Are 99.99% of human beings lemmings?

Joe Nocera writes about hedge fund manager Jeremy Grantham’s rant against the efficient market hypothesis, which claims stock prices rationally embody all available information and reflect the best possible estimate of each share’s true value. A corollary of the efficient market hypothesis is that no one can systematically beat the market.

Grantham says the efficient market theorem is wrong because institutional constraints and risk aversion prevent money managers from acting even when they know market prices have become totally insane. Yale economist Robert Shiller — who predicted both the 2000 stock market crash and the housing market crash — said that he made a presentation before the market collapse to (I believe) a major investment bank. Afterwards, a powerful money manager at the bank told him his speech had scared him deeply and convinced him absolutely but that he wouldn’t and couldn’t invest any differently because he’d get fired. This story meshes with this point in Nocera’s article:

The efficient market theoreticians always assumed that smart market participants would force stock prices to become rational. How? By doing exactly what they don’t do in real life: take the other side of trades if prices get out of whack. Their ivory tower view reflected an idealized market that simply doesn’t exist.

The hypothesis and its corollary have strong — but far from complete — empirical support. Most professional money managers — esp. mutual fund managers — perform significantly worse than market indexes, but a few investors — like Buffett and Grantham — have tremendously outperformed market averages for decades. Picking stocks that outperform the market is very hard, yet Grantham argues that asset markets go quite mad — as with the stock market bubble of 2000 and the housing market bubble of this decade — in ways that make it really easy for smart investors to grab free money.

In April, I attended a Grantham speech… one of the funniest speeches — and certainly the most sardonic — I’ve ever heard. Grantham claimed that everyone his hedge fund had been listening to had predicted the current crash! Grantham called it something like “the most anticipated total surprise of all time.”

I hope some day someone (Michael Lewis?) explains the complete disconnect between public information sources and the hedge fund crowd gossip. Grantham, Shiller and others did know the crash was coming. Why was the vast majority of America — including all the business TV shows, Congress, the president, the SEC, the rating agencies, and even the Federal Reserve — taken by surprise when a mortgage-and-finance industry that has very accurately been described as “a House of Cards” collapsed?

Nocera suspects the public was fooled because even most “smart” people are really shockingly ignorant:

I called Burton G. Malkiel, the Princeton economist [and] author of “A Random Walk Down Wall Street,” surely one of the greatest popularizers of any academic theory that’s ever been written…

“I do think bubbles exist,” he said. “The problem with bubbles is that you cannot recognize them in advance. We now know that stock prices were crazy in March of 2000. We know that condo prices were nuts.”

I thought to myself: if a smart guy like Burton Malkiel had to wait for the Internet bubble to end to realize we had been in one, then maybe Mr. Grantham has a point after all.

Posted by James on Saturday, June 06, 2009