Beyond Efficient Markets

Market efficiency under pressure

In recent weeks, someone pointed me to an interesting paper written late last year by Clifford Asness, managing principal at AQR Capital Management in Greenwich, CT. The paper, titled The Less-Efficient Market Hypothesis, is about twenty pages long, and I felt it was a must-read. The paper presents a compelling argument that, over the past three decades, financial markets have become less efficient in the relative pricing of common stocks, particularly over medium-term horizons.

The author begins by emphasizing that market efficiency is crucial for the optimal allocation of resources within an economy. Efficient markets ensure that stock prices accurately reflect the underlying value of companies, guiding investors and corporations in their financial decisions. When prices align with a company’s true value, capital flows to its most productive uses, fostering economic growth and innovation. Conversely, mispriced assets can lead to suboptimal investment decisions, resource misallocation, and potential economic distortions.

A simple example of this inefficiency can be seen when two comparable companies in the same industry experience significantly different stock price movements despite having similar fundamentals:

• Company A and Company B both generate similar profits, have comparable growth prospects, and operate under similar risks.
• In an efficient market, their stock prices should move in tandem, reflecting their intrinsic value.
• However, in a less efficient market, Company A's stock price might surge 50% within a few months due to speculative buying or trend-following investors, while Company B's stock remains stagnant.
• This discrepancy is not driven by fundamentals but rather by market dynamics, making it harder for prices to accurately reflect value in the medium term.

Overvalued companies may attract excessive capital, even when their business fundamentals do not justify their valuations. This can result in excessive investment in less productive or even unsustainable businesses, diverting resources from more deserving firms.

A widening value spread: Evidence of market distortions

However, that is the theory. In reality, as Asness observes, financial markets have exhibited increasing inefficiencies over the past thirty years, contrary to the expectations set by the Efficient Market Hypothesis. This is particularly evident in the relative pricing of common stocks over medium-term periods. Such inefficiencies manifest as mispricings that persist longer than traditional financial theories would predict, suggesting that prices are not adjusting as swiftly or accurately to new information as they once did.

Of course, testing market efficiency has always been difficult and controversial. To support his argument, Asness relies on the so-called “value spread”, the ratio of the valuation (using any preferred metric) of expensive stocks to cheap stocks. In this particular paper, he uses the price-to-book ratio for large-cap stocks, comparing those with low versus high multiples. When the value spread is high, investors are paying significantly more for their favorite stocks relative to those they dislike, and vice versa.

From 1950 to nearly 2000, this value spread remained relatively stable, fluctuating between 3 and 6. However, in 1999–2000, it surged to unprecedented levels, reaching nearly 9. During this period, returns to value strategies, whether based on simple price multiples (e.g., forming portfolios using ratios of price to fundamentals such as book value, sales, earnings, or cash flow) or more “holistic” approaches incorporating additional factors like quality, collapsed to previously unseen levels. As the prices of already expensive stocks soared, cheap stocks lagged behind. Yet, in the years following the peak, value strategies recovered all of their losses and more.

With 1999–2000 representing the most extreme distortion in fifty years, Asness jokes that he thought he would never witness such an event again in his lifetime. Yet, only twenty years later, history repeated itself. It took a global pandemic to push the value spread beyond the highs of 1999–2000, reaching a new record of 10.

Why are markets less efficient? Three key hypotheses

But if this is the new reality, then how did we get here? That is exactly what Asness has studied, and he proposes three primary hypotheses to explain this decline in market efficiency:

1. Technological advancements and information overload: The rise of digital technologies, particularly social media platforms, has dramatically increased both the volume and speed of information dissemination. While this could theoretically enhance efficiency by providing more data to market participants, it often leads to information overload. Investors are bombarded with reports, rumors, and countless opinions, making it difficult to separate valuable insights from noise. This environment exacerbates herd behavior, as individuals may rely on the same sources or sentiments, leading to synchronized, and sometimes irrational, investment decisions.
2. The rise of passive investing: The rapid growth of passive investment vehicles, such as index funds and ETFs, has resulted in a larger portion of capital being allocated without consideration for individual company fundamentals. This shift reduces the influence of active, price-discerning investors, potentially allowing mispricings to persist for longer periods. Since passive investing does not involve active stock selection or analysis, it can contribute to price distortions, especially when a substantial share of the market adopts this approach.
3. Behavioral factors and market sentiment: Human psychology plays a pivotal role in investment decisions. Cognitive biases such as overconfidence, confirmation bias, and the tendency to follow the crowd can lead to persistent mispricings. The amplification of these biases through social media and other (free or paid) platforms results in more pronounced and prolonged deviations from intrinsic values.

Opportunities and Challenges for Active Investors

So, if this is the state of financial markets today, does it work to the advantage of active investors? For those willing to navigate these inefficiencies, Asness indeed suggests that there may be opportunities for higher expected returns. However, capitalizing on these opportunities requires a disciplined approach and a tolerance for increased risk.

Mispricings can persist far longer than anticipated—bringing to mind John Maynard Keynes’ famous quote: “Markets can remain irrational longer than you can remain solvent.” Betting against prevailing market trends can be both psychologically and financially challenging. As a result, investors must be prepared for heightened volatility and extended periods of underperformance before eventually realizing gains.

All of this sounds promising, right? At least for active investors willing to do their homework with fundamental analysis? And indeed, to navigate this evolving landscape effectively, Asness recommends a few key strategies:

• Long-term investment horizon: Adopting a long-term perspective can help investors withstand short-term volatility and benefit from the eventual correction of mispricings. Patience allows fundamental values to reassert themselves over time, rewarding those who maintain their positions amid market fluctuations.
• Diversification: Building a diversified portfolio can mitigate the risks associated with individual mispricings. By spreading investments across various assets and sectors, investors can reduce the impact of any single underperforming position.
• Behavioral discipline: Maintaining discipline and avoiding emotional reactions to market movements is crucial. This includes resisting the urge to follow the crowd during periods of market euphoria or panic (easier said than done). Implementing systematic investment processes can help investors adhere to rational decision-making frameworks.
• Continuous education and adaptation: Staying informed about market developments and adapting strategies as new information emerges can enhance an investor's ability to navigate inefficiencies. This involves not only understanding traditional financial metrics but also recognizing how technological and social changes impact market dynamics.

Conclusion: The High-Stakes Game of Active Investing

In conclusion, Asness's analysis challenges the traditional view of ever-increasing market efficiency. By highlighting factors such as technological advancements, gamified 24/7 trading on smartphones, social media influence, the rise of passive investing, and behavioral biases, he offers a nuanced perspective on today’s market dynamics.

He argues that these developments have raised the stakes for rational active investing. Market fluctuations are likely to be more pronounced and persist for longer periods, potentially creating greater opportunities for those who can stay the course, but also making it more difficult to do so.

For investors, recognizing and understanding these inefficiencies is the first step in developing strategies that can potentially capitalize on them, while also acknowledging the risks and challenges involved.