdating of Options

Do you believe options were purpously backdated so that top executives could get rich at the expense of shareholders? ---see WSJ article Monday, May 22

Top executives are granted options ---the right to buy the underlying stock at a determined "strike" price--- to align their incentives with the shareholders': managers gain from these "call" options if the stock price is grater than the strike price by pocketing the difference between the two. Thus, they have the incentive to increase the value of the company. When options are granted, the strike price is usually equal to the price of the stock on that day. That is, the option is at the money.

Does an option at the money provide a good incentive? From the executives' side, what if the price of the stock drops from the strike price for reasons beyond their control. What if some shock affects the entire industry or the economy and as a result the share price drops despite the managers' best effort?
Or, the current price at the time of the grant could be "abnormally" high, so that some downward adjustment is expected by the board.

It would seem that in these cases, aligning managers and shareholders incentives would call for a strike price lower than the stock price at the time of granting: the option should be in the money.


But, under accounting rules that were long in effect until recently, issuing a below-market option would trigger extra compensation expense, reducing a company's net income. By granting options at the same price of the stock, until recently, a company could avoid expensing options completely, thus not affecting earning figures.

Given accounting rules, and the importance of meeting or exceeding earnings expectations, backdating seems an easy way to grant options with a lower strike price without the need of expensing them. So, it's very possible that some or much of the backdating is another form of accounting schemes to improve the earning outlook of a company. This possibility should be one more reason to favor the expensing of stock options by corporations.