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The Inefficient Stock Market Chapter 15: “The Wrong 20-Yard Line” The Trilogy “The New Finance” “Beast “The on Wall Street” Inefficient Stock Market” “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 Length of the Short Run • Prior to 1924 - Stock valuation based on current normalized earnings. • 1925 - E. L. Smith advises stock valuation based on future growth - New Era Theory. • 1934 - Graham and Dodd dispute New Era Theory’s views on growth and valuation. • 1960’s - Growth stock investing makes comeback. But … • The speed of mean-reversion in earnings growth appears to be quite fast. • If, in general, it is faster than the market expects, cheap (expensive) stocks should tend to grow faster (slower) than expected. • If this happens, cheap stocks should tend to out-perform expensive stocks. The Relative Performance of Portfolios Equallyweighted 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 Between the Returns to Value and Growth Composites 50% 30% 20% -10% -20% Year 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 1977 1976 1975 0% 1974 10% 1973 Relative Difference 40% Seasonal Returns to Value and Growth Portfolios 14% 12% Average Monthly Return 10% Prior Losers January Feb. - Dec. 8% 6% 4% 2% 0% 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 What has Over-estimation of the Length of the Short Run Done to Risk and Return? • Cheap (expensive) stocks tend to have surprisingly high (low) realized returns • Cheap (expensive) stocks tend to have low (high) volatility, because little (much) is expected of them • Investors may expect higher returns from expensive stocks but they may be repeatedly surprised by disappointing earnings reports How Long Have Risk and Return Been Upside Down? • If it’s caused by an over-estimation of the short run, it should begin with the renaissance of growth stock investing at the end of the 1950’s. • What has been the relative performance between the low-volatility stock portfolio and the market index over time? Cumulative Difference in Return Between Low Volatility Portfolio and S&P 500 Cumulative Difference 25% 15% 5% -5% -15% -25% -35% 1928 1938 1948 1958 1968 1978 1988 The Relationship Between the Perceived and True Growth Horizon and Average Growth Rates • Define the growth horizon as the length of time a typical stock takes to mean-revert to the average rate of earnings growth. • The evidence indicates that the perceived horizon is longer than the true horizon. The Relationship Between the Perceived and True Growth Horizon and Average Growth Rates • The true horizon tends to be relatively constant, but investor perceptions may change. • If investors perceive that relative differences in growth will persist for longer periods, growth stocks may out-perform. • Changes in the perceived horizon may create a cycle in growth/value performance. Rolling Annualized Average 5-year Difference Between the Returns to Value and Growth Composites 50% 30% 20% -10% -20% Year 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 1977 1976 1975 0% 1974 10% 1973 Relative Difference 40% “Beast on Wall Street” 2nd book in trilogy Focuses Three on stock volatility components of volatility Three Components of Stock Volatility Event-driven volatility Error-driven volatility Price-driven volatility High-wire Act at the Financial Circus The wire The aerialists Movements in balance bars The economy Different stocks Movements in stock prices Components of the Movements in the Balance Bars Event-driven The best moves in the bars humanly possible Error-driven Over- and under-reactions to shocks in the wire Price-driven Aerialists interacting with each other Haugen 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 Synthesis The results of many old studies, when considered together, point to startling new conclusions. Contentions Price-driven volatility is the largest of the three components. Price-driven volatility is explosive. Price-driven volatility is an important drag on long-run economic growth. Explosions in Price-driven volatility create disruptions in economic activity. For example. the Great Crash of 1929 caused the Great Depression. Mysteries of the Stock Market Too much stock volatility (Shiller, American Economic Review, 1981) Market Price and Perfect Forecast Price: Constant Discount Rates 34 Pt / Et30 30 P/E 30 26 22 18 14 PFt / Et30 10 6 1900 1910 1920 1930 1940 1950 Year 1960 1970 1980 1990 Mysteries of the Stock Market Too much stock volatility Volatility too unstable (Haugen, Talmor, and Torous, Journal of Finance, 1991) Volatility Shifts Over 8-week Trading Periods HTT find (with 99% confidence) 402 cases where volatility becomes significantly larger or smaller between the first and second 4-week blocks. Realization of Risk Premiums Following the Price-level Adjustments Following the price-adjustments to volatility changes, subsequent stock returns are, on average, 460 basis points higher following volatility increases. (The higher required returns are apparently realized.) Interestingly, only 10% of the shifts have an associated cause traceable in the media. Mysteries of the Stock Market Too much stock volatility Volatility too unstable Unconnected market (Cutler, Poterba, and Summers, Journal of Portfolio Management, 1989) Percentage Changes in Stock Prices on 49 Historic Days Examples: Pearl Harbor Attacked Roosevelt Dies Bay of Pigs John Kennedy Assassinated Robert Kennedy Assassinated Chernobyl -4.37% 1.07% .47% -2.81% -.49% -1.06% Percentage Changes in Stock Prices on Historic Days Average absolute return over 49 historic days 1.46% Average absolute return over all other days .56% (standard deviation: .82%) “Events” Associated with the Five Largest One-day Percentage Changes in Stock Prices Worry over dollar (10/19/87) -20.47% Deficit talks in Wash. (10/21/87) 9.10% Fear of deficit (10/26/87) -8.28% No reason for decline (09/03/46) -6.73% Roll-back of steel prices (05/28/62) -6.68% 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” • 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 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 pricedriven volatility stands between investors and the “candy” It’s Tough to Beat the Market 1. Professional investors are victims of agency problems – – 2. Easier to make a “story” for growth stocks than for value stocks Worry about “benchmark risk” rather than total risk 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 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 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 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 Line As 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 Line Active 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 Line Most finance professors: • Believe the markets are close to the efficient markets end zone, maybe at the 20-yard line Haugen believes: • Price-driven volatility is unstable • When it explodes, the markets may approach the 10or 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 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