The Nobel Prize in Economics, awarded to three leading economists, was a study in contrast. It was interesting to see the committee walk a fine line between and betwixt the theory of how capital markets work. Of the recipients, Eugene Fama, is known for his work with the Efficient Market Hypothesis, the notion that markets react swiftly and surely to all known information and adjust prices accordingly. One of the others, Robert Schiller, has spent much time documenting the various inefficiencies in those same capital markets. How could both be right?
We’ve always felt there was considerable merit in both viewpoints. Markets do tend to be efficient in “discounting” or incorporating all known information. This sort of efficiency is very clearly seen in the movement of a particular stock about which new information is suddenly known. The markets react quickly to adjust the price to the new information, up or down accordingly. But markets tend to do less well with the really big stuff, precisely because there are always unknowns out at the edge of the horizon. Markets also don’t do a good job of incorporating “mean reversion” into the mix very quickly. That’s because markets, at the bottom, are composed of people and people tend to feel different ways about the same thing. When high quality securities of all sorts plunged to ridiculously low levels during the 08-09 selloff some saw opportunity and others saw a reason to run for the exits. Fear and Greed it seems are responsible for market movements but logic and mathematics based on all known information contribute a great deal as well.
Sometimes small pithy statements really do tell the story. “Red sky at night, sailors delight” has a great deal of truth incorporated in a memorable rhyme. We also do well to heed that markets are “voting machines in the short run and weighing machines for the long term”. Short term “voting”, often done with one’s feet, provides real opportunities for investors more able to take the time to correctly “weigh” the situation. Reversion to the mean is a solid principle of money management and value can be added by those who are patient enough to stay their course and perceptive enough to determine market excess.
This year’s award, to Fama and Schiller reinforces both the ambiguity of markets and reaffirms the notion of adding value through analysis and discipline.