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Economic Insights
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Subsuming the Efficient Market Hypothesis
By Keith C. Goddard, CFA
March 1, 2011

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Those very bright people together choked on the assumption that housing prices would never collapse on a nationwide basis.  How silly was this assumption at the time, when in recent history, U.S. housing prices had never collapsed on a nationwide basis?  Anyone who built a model of the housing market from the actual history of home prices might be forgiven for failing to anticipate an event unprecedented in the long-term historical record.  Rational? Yes. But very wrong nonetheless.

Rational Irrationality (RI), as presented by Edesess in his recent article, is a fascinating complement to RBE because it supports the same notion that rational investors get it wrong from time to time, but it reaches the same conclusion from a different starting point.  Whereas RBE describes investor mistakes as a natural consequence of normal people feeling their way through an uncertain world, RI shows that, sometimes, incentives in the marketplace align in such a way that the practical self-interest of individuals produces disastrous results for the system as a whole.  A classic example is bank runs, wherein each individual depositor is justified in withdrawing money from a struggling bank, but many individuals doing so ultimately cause the bank to fail.

Referring back to the recent housing crisis, it is clear that elements of both RBE and RI were at work in that cycle.  The collective mistake that allowed a housing bubble to form in the first place can be explained by Kurz’ theory of Rational Beliefs.  Yet it was the perverse incentive structure that evolved within the ecosystem of lenders, mortgage brokers, investment banks, and ratings agencies that ultimately inflated the bubble to disastrous proportions.  This latter element is a case study in Rational Irrationality.

Theories like RBE and RI are important because they have the potential to change investor behavior for the better if market participants ever adopt them to the same degree that they have embraced EMH over the past 50 years.  Consider how differently investors might behave if they begin with an assumption that market prices are more likely to be wrong than right.  One thing that might change is the dumbfounding refusal among proponents of EMH to acknowledge that asset markets move in cycles.  Exploitation of these cycles may be the most valuable service professional investors can provide, yet the vast majority of them chooses to behave as if the cycles don’t even exist.

Two market cycles offer practical value for investors willing to exploit them.  The first is a valuation cycle based on the cyclically adjusted price-to-earnings ratio (CAPE) in the stock market.  Yale economist Robert Shiller provides a valuable service for investors by sharing his database for the U.S. CAPE going back to 1871. The research team at my firm, Capital Advisors, Inc., has studied Shiller’s data extensively.  We found a stark difference in the distribution of outcomes for stocks based on different starting points.  The table below tracks the distribution of three-year returns for the U.S. stock market starting from four different valuation quartiles for the CAPE:

Distribution of 3-Year Returns
U.S. Stocks:  1881 - 2010
1,524 Overlapping (monthly) Observations


Beginning Valuation
(CAP)

Average
Three-Year
Return  

Best

     Worst

Frequency
 of
Negative
Returns

Cheapest Quartile
(4.8 – 11.6)   

16.3%

194.5%

0.9%

None

2nd Quartile
(11.7 – 15.6)             

9.6

176.2

(23.5)

9.0%

3rd Quartile
(15.7 – 19.4)             

6.8

99.5

(35.4)

23.4%

Expensive Quartile
(19.5 – 44.2)      

5.9

134.1

(80.8)

32.0%

Source:  Robert J. Shiller; Standard & Poor’s; Bloomberg, LP; Capital Advisors, Inc.

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