Who can beat the market?

Still nothing to write home about on Wall Street. No big sell-off. No big boom. It’s late summer. Stocks are high and the mommas are good lookin’.

When we left off our series yesterday, we had run through the basics of the Efficient Market Hypothesis (EMH), and the reasons it is not correct, and how you can benefit from other investors’ mistakes. 

In a nutshell, just do the maths. When a stock is worth more than the market price, sell. When it is worth less, buy. When it is in between, just sit tight. There, what could be simpler? 

How do you figure out how much a stock is really worth? Read Ben Graham’s classic, Security Analysis. Everything you need to know is there. 

No time for security analysis? Well, our STS (Simplified Timing System) is about as simple as it gets. Buy when the Dow is under ten times earnings. Sell when it gets over 20. Otherwise, do nothing. That’s the hard part. 

Your editor likes STS, because he doesn’t have the temperament for detailed stock research. 

Will it work for you? Hey, no one knows. All we know is that it has in the past. Following the STS over the last 114 years would have allowed you to participate in the big run-ups in the ‘20s, the ‘60s, and the ‘80s/’90s.

Each time, your friends would have told you that you “sold out too soon”. But you would have missed the big drawdowns of the ‘30s, the ‘70s, and the early ‘00s too. 

Of course, this time could be different! Maybe the STS approach won’t work anymore. Remember, you can never prove a hypothesis; you can only disprove it.

And maybe you don’t want to wait five, ten or 20 years for the price/earnings (p/e) ratio to fall under ten, so you can get into the stock market, anyway. Everything has a price. And the price you pay for the safety and performance of STS is time. 

But today, we want to take up the subject from a slightly different direction. We want to explain a hypothesis of our own view. 

First, as you could see from our discussion of EMH and its critics, the matter was far from decided. On the one hand, EMH says investors are rational, profit seeking people who will use all the known facts and opinions to set the right prices. The other says they will consistently err.

But the other side also says that while some investors are smart enough to take advantage of other investors’ errors, they are not smart enough to eliminate them. There’s the rub. Why not? 

Both sides believe that stocks have a ‘correct’ price. EMH advocates believe the correct price is set by the market. EMH critics believe the market frequently errs, and that its mistakes are observable, calculable and correctable (or arbitrageable).

The critics do not explain how come – assuming you can see them and bet against them – the ‘innovations’ persist. 

Seeing a stock underpriced by the mob should bring forth buying on the part of the smart money, thus bringing the price immediately back into line with expected earnings.

Porter attempted to explain this inconsistency by saying errors persisted only in ‘inefficient’ markets and so forth. But if there were money to be made, you’d think an ignored market would attract interest and become much more efficient, fast.

He also said that ‘conflicts of interest’ prevented the big players from betting against certain anomalies. But that assumes all the big players are on the same team. They are not.

Our experience of Wall Street tells us that the big firms are very cannibalistic. Given a choice, they would prefer to feast on the carcass of one of their own species than on the flesh of small investors. 

It is more likely that the ‘errors’ persist, because they are not as visible and redressable as the critics maintain. They are errors of judgment – and thus subject to a substantial amount of error themselves – not errors of calculation. 

In short, our hypothesis is this: both EMH and its critics are wrong. Markets are not ‘perfect’ nor ‘efficient.’ But neither are they mistaken, in the sense that errors are obvious and calculable. The smart money is not just observing and correcting mistakes; it is also making its own guesses, and, often, its own mistakes. Often, the smart money succeeds. Sometimes it does not. 

Our hypothesis comes from the recognition of the asymmetry of knowledge. We can never know what a stock is worth. All we can do is guess. It stands to reason, that people who do their homework take better guesses. 

But there are no ‘correct’ answers. The market discovers new prices every second based on all the inputs to which humankind is receptive. Those include a rational calculation of the present value of a stock’s expected future earnings, discounted for risk.

Also included are opinions, guesses, rumors, myths, and all manner of prejudicial half-truths – some firmly founded on logical thought and observation, others more delusional and whimsical. 

There are no ‘innovations.’ Because there is no correct answer to innovate against. 

The market merely aggregates opinions – right, wrong, stupid, baffling – and discovers a consensus. Usually, those who do the hard work of valuing an income stream make better predictions about tomorrow’s consensus prices. But not always. 

In our view, a market – and life itself – is only somewhat subject to rational calculation. Sometimes, doing the numbers works. Sometimes, yesterday’s numbers give no hint of things that will happen tomorrow. 

There’s more to the story, something else going on. Something that often defies your logic and throws your hard work in your face. Just what kind of thing are we dealing with?