Efficient markets

The efficient (financial) markets hypothesis still has plenty of defenders, though their arguments are looking rather ragged at present. Coincidentally, it’s ten years since the merger of Time Warner and AOL, the biggest and most disastrous in history. If any single event symbolises the failure of the EMH, it’s this merger, driven by the ludicrous valuations of the dotcom era. As I commented at the time

If the accounting numbers are taken at face value, AOL Time Warner will have a price-earnings ratio of about 350 to 1, modest by Internet standards. When options are taken into account, the ratio is more like 1000 to 1. It is difficult to see how an economy in which investment decisions are based on numbers like these can avoid some sort of financial catastrophe

35 thoughts on “Efficient markets

  1. Well theoretically you might use a compromise between these three:

    1. Estimate of discounted future dividends to be paid by the company.
    2. Estimate of discounted future retained profits to be earned by the company.
    3. Estimate of the companies current asset value.

    But the thing is, if the company is using debt and is subject to a tax on its retained earnings then the right behaviour, in terms of management serving the shareholder interest, is indeterminate. Even if you could predict their potential earnings you are still not to come up with a good share price, nor can you prescribe what management behaviour ought to consist of with certainty. Because management doesn’t have a clear policy with which to act upon.

    If there is debt involved the companies valuation can be dependent on the rate of monetary growth. Since a highly leveraged company can be better off with a burst of monetary growth. If the company goes for a high return on total assets it will wind up paying a lot more tax and it is not really possible to know if management is thereby doing the right thing. What this leads to is a massive magnification of the problem of agency.

    The market can therefore be made more “efficient” by removing those factors which create all this ambiguity and by at the same time allowing the company to buy back shares.

    Debt-financing, erratic monetary policy, and taxes on profits all add ambiguity to the job of pricing the shares. But without these factors the job of management is very clear cut. They ought to maximise book value divided by outstanding shares. And if the company is undervalued they can use their profits to buy back some of these shares. Without the ambiguity of the factors mentioned then its clear that the company must strive at all costs to make a profit every quarter. Even if this means going into retrenchment.

  2. @Michael Harris

    “The first is that unless the investor has some inside information not available to other investors, he cannot tell if stock prices are too low, too high, or just right. This means that on average you can’t gain by using a general theory that says when stocks are over- or under-valued. The evidence in favor of this theory is overwhelming”.

    Would the investor, Mr or Ms “on average” please stand up?

    The article refers to the Fama strand of the efficient market literature. The Fama strand is methodologically severely flawed. The original 1970 and 1976 Fama hypothesis (3 forms) is not refutable by design. The above quoted statement relates to a severely watered down statement (as per Frank Milne’s 1983 unpublished paper). But even this watered down version is fundamentally flawed:

    If the entire financial system collapses (characterised by no issue of and no trade in financial securities – not a farfetched scenario) then by the methodology of Fama and his disciples, the hypothesis that ‘the market’ is efficient can’t be rejected because nobody is making any monetary profit as of the date of the meltdown event. (But those who have a few chooks in the backyard may survive and prosper relatively well in a commodity exchange community at least for some time. This corresponds to some general theory and to empirical evidence in the form of Germany after WWII)

  3. @smiths
    Smiths – the rule of law is applicable to all only in criminal law and only in prosecution. Defence is available only to those who can afford it or only to those with such a low income that legal aid applies. Civil law is available only to those who can afford it. Law may be applicable to all but the protection it affords is not available to all.

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