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Top 952. Jul 22, 2000 10:36 AM

» Kirk - Some Quotes for Rande

Some funnies:

"We have two classes of forecasters: Those who don't know--and those who don't know they don't know."

John Kenneth Galbraith

"Personally, I think everybody who predicts the future with a straight face should be required (by federal law) to change out of the business suit, wrap him/herself in a gypsy shawl, wear one of those pointed wizard's hats with a picture of a crescent moon on it, and make conjuring sounds over a crystal ball. That way, everybody would know exactly what's going on and how much credibility to give the answer."

…..Robert N. Veres, The Vision Thing in Investment Advisor (June 97)

My definition of a guru is someone who is lucky enough to be quoted in the right publication at the right time saying the right thing.

Herb Greenberg (The Street - 3/4/98)

I wonder what Bob will have to say about the future today? lol! ;)

-- posted by Kirk

Top 953. Jul 24, 2000 9:33 AM

» Rande - Nice to see the site back up -- guess it was a good time to be a

Nice to see the site back up -- guess it was a good time to be away for a few days.

Kirk -- great quotes!

-- posted by Rande

Top 954. Jul 24, 2000 9:49 AM

» Rande - Good answers from Kirk on the questions posed above.

Good answers from Kirk on the questions posed above. Would just add 1) There is software out there with which to search bond funds based on such things as percentage of certain levels of credit quality, etc., and 2) Agree that paying too much attention to after-hours action is even worse than paying too much attention to regular session trading.

-- posted by Rande

Top 955. Jul 24, 2000 11:26 AM

» Rande - With some continued discussion about efficient markets and recen

With some continued discussion about efficient markets and recent mention here of Eugene Fama, thought the following from Investor Home would be of interest to some:

The Efficient Market Hypothesis evolved in the 1960s from the Ph.D. dissertation of Eugene Fama (link courtesy of Ibbotson Associates). Fama persuasively made the argument that in an active market that includes many well-informed and intelligent investors, securities will be appropriately priced and reflect all available information. If a market is efficient, no information or analysis can be expected to result in outperformance of an appropriate benchmark.

"An 'efficient' market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value." [Eugene F. Fama, "Random Walks in Stock Market Prices," Financial Analysts Journal, September/October 1965 (reprinted January-February 1995). One of Fama's recent papers (Market Efficiency, Long-Term Returns, and Behavioral Finance at the Social Science Research Network in Adobe Acrobat format) is one of the most popular investment downloads on the web. ]

The random walk theory asserts that price movements will not follow any patterns or trends and that past price movements cannot be used to predict future price movements. Much of the theory on these subjects can be traced to French mathematician Louis Bachelier whose Ph.D. dissertation titled "The Theory of Speculation" (1900) included some remarkably insights and commentary. Bachelier came to the conclusion that "The mathematical expectation of the speculator is zero" and he described this condition as a "fair game." Unfortunately, his insights were so far ahead of the times that they went largely unnoticed for over 50 years until his paper was rediscovered and eventually translated into English and published in 1964. (See Peter Bernstein's Capital Ideas for more on these topics.)

There are three forms of the efficient market hypothesis

1. The "Weak" form asserts that all past market prices and data are fully reflected in securities prices. In other words, technical analysis is of no use.

2. The "Semistrong" form asserts that all publicly available information is fully reflected in securities prices. In other words, fundamental analysis is of no use.

3. The "Strong" form asserts that all information is fully reflected in securities prices. In other words, even insider information is of no use.

Securities markets are flooded with thousands of intelligent, well-paid, and well-educated investors seeking under and over-valued securities to buy and sell. The more participants and the faster the dissemination of information, the more efficient a market should be.

The debate about efficient markets has resulted in hundreds and thousands of empirical studies attempting to determine whether specific markets are in fact "efficient" and if so to what degree. Many novice investors are surprised to learn that a tremendous amount of evidence supports the efficient market hypothesis. Early tests of the EMH focused on technical analysis and it is chartists whose very existence seems most challenged by the EMH. And in fact, the vast majority of studies of technical theories have found the strategies to be completely useless in predicting securities prices. However, researchers have documented some technical anomalies that may offer some hope for technicians, although transactions costs may reduce or eliminate any advantage.

Researchers have also uncovered numerous other stock market anomalies that seem to contradict the efficient market hypothesis. The search for anomalies is effectively the search for systems or patterns that can be used to outperform passive and/or buy-and-hold strategies. Theoretically though, once an anomaly is discovered, investors attempting to profit by exploiting the inefficiency should result its disappearance. In fact, numerous anomalies that have been documented via back-testing have subsequently disappeared or proven to be impossible to exploit because of transactions costs.

The paradox of efficient markets is that if every investor believed a market was efficient, then the market would not be efficient because no one would analyze securities. In effect, efficient markets depend on market participants who believe the market is inefficient and trade securities in an attempt to outperform the market.

In reality, markets are neither perfectly efficient nor completely inefficient. All markets are efficient to a certain extent, some more so than others. Rather than being an issue of black or white, market efficiency is more a matter of shades of gray. In markets with substantial impairments of efficiency, more knowledgeable investors can strive to outperform less knowledgeable ones. Government bond markets for instance, are considered to be extremely efficient. Most researchers consider large capitalization stocks to also be very efficient, while small capitalization stocks and international stocks are considered by some to be less efficient. Real estate and venture capital, which don't have fluid and continuous markets, are considered to be less efficient because different participants may have varying amounts and quality of information.

The efficient market debate plays an important role in the decision between active and passive investing. Active managers argue that less efficient markets provide the opportunity for outperformance by skillful managers. However, its important to realize that a majority of active managers in a given market will underperform the appropriate benchmark in the long run whether markets are or are not efficient. This is because active management is a zero-sum game in which the only way a participant can profit is for another less fortunate active participant to lose. However, when costs are added, even marginally successful active managers may underperform. (See "The Arithmetic of Active Management" from Nobel laureate William Sharpe for more on this subject.)

"I believe a third view of market efficiency, which holds that the securities market will not always be either quick or accurate in processing new information. On the other hand, it is not easy to transform the resulting opportunities to trade profitably against the market consensus into superior portfolio performance. Unless the active investor understands what really goes on in the trading game, he can easily convert even superior research information into the kind of performance that will drive his clients to the poorhouse . . . why aren't more active investors consistently successful? The answer lies in the cost of trading. [Jack Treynor, "What Does It Take to Win the Trading Game?" Financial Analysts Journal, January/February 1981 ]

If markets are efficient, the serious question for investment professionals is what role can they play (and be compensated for). Those that accept the EMH generally reason that the primary role of a portfolio manager consists of analyzing and investing appropriately based on an investor's tax considerations and risk profile. Optimal portfolios will vary according to factors such as age, tax bracket, risk aversion, and employment. The role of the portfolio manager in an efficient market is to tailor a portfolio to those needs, rather than to beat the market.

While proponents of the EMH don't believe its possible to beat the market, some believe that stocks can be divided into categories based on risk factors (and corresponding higher or lower expected returns). For instance, some believe that small stocks are riskier and therefore are expected to have higher returns. Similarly some believe "value" stocks are riskier than "growth" stocks and therefore have higher expected returns. See also Still on a random walk by Burton Malkiel in Bloomberg Personal Finance (July/August 98).

Faced with the inference that they cannot add value, many active managers argue that the markets are not efficient (otherwise their jobs can be viewed as nothing more than speculation). Similarly, the investment media is generally considered to be ambivalent toward the efficient market hypothesis because they make money supplying information to investors who believe that the information has value (beyond the time when it initially becomes public). If the information is rapidly reflected in prices, there is no reason for investors to seek (or purchase) information about securities and markets.

While many argue that outperformance by one or more participants in a market signifies an inefficient market, it's important to recognize that successful active managers should be evaluated in the context of all participants. Its difficult in many cases to determine whether outperformance can be attributed to skill as opposed to luck. For instance, with hundreds or even thousands of active managers, its common and in fact expected (based on probability) that one or more will experience sustained and significant outperformance. However, the challenge is to identify an outperformer before the fact, rather than in hindsight.
Additionally, in many cases, strong performers in one period frequently turn around and underperform in subsequent periods. A substantial number of studies have found little or no correlation between strong performers from one period to the next. The lack of consistent performance persistence among active managers is further evidence in support of the EMH.

"Market efficiency is a description of how prices in competitive markets respond to new information. The arrival of new information to a competitive market can be likened to the arrival of a lamb chop to a school of flesh-eating piranha, where investors are - plausibly enough - the piranha. The instant the lamb chop hits the water, there is turmoil as the fish devour the meat. Very soon the meat is gone, leaving only the worthless bone behind, and the water returns to normal. Similarly, when new information reaches a competitive market there is much turmoil as investors buy and sell securities in response to the news, causing prices to change. Once prices adjust, all that is left of the information is the worthless bone. No amount of gnawing on the bone will yield any more meat, and no further study of old information will yield any more valuable intelligence." [Robert C. Higgins, Analysis for Financial Management (3rd edition 1992) ]

Good site worth visiting: http://www.investorhome.com/

-- posted by Rande

Top 956. Jul 24, 2000 1:01 PM

» SteveT - Rande

Glad to see you made it back;) In your post above you said "There are three forms of the efficient market hypothesis 1. The "Weak" form asserts that all past market prices and data are fully reflected in securities prices. In other words, technical analysis is of no use.

2. The "Semistrong" form asserts that all publicly available information is fully reflected in securities prices. In other words, fundamental analysis is of no use.

3. The "Strong" form asserts that all information is fully reflected in securities prices. In other words, even insider information is of no use."

No wonder Chimps throwing darts often out perform the pros smile

-- posted by SteveT

Top 957. Jul 24, 2000 1:06 PM

» Rande - Steve,

Steve,

Yes, especially when you consider the chimps are willing to work for bananas. Actually, when it comes to the "three forms" of EMH, there aren't too many out there who go completely along with the strong form and contend that inside information is of no use. I would certainly agree with the weak form and, to a large extent, the semi-strong form myself.

-- posted by Rande

Top 958. Jul 24, 2000 8:54 PM

» Marty_H - Questions about EMH

Rande-

I believe that the markets are efficient in the long run. They may not be rational from a mathematical perspective, but they are the best way to value a company. The price for a stock at any given time is "efficient" in that people holding the stock believe that it will be worth more someday. Otherwise, why not sell it now?

That said, I had a couple of questions about EMH.

If the market is truly efficient why are there derivatives? For example, how does EMH explain a "short squeeze" where prices are being bid up on a stock so that short sellers can cover their positions?

Does EMH depend on a perfect transfer of information to the public? I'd liken the level of information available to a tornado. If a given company is a whisper in that tornado, does the EMH hold? The converse case is easier to demonstrate: For example, a stock gets mentioned on a program like CNBC and jumps-just on the publicity. Or it gets upgraded by a big name analyst-and jumps. The information on the stock hasn't changed, just how widely disseminated that information is. Then, of course, there are the conference calls that seem to be more important than the earnings reports they accompany, as the CFO or president "spins" his company's story. Finally, there are occasional cases of touting, and other misrepresentation of a stock to drive the price one way or another. All of these seem to work counter to the EMH.

Perhaps Abe Lincoln, that old EMH proponent, said it best: "You can fool all of the market some of the time, and you can fool some of the market all of the time, but you can't fool all of the market all of the time."

Marty

-- posted by Marty_H

Top 959. Jul 25, 2000 6:26 AM

» Rande - Marty,

Marty,

Academic theories sometimes work off a base of assumptions that may be difficult to find in the real world, particularly when it comes to economic models (ceteris peribus). EMH does make a number of assumptions, at least two of which may be open to particular debate:

1. Investors are rational in that they prefer higher return to lower return and lower risk to higher risk.

2. Information is readily and instantaneously available to all participants.

Climbing outside the ivory tower for a moment, most of us recognize that people don't always act rationally at times and that information is not always available to everyone at the same time and to the same degree. However, EMH is as close to reality as any theory can be to the way the markets really work. For the most part, people (particularly those running institutional portfolios) are amenable to higher returns while remaining averse to undue risk and there are a lot of really (really!) smart and well-educated people playing the game at all hours of the day so that the financial markets do tend to function quite efficiently. Perfectly efficient? Nothing in the real world is ever perfect. But when you add it all up, there is powerful evidence that trying to outperform an efficient market, however imperfect it might be, over long periods of time is a hurculean task which might be more costly than it is worth, given real-world expenses, transaction costs, and taxes.

Thank goodness most will never give up trying. Keeps things efficient.

-- posted by Rande

Top 960. Jul 25, 2000 7:19 AM

» Rande - Econ Watch:

Econ Watch:

June existing home sales at 5.23 million vs. expectation for 5.01 million.

Consumer confidence at 141.7 vs. expectation of 140.5.

-- posted by Rande