Stock Market Efficiency, part 3


Here is what I believe is the only way the stock market can keep returning 10% a year despite everyone knowing it returns 10% a year: everyone doesn't actually "know" it returns 10% a year.

To clarify, I think everyone does "know" this fact much of the time; let's call these the times of Faith. People know it and believe it. But there are long stretches of time when they don't believe it; let's call these the times of Heresy.

During times of Faith, people look back at the average historical 10% returns and expect 10% returns in the future. The actual returns are probably zero or negative since the returns are already discounted.

During times of Heresy, people look back at recent history (the times of Faith) and see zero or negative returns and convince themselves that the stock market is last place to put your money. The actual returns are positive because no discounting takes place.

Average together the times of Faith and Heresy and you get a 10% yearly returns over the long term.

Does history agree with my theoretical conclusion? I believe so. There have been long stretches during which the average returns (not accounting for inflation or deflation) are zero: 1929-1954 and 1966-1982. At the end of those stretches of 25 and 16 years respectively, I imagine people were thoroughly disgusted and convinced that the stock market is a money pit. Those would've been the best times to invest.

Some implications:

  • A contrarian approach to investing is irrefutably necessary. Efficiency demands it. I put this in bold for emphasis. It is simply impossible to beat the stock market without being a contrarian.
  • Because the average return is 10% a year, the historical returns during the times of Heresy have to be much higher. The way to riches is to save up during times of Faith and invest only in times of Heresy. Easier said than done, I agree.
  • One doesn't need to know anything about economics or finance to succeed at investing; one only needs to accurately measure people's faith in the market.
  • I believe we are currently in a time of Faith. People haven't given up completely on the market. Few heretics are seen in the popular press. Give it a few more years.
  • The much ballyhooed "confidence" is a lagging, contrarian indicator.
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Sounds good to me. Not sure

Sounds good to me. Not sure about using the word "irrefutable", since in context, you're saying, it's irrefutably necessary if you're right. But of course, everything is irrefutable if it's right. :)

Please, please get familiar

Please, please get familiar with the mainstream explanation first. Unfortunately I've been apparently unsuccessful at explaining it.

There is no reason an average risky return should be discounted because people are risk averse.

Let me create a company X now. X will raise capital from you and gamble it all on a coin toss, double or nothing by the end of the year.

I've started selling a few shares, the current price for $1000 of capital is $900. Oh my god it's a guaranteed average10% return , what are you waiting for, buy from me !

Yes and No, or On Personal Finance

The Faith/Heresy thesis finds some support in the evidence that a huge percentage of stock market gains occur on a minority of trading days. In other words, the median daily return is much less than the average.

But if you believe in an efficient market, then I can’t see the merits of a contrarian strategy—or indeed any strategy that is not grounded in how your personal characteristics differ from the marginal person’s characteristics. For a contrarian strategy to work, you’d have to believe that you alone have some unique capacity to evaluate and exploit publicly-available information; that’s pretty much the definition of an inefficient market. Even if a majority of people are dupes, how many contrarians would it take to bid up the price of stocks just as the market was about to resume its growth in order to eliminate the benefits of a contrarian strategy?

Because I largely accept the efficient market hypothesis, I conclude that the principle strategic choice I make is to decide whether to invest in stocks. Having decided to do so, the only real move I have is to ensure that I hold my stocks during those high-growth trading days. Because I believe in the efficient market hypothesis, I don’t believe I can benefit from any discoverable short-term jump; the only way I can benefit is if the jump is not foreseeable – by me or anyone else – and therefore the benefit is not already incorporated into the price of stocks. Now, how can I benefit from a stock market swing I can’t anticipate? Only by being invested at all times. It’s simple Buy and Hold.

An aside: Investing advisors often ballyhoo the benefits of “dollar-cost averaging” – that is, investing the same amount in the market every month, such that you buy more shares when prices are down and fewer shares when prices are up. Yet dollar-cost averaging is really just another form of market timing. It may reduce your risk, but it also reduces your return. Thus, if you have a pot of money, the stock-market strategy that tends to yield the maximum return (unadjusted for risk) would be to invest the entire lump sum today, not to dribble the investment into the market over time. (Plus, it will simplify your accounting.)

This isn't new territory

I imagine people were thoroughly disgusted and convinced that the stock market is a money pit. Those would've been the best times to invest.

Well, to be accurate, the ends of those periods would have been the best times to invest. This isn't new territory though. See, for example, Vitaliy Katsenelson's thesis on secular markets.

Because I believe in the efficient market hypothesis

The efficient market hypothesis is sort of in tatters today, at least the strong version of it. It's mostly true over the long term, but not in the near term. This is an observation that precedes the term "Efficient Market" itself, since it was encapsulated in Benjamin Graham's old aphorism that the market is a "voting machine" in the short term but a "weighing machine" in the long term.

For some examples of why the market isn't fully efficient in the short term, you could look up a number of stocks that were trading for less than their net cash earlier this year (e.g., USEG, KSW). Reasonable people can disagree on what a particular going concern is worth, but who would argue that the underlying, unencumbered, business of a company plus its potential future cash flows, its fixed assets, etc., should be worth a negative number? And yet that's exactly what the market was saying by valuing some companies at less than the net cash they had on their books. If the market were fully efficient, these companies would not have traded for less than their net cash.

If the market were fully

If the market were fully efficient, these companies would not have traded for less than their net cash.

I can conceive of reasons one might value a company at less than its net cash, for example a nonzero probability that the cash will be wasted. I don't mean the CEO is expected to gamble it away in Las Vegas. I mean it might be wasted in perfectly ordinary ways, such as continuing to pay the salaries of the employees without enough revenue to replenish the cash.

In principle, of course, the stockholders could vote to immediately liquidate and sell the company's assets, but there practical problems with this. Nor do I think that would be a violation of the EMF, as I understand the EMF to concern trading assets, not controlling them.

Let me give you some more

Let me give you some more details on one of the particular companies I mentioned above (KSW), and you can tell me if you still think the market was efficient in valuing it at less than its net cash. It so happens I used this company as an example in an exchange with a strong EHM adherent back in March, where I included the relevant numbers. Here was my comment to this fellow from 3/15:

KSW is an HVAC contractor in New York. I can tell you the proximate reason why it’s trading for less than its cash: a few months ago, two big projects in its backlog of business were put on hold. Beyond that, with the real estate bust, there are obvious concerns with a construction-related company. That said, the company is profitable and also does maintenance and new construction work in the government and not-for-profit sector — e.g., hospitals, court houses, etc. — and still has a backlog of business equal to about 70% of its revenues over the last year. In addition, it’s bidding on two new government projects next month that could potentially double its backlog.

So what should this company be worth? Some value investors might attempt to project out an earnings stream and discount that back to the present to come up with an “intrinsic value” for the company. I happen to think that sort of thing can lead to a false sense of precision. Another approach might be to consider what a similar private company might sell for. It so happens that I spoke to a business broker a few months ago who was selling a (much smaller) privately-held HVAC contractor in California. The minimum price his client was willing to sell for was several million dollars. His client’s HVAC company had $10 million in trailing revenues, versus about $87 million in trailing revenues for KSW.

Let’s imagine that this business broker was full of it, that he exaggerated his seller’s minimum price by factor of ten. Even in that case, his client’s company would be worth several hundred thousand dollars, and KSW would presumably worth more than that, as it’s a larger company.

A strong EMH adherent, I suppose, would argue that this company is worth whatever the market is currently paying for it. So what is the market currently pricing the company at? -$5.44 million (i.e., negative $5.44 million). This, I think, is an example of a market inefficiency. Reasonable people can disagree on what this company might be worth, but I don’t see how it can be worth a negative number — which is what the market is saying, considering that the company has, as of the most recently available data, $18.96 million in cash, no debt, and a market cap of $13.52 million.

1) It seems undervalued. 2)

1) It seems undervalued.

2) I'm too ignorant to make any judgment with confidence. In fact I'm so ignorant I don't know how it is possible for the market to price a company at a negative value. Does this mean I can acquire as much of the company's stock as I want and be paid for my trouble by the current owners who will pay me to take the stocks off their hands? That's ridiculous - but it just illustrates how little I know.

"I believe in efficient

"I believe in efficient markets, therefore I can market time via this method."

Okay... That line of reasoning doesn't quite follow. Why do you believe that you can find some measure of a contrarian position that will work if the efficient market orthodoxy is at the core of your beliefs?

Read "A Random Walk Down Wall Street" to get a baseline understanding of what people mean when they talk about efficient markets so you can figure out what a nonrandom walk down wall street looks like (Which happens to also be the title of another good book).


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