LESS EFFICIENT MARKET HYPOTHESIS—a review of the C Asness paper

As some may have noted I spend a lot of time writing and thinking about investment theory and philosophies. The reasons for this are not that I like delving into esoteric subjects, but over my time in investing, I have yet to come across a multi-decade successful investor that doesn’t have a robust investment philosophy and process (IP&P). I am after repeatable alpha over long timeframes. A strong IP&P makes an average investor good and a good investor great, IMO. Evolving and improving my IP&P I think is an important part of a successful investment journey.

Secondly, I have been meaning to write something about the efficiency of markets for some time and this paper forces my hand. I became irritated that old colleagues were complaining about how the markets were much more difficult and efficient now and that they couldn’t generate the returns they did previously, like in the 1980s and 1990s. Little doubt that the markets have indeed become harder for them. Markets evolve and we as investors must evolve as well. The conclusion these guys are making is that the markets are much harder (more efficient) and, IMO, are incorrect, it is because they have not evolved, attempting to use yesterday's strategies that no longer work that well. that’s my view and now onto the paper.

The paper commences describing the Efficient Market Hypothesis (EMH), I'm not going to repeat the detail and take it as read that we understand the basics of EMH. Asness quotes Fama (the EMH author), that perfect efficiency is an extreme and unrealistic hypothesis while stating that true bubbles (the counter to the EMH theory) are also rare. The market then moves in an “efficiency” range which I think is a reasonable conclusion.

Of course, the issue here is that it is nearly impossible to disprove or prove the EMH theory. We can only look at data and guess causality. Asness adds that it is likely that market efficiency increases and decreases over time. The main case for increased efficiency appears to come from lower trading costs and the increased speed of information dissemination. Asness argues the increased utility of speed is limited and falls as it becomes faster (ed. No disagreement with me) and adds speed of information access is irrelevant for medium-term investing.

Asness then looks at data to indicate whether the market is becoming more or less efficient.

Asness adds the below chart which is the 30% most expensive P/bk stocks versus the cheapest 30% P/bk as evidence of increasing market inefficiency.

No one should be surprised at this data. This outcome is reasonably well-known and has been the bane of value investors and the joy of growth investors since the GFC. The dot-com bubble is shown as a reference. The interesting aspect is the rise and fall in 1999/2001 compared to the longer-lasting present phenomenon.

Using a five-year moving average shows the trend more clearly. Something has been going on.

Asness dismisses the usually assumed culprits being, that it's all tech stocks, it's due to intangible accounting, super expensive US mega caps, ROA differences between growth and value and low interest rates. Not many details are given here by Asness and I am in the camp of viewing the structural decline in interest rates and therefore the cost of capital as being a big factor contributing to the hegemony of growth stocks. His firm apparently, ran various quant models to disprove these factors. I'm unconvinced on this issue. Again we can see the results the cause is up for debate.

The big question is then why are we seeing markets become more disconnected from reality over time? that question is quite provocative and sure to get growth investors to defend the moves as rational and reasonable. Asness openly states that definitive answers here are not provable and we must look at theories.

1.     Indexing has ruined the Market. How much of the market can be indexed and we can still rely on the market to deliver reasonable price outcomes? We don’t know, Asness believes that indexing per se is a small factor in the impact on markets. There is a perverse second-order impact. He believes that the mix of active investors has shifted with the growth in passive. There has been a migration of valuation-based investors into passive, eg less value funds. That has left more misinformed investors in the markets who have skewed the active population and is leading to more irrational outcomes. Of course, this is not proven.

2.     Low interest rates for a long period. I was a bit confused about this given the earlier comments, but Asness seems to differentiate longer-term lower interest rates from short-term moves. Pointing out that the 1999/2001 bubble occurred with higher interest rates. Conceding the interest rate structure could be a serious cause of the above phenomenon. (ed. As said earlier the large move lower and the duration of the lower interest rates change the valuation of growth stocks and also improve the likelihood of success of early growth companies IMO, so it is a major impact).

3.     We have the effect of technology backwards. The theory is that the huge impact of social media is having a perverse impact. The ubiquity of social media and low-cost trading has destroyed the independence of crowds, one of the major benefits of the wisdom of crowds (ed I have mentioned this before in another post).  Asness states, correctly IMO, the availability of data has never been what's hardest about investing, it is the rational processing of information that is dear. (ed my view is that momentum investing, given its scale and ease of trend following as an executable process is having a larger impact, both in the retail and institutional world. I am not saying momentum is a poor strategy or immoral etc, but it is based on front-running valuation investors as well as trend following—what if most investors are momentum investors not valuation investors—how is intrinsic value reflected in share prices?). As I have said before both passive and momentum investing, the large growth areas in the last 20 years have in common no regard for valuation. In this case, expect much larger swings around any intrinsic value.

Implications

Asness concludes that we will see more extreme valuations over time. That is both good and bad for active investors. Longer-term investors will get opportunities to add positions at extremes. The bad part is the psychological difficulty of being wrong for longer and seeing larger drawdowns. Asness concludes that the future will be potentially more lucrative but harder to stick with due to the volatility. Many will move to passive. Asnes also criticises Private equity for pretending to smooth out volatility which I agree with but looks more like a hobby horse argument (for him and me, lol) and not really relevant to the paper.

What to Do?

May be unrealistic, but be a Vulcan and stick with anything as long as it is long-term logical. He also adds (and I agree) that to assume future positive re-ratings to continue (Pe’s of high priced stocks to keep going higher) forever is an obvious folly.

1.     Have a longer-term horizon. The rise of the trend following strategies will mean you are likely to be wrong shorter term. Do not jump ship at the wrong time.

2.     Keep a view of the whole portfolio. Some sub-parts will always be disappointing. Try to understand what has happened and why. Expect that illogical moves will occur, and have some solace if the move is an unreasonable PE de/re-rating and not an earnings issue. PE has historically normalised over the LT (ed I agree PE re-ratings from excessive levels are low-quality gains, IMO). Even though you will be wrong for a while, it is likely within normal statistical time frames (even though it feels like a lifetime).

3.     Remember that a large part of returns comes from the market, which is riding the equity risk premium, so don’t fret. Stay invested.

4.     Momentum will likely last 6-12 months and being a mild contrarian is more successful over 3-5 years. (ed momentum seems to last a bit longer than that to me)

Conclusion

Asness blames social media for most of the inefficiency in the market. This phenomenon raises the stakes for active investing, the ups and downs will be bigger and last longer. More wealth will be generated from these mispricing but it will be harder to achieve them due to the psychological pressures.

Good investing has always been a challenge of combining what is right and sticking to what is right.

(ed Around about 2014 I realised something had changed and my old boom/bust cycle of valuation style investing was not working. The post-GFC environment had begun. I agree with the broad thrust of the article. However, I point to the huge growth in momentum and even closet momentum by active managers as the main issue in distorting valuations, we will probably never know the truth). The issue for active investors is dealing with it and evolving their investing style to suit the new circumstance IMO).

The full paper is 24 pages widely available feel free to read it and come to your view.

Cliff Asness from AQR Capital Mgt has written a ton of stuff in various investment mediums.

Ps- as an aside what about the growing tribe of investors that only know the post-GFC environment, what does that imply for market behaviour, still thinking that one through, we have a few more years before they take over. Lol.