the inefficient stock market chapter 15: “the wrong 20-yard line”
TRANSCRIPT
The Inefficient The Inefficient Stock MarketStock Market
Chapter 15:Chapter 15:“The Wrong 20-Yard Line”“The Wrong 20-Yard Line”
The TrilogyThe Trilogy
““The New Finance”The New Finance”““Beast on Wall Street”Beast on Wall Street”““The Inefficient Stock Market”The Inefficient Stock Market”
““The New Finance”The New Finance”
• Focuses on the market’s major systematic error:– Fails to appreciate the strength of competitive forces in a market
economy– Over-estimates the length of the “short run”– Over-reacts to records of success and failure for individual
companies– Drives the prices of successful companies too high– Drives the prices of unsuccessful companies too low
• So:– Successful firms tend to experience negative earnings surprises
down the road– Unsuccessful firms tend to benefit from positive earnings surprises
Changing Investor Opinion as to the Changing Investor Opinion as to the Length of the Short RunLength of the Short Run
• Prior to 1924 Prior to 1924 - Stock valuation based on Stock valuation based on current normalizedcurrent normalized earnings. earnings.
• 19251925- E. L. Smith advises stock valuation based on future E. L. Smith advises stock valuation based on future
growth - New Era Theory.growth - New Era Theory.
• 19341934- Graham and Dodd dispute New Era Theory’s views on Graham and Dodd dispute New Era Theory’s views on
growth and valuation.growth and valuation.
• 1960’s1960’s- Growth stock investing makes comeback.Growth stock investing makes comeback.
But …But …
• The speed of mean-reversion in earnings The speed of mean-reversion in earnings growth appears to be quite fast.growth appears to be quite fast.
• If, in general, it is faster than the market If, in general, it is faster than the market expects, cheap (expensive) stocks should expects, cheap (expensive) stocks should tend to grow faster (slower) than expected.tend to grow faster (slower) than expected.
• If this happens, cheap stocks should tend If this happens, cheap stocks should tend to out-perform expensive stocks.to out-perform expensive stocks.
The Relative Performance of Portfolios Equally-The Relative Performance of Portfolios Equally-weighted in the Cheap and Expensive Quartilesweighted in the Cheap and Expensive Quartiles
• The difference in cumulative return is measured over rolling 5-year periods.
• The relative performance appears to cycle over time.
• Cheap stocks out-perform more often than not.
Rolling Annualized Average 5-year Difference Rolling Annualized Average 5-year Difference Between the Returns to Value and Growth Composites Between the Returns to Value and Growth Composites
-20%-20%
-10%-10%
0%0%
10%10%
20%20%
30%30%
40%40%
50%50%
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Seasonal Returns to Value and Growth Portfolios Seasonal Returns to Value and Growth Portfolios
11 22 33 44 55 66 77 88 99 1010 1111 1212 1313 1414 1515 1616 1717 1818 1919 2020
0%0%
2%2%
4%4%
6%6%
8%8%
10%10%
12%12%
14%14%
AverageAverage Monthly Monthly
ReturnReturn
Rank based on Previous 5-year Return
Rank based on Previous 5-year Return
Feb. - Dec.Feb. - Dec.
JanuaryJanuaryPrior LosersPrior Losers
Prior Winners
Prior Winners
What has Over-estimation of the Length of the Short Run What has Over-estimation of the Length of the Short Run Done to Risk and Return?Done to Risk and Return?
• Cheap (expensive) stocks tend to have Cheap (expensive) stocks tend to have surprisingly high (low) realized returnssurprisingly high (low) realized returns
• Cheap (expensive) stocks tend to have low Cheap (expensive) stocks tend to have low (high) volatility, because little (much) is (high) volatility, because little (much) is expected of themexpected of them
• Investors may Investors may expectexpect higher returns from higher returns from expensive stocks but they may be expensive stocks but they may be repeatedly repeatedly surprisedsurprised by disappointing by disappointing earnings reportsearnings reports
How Long Have Risk and Return Been Up-How Long Have Risk and Return Been Up-side Down?side Down?
• If it’s caused by an over-estimation of the If it’s caused by an over-estimation of the short run, it should begin with the short run, it should begin with the renaissance of growth stock investing at renaissance of growth stock investing at the end of the 1950’s.the end of the 1950’s.
• What has been the relative performance What has been the relative performance between the low-volatility stock portfolio between the low-volatility stock portfolio and the market index over time?and the market index over time?
Cumulative Difference in Return Between Cumulative Difference in Return Between Low Volatility Portfolio and S&P 500 Low Volatility Portfolio and S&P 500
19281928 19381938 19481948 19581958 19681968 19781978 19881988
-35%-35%
-25%-25%
-15%-15%
-5%-5%
5%5%
15%15%
25%25%
Cumulative Cumulative DifferenceDifference
The Relationship Between the Perceived and True Growth Horizon The Relationship Between the Perceived and True Growth Horizon and Average Growth Ratesand Average Growth Rates
• Define the growth horizon as the length of Define the growth horizon as the length of time a typical stock takes to mean-revert to time a typical stock takes to mean-revert to the average rate of earnings growth.the average rate of earnings growth.
• The evidence indicates that the The evidence indicates that the perceivedperceived horizon is longer than the horizon is longer than the truetrue horizon. horizon.
The Relationship Between the Perceived and True Growth Horizon The Relationship Between the Perceived and True Growth Horizon and Average Growth Ratesand Average Growth Rates
• The true horizon tends to be relatively The true horizon tends to be relatively constant, but investor constant, but investor perceptionsperceptions may may change.change.
• If investors perceive that relative If investors perceive that relative differences in growth will persist for longer differences in growth will persist for longer periods, growth stocks may out-perform.periods, growth stocks may out-perform.
• Changes in the Changes in the perceivedperceived horizon may horizon may create a cycle in growth/value performance.create a cycle in growth/value performance.
Rolling Annualized Average 5-year Difference Rolling Annualized Average 5-year Difference Between the Returns to Value and Growth Composites Between the Returns to Value and Growth Composites
-20%-20%
-10%-10%
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““Beast on Wall Street”Beast on Wall Street”
22ndnd book in trilogy book in trilogyFocuses on stock volatilityFocuses on stock volatilityThree components of volatilityThree components of volatility
Three Components of Stock VolatilityThree Components of Stock Volatility
Event-driven volatilityEvent-driven volatilityError-driven volatilityError-driven volatilityPrice-driven volatilityPrice-driven volatility
High-wire Act at the Financial CircusHigh-wire Act at the Financial Circus
The wireThe wire The economyThe economy
The aerialistsThe aerialists Different stocksDifferent stocks
Movements inMovements in Movements in Movements in balance barsbalance bars stock pricesstock prices
Components of the Movements Components of the Movements in the Balance Barsin the Balance Bars
Event-drivenEvent-driven
The best moves in the bars humanly possibleThe best moves in the bars humanly possible
Error-drivenError-driven
Over- and under-reactions to shocks in the wireOver- and under-reactions to shocks in the wire
Price-drivenPrice-driven
Aerialists interacting with each other Aerialists interacting with each other
Haugen vs. MauboussinHaugen vs. Mauboussin
• Event-driven and error-driven volatility are caused by investors reacting to specific information that could be expected to affect stock values
• Price-driven volatility, on the other hand, works in the opposite direction – it is caused by investors reacting to what is happening in the stock market itself– i.e., there is a reassessment of stock valuations solely as a
consequence of changes in stock prices …– rather than stock prices changing as a consequence of changes
in stock valuations that are being driven by outside information
• This is very close to the “adaptive” component in the view of the market as a complex adaptive system
SynthesisSynthesis
The results of many old studies, The results of many old studies, when considered together, point when considered together, point
to startling new conclusions.to startling new conclusions.
ContentionsContentions
Price-driven volatility is the largest of the three components.Price-driven volatility is the largest of the three components. Price-driven volatility is explosive.Price-driven volatility is explosive. Price-driven volatility is an important drag on long-run economic Price-driven volatility is an important drag on long-run economic
growth.growth. Explosions in Price-driven volatility create disruptions in economic Explosions in Price-driven volatility create disruptions in economic
activity.activity.
For example. the Great Crash of 1929 caused the Great Depression.For example. the Great Crash of 1929 caused the Great Depression.
Mysteries of the Stock MarketMysteries of the Stock Market
Too much stock volatility Too much stock volatility (Shiller, (Shiller, American Economic Review, 1981)American Economic Review, 1981)
Market Price and Perfect Forecast Price: Constant Discount RatesMarket Price and Perfect Forecast Price: Constant Discount Rates
19001900 19101910 19201920 19301930 19401940 19501950 19601960 19701970 19801980 19901990
YearYear
66
1010
1414
1818
2222
2626
3030
3434
P/E
P/E
30
PPt t / E/ Ett3030
PFPFt t / E/ Ett3030
Mysteries of the Stock MarketMysteries of the Stock Market
Too much stock volatilityToo much stock volatility
Volatility too unstable Volatility too unstable (Haugen, Talmor, and Torous, (Haugen, Talmor, and Torous, Journal Journal of Financeof Finance, 1991), 1991)
Volatility Shifts Over 8-week Trading PeriodsVolatility Shifts Over 8-week Trading Periods
HTT find (with 99% confidence) 402 cases where HTT find (with 99% confidence) 402 cases where volatility becomes significantly larger or smaller volatility becomes significantly larger or smaller between the first and second 4-week blocks.between the first and second 4-week blocks.
Realization of Risk Premiums Following the Realization of Risk Premiums Following the Price-level AdjustmentsPrice-level Adjustments
Following the price-adjustments to volatility Following the price-adjustments to volatility changes, subsequent stock returns are, on changes, subsequent stock returns are, on average, 460 basis points higher following average, 460 basis points higher following volatility increases. (The higher required returns volatility increases. (The higher required returns are apparently realized.)are apparently realized.)
Interestingly, only 10% of the shifts have an Interestingly, only 10% of the shifts have an associated cause traceable in the media. associated cause traceable in the media.
Mysteries of the Stock MarketMysteries of the Stock Market
Too much stock volatilityToo much stock volatility Volatility too unstableVolatility too unstable Unconnected market Unconnected market
((Cutler, Poterba, and Summers, Cutler, Poterba, and Summers, Journal of Journal of Portfolio ManagementPortfolio Management, 1989), 1989)
Percentage Changes in Stock Percentage Changes in Stock Prices on 49 Historic DaysPrices on 49 Historic Days
Examples:Examples:
Pearl Harbor AttackedPearl Harbor Attacked -4.37%-4.37%
Roosevelt DiesRoosevelt Dies 1.07%1.07%
Bay of PigsBay of Pigs .47%.47%
John Kennedy AssassinatedJohn Kennedy Assassinated -2.81%-2.81%
Robert Kennedy Assassinated Robert Kennedy Assassinated -.49%-.49%
ChernobylChernobyl -1.06%-1.06%
Percentage Changes in Stock Percentage Changes in Stock Prices on Historic DaysPrices on Historic Days
Average absolute return Average absolute return over 49 historic days over 49 historic days 1.46%1.46%
Average absolute return Average absolute return over all other days over all other days .56%.56% (standard deviation: .82%)(standard deviation: .82%)
““Events” Associated with the Five Largest Events” Associated with the Five Largest One-day Percentage Changes in Stock PricesOne-day Percentage Changes in Stock Prices
Worry over dollar Worry over dollar (10/19/87)(10/19/87) -20.47%-20.47%
Deficit talks in Wash. Deficit talks in Wash. (10/21/87)(10/21/87) 9.10%9.10%
Fear of deficit Fear of deficit (10/26/87)(10/26/87) -8.28%-8.28%
No reason for decline No reason for decline (09/03/46)(09/03/46) -6.73%-6.73%
Roll-back of steel prices Roll-back of steel prices (05/28/62)(05/28/62) -6.68%-6.68%
Haugen vs. Mauboussin (Again)Haugen vs. Mauboussin (Again)
• Note that the previous observation is consistent with Mauboussin’s hypothesis of the financial markets as a complex adaptive system
• Nonlinearity causes stock price movements to bear little relation to specific definable causes
““The Inefficient Stock Market”The Inefficient Stock Market”
• 3rd book in trilogy• Focuses on expected return factor models
– Attempt, in part, to exploit error-driven volatility• Positive payoff to cheapness results from market’s overreaction to
success and failure
• Positive payoff to intermediate term momentum results from the market’s underreaction to positive and negative earnings surprises in individual earnings reports
– Also exploit the distortions in the structure of stock prices brought about by price-driven volatility
It’s Tough to Beat the MarketIt’s Tough to Beat the Market
• It the market is so inefficient, why isn’t beating it “like taking candy from a baby?”
• Two reasons:1. Many professional investors are victims of their
own agency problems
2. More importantly, a gale of unpredictable price-driven volatility stands between investors and the “candy”
It’s Tough to Beat the MarketIt’s Tough to Beat the Market
1. Professional investors are victims of agency problems– Easier to make a “story” for growth stocks than for value stocks– Worry about “benchmark risk” rather than total risk
2. Gale of unpredictable price-driven volatility stands between investors and consistent profits
– Price-driven volatility is unpredictable, increasing the element of chance in stock returns
– Even after maximizing predictability of stock returns, only 10% of differences in monthly stock returns can be explained by model
– Overvalued growth stocks can always go up even more before finally “coming down to earth”
The Wrong 20-Yard LineThe Wrong 20-Yard Line
• Spectrum of market efficiency equivalent to positions on a football field– At one end zone, perfectly efficient markets– At other end, completely inefficient markets
The Wrong 20-Yard LineThe Wrong 20-Yard Line
Near efficient markets end zone (the left end zone):• All volatility is event-driven• Models based on rational economic behavior do a
good job of explaining and predicting market pricing
• No under- or over-valued stocks, so no role for active investment– No inefficiencies for active managers to exploit– Fact that fund managers tend to underperform the
market taken as evidence that markets are efficient
The Wrong 20-Yard LineThe Wrong 20-Yard Line
Near the other endzone (the right end zone):
• All volatility is price-driven
• Market pays no attention whatsoever to fundamentals
• Market, in the short-term, is in a state of complete and unpredictable chaos
The Wrong 20-Yard LineThe Wrong 20-Yard LineAs we move from the left to the right end zone:• Models based on rational economic behavior begin to
lose power• As you cross midfield, behavioral models begin to
dominate– Note: under these models, markets have biased reactions to
real economic events, but they do still react to real economic events
• As you move to the extreme right, even behavioral models lose power, and the market reacts only to its own events (at least in the short run)– Aerialists pay no attention to the wire whatsoever
The Wrong 20-Yard LineThe Wrong 20-Yard LineActive managers would perform best when the market is
near the 60-yard line:• Too close to the efficient markets end zone, and there are
no inefficiencies for the active managers to exploit• Too close to the inefficient markets end zone, and
unpredictable, price-driven volatility begins to dominate, making it nearly as impossible for active managers to beat the market as at the right end zone– Best way to do well in this case would be by buying future
dividend streams at relatively cheap prices, cf., Warren Buffett
• Lack of clear success by active managers indicates only that we are near one of the end zones, not which one we are near
The Wrong 20-Yard LineThe Wrong 20-Yard LineMost finance professors:• Believe the markets are close to the efficient markets
end zone, maybe at the 20-yard lineHaugen believes:• Price-driven volatility is unstable• When it explodes, the markets may approach the 10-
or even the 5-yard line• When it recedes, the markets may cross the 50-yard
line into the other end of the field• But, on average, the markets are more likely to reside
near the right-end 20-yard line
The TriumphThe Triumph• Finance needs to go back and forth between theory and
empirical findings– Can’t remain stuck on the theory of Modern Finance– Need to move on to a new paradigm
• Haugen’s suggestion – The New Finance– Built on a foundation of statistics, econometrics, and
psychology– Look at what works, not just at what theory says should work– Allows for an integration of evidence contradicting the efficient
markets hypothesis