Taking Another Shot At Market Efficiency

The market is inefficient.

What I mean by this is that the market is always in a state of controlled chaos. Some may consider this equilibria, but it is equilibria in a very limited sense of the word. Equilibria is not the same as intrinsic or fundamental value (which is also in the eye of the beholder).

Because market prices are a function of consensus feelings, emotions, expectations and sentiment regarding earnings, interest rates, risk and the future (in other words they reflect the current zeitgeist of the day and embed some feelings for the future), they are necessarily wrong all the time. No one knows what the future holds. Of course as markets correct and swing from overvalued to undervalued and vice versa, they must by definition pass through some median or fair value point. The problem is they rarely trade at the fair value point for any steady state period of time.

Getting cyclical trend and momentum right are consequently the most important ingredients to long term active investing, while have a mean reversion contrarian disposition can help cut off the excesses of the tails. The problem is we never really know beforehand the timing, time or magnitude of any new cycle.

Therein lies the problem.

Is The Market Efficient?

I have asked this question a time or two before. But I have thought about it in a different way and have decided for today that the market is not efficient. At least not efficient in the sense that it adheres to some average valuation level.

The problem is the market is overvalued and undervalued for long periods of time. It is hard for an investor to know when it will revert to the mean, and in all likelihood overshoot on the other side.

Overshoot and undershoot are a structural aesthetic of the market. The duration and magnitude of overshoot or undershoot is not well understood.

I would say the market is virtually never efficient. At least not from a valuation perspective.

It seems to me that there are times when the market is overvalued. The implication is market participants are expecting better things in the future. And there are times when the market is undervalued. The implication being market participants are expecting worse things in the future. But throughout, regime changes and overshoot are a function of changing expectations, money flows, fear/greed levels, and liquidity. 

Over and undervaluation point to correlated mistakes.  Paul Samuelson said something to the effect, markets are macro inefficient but micro efficient. That is probably right although it doesn't make much sense.

Just as correlations and assumptions of normal distributions are non-stationary and change over time, so to does the market average valuation line. With that being the case, one would presume that more recent data (valuation levels) would be more relevant for ascertaining the "modern" average valuation level as compared to a longer term mean. This may or may not be a good assumption to make. Only time will tell ('tis the answer to everything).

What Is Market Efficiency?

No one knows what intrinsic value really is. That is what makes a market. Myriad investors with different amounts of money, different levels of sophistication and different motives place their bets and the current market price is where that supply and demand meet.

I believe there is such a thing as intrinsic value. However, intrinsic value is in the eye of the beholder (different investors use different discount rates, different growth and profitability assumptions, different multiples) and is better looked at as something within a band or range of values (as compared to a singular point estimate). At a micro level that band is narrower for individual companies than it is for the market as a whole. As you add companies to the investment universe, the number of factors, level of uncertainty and multitude of different individual value ranges expands the general market's intrinsic value range.

So, for example, a company's intrinsic value may range between $18-$22 given all currently available information. This might translate to a multiple of 14x-16x based on an historic average multiple of 15x. This does not mean a company's stock will be priced within its intrinsic value range. Conversely, the general market's intrinsic value may range between $16-$24 based on cumulative individual valuations with a multiple ranging from 12x-18x based on a historic average multiple of 15x.

When the market price (and a company's price) is within its intrinsic value range you should go with the trend (momentum). When the market price goes outside its intrinsic value range that is when you should adopt a contrarian or mean reversion position.

80% of the time, the market trades within its intrinsic value range. But there are times when "animal spirits" (whether fear or greed) commandeer the zeitgeist and lead to exploitable inefficiencies (playing defense when things are overcooked and offense when things are falling apart).

A Developing Thought - Traditional Security Analysis as Scholastic Philosophy

In the same way traditional security analysis sought to justify rationally, ie. put a structure around, what the marketplace already accepted so Scholasticism sought to justify rationally what the church had already accepted.

The main schools of thought during the scholastic period were universalia ante rem (essence precedes existence) and universalia post rem (existence precedes essence) arguing over what came first or what comes first, essence or existence. The same can be applied to security analysis with regard to whether fundamental value comes first or market price comes first.

In the ethical/moral realm scholastics guiding light was summum bonum (absolute good) as the yard stick for devining whether something was good (a relative value basis). In security analysis there is the implied belief that there is some fundamental/intrinsic value based upon some as yet unknown future set of cash flows discounted at an appropriate rate that equals an assets true value (absolute value) which can then be compared to its current market price to determine whether it is undervalued or overvalued.

This is still a developing thought, but one I hope to explore a little more in the future.

Likewise, modern finance (Modern Portfolio Theory, Efficient Markets, CAPM) may be equated with the philosophy trends of the enlightenment (especially Hume's rationalism), and recent developments in finance practice (HFT, quantification, algos) may be equated with quantum physics or existentialism.