You can now sleep better at night. Jeremy Grantham, market strategist for GMO, an institutional asset management firm, has found the culprit for the market crisis. According to Grantham, the efficient market hypothesis is to blame for the financial crisis. Quoting Mr. Grantham, "The incredibly inaccurate efficient market theory was believed in totality by our financial leaders.... It left our economic and government establishment sitting by confidently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments led to our current plight". Clearly Mr. Grantham has a gift for hyperbole but is he speaking the truth? Let's take apart his claims:
1. "Incredibly inaccurate efficient market theory": Perhaps, but my understanding of efficient markets is different from Mr. Grantham. My understanding is that very few investors can beat the market in an efficient market, and there is a catch in almost any strategy that claims to make money easily. I am not sure what part of this statement is inaccurate and I would love to be enlightened. It does take a lot of gumption for someone with Mr. Grantham's track record to talk about inaccuracy, but you are welcome to check out his history:
2. "Believed in totality by our financial leaders": Interesting. I did not know that we had financial leaders, but I guess Mr. Grantham is talking about the academia and investment banks. If it is academia, he is wrong, because almost every problem with market efficiency has been uncovered by academia, and academics (such as Robert Shiller) were among the first to draw attention to the dot-com and housing bubbles. It could not be investment bankers that he is referring to, because almost everything they do is premised on markets being inefficient. After all, what would the point of securitization be, if every one paid a fair price and there were no easy profits? Or of acquisitions, when all target companies trade at the right price?
3. "Lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments": Market efficiency is to blame for all of these? Really? So, let's see.
- The efficient market hypothesis is about 40 years old. There must have been no asset bubbles before then. I wonder how those investors in South Sea stock (London in 1711) and tulip bulbs (Amsterdam in 1637) got their hands on the efficient market hypothesis.
- Lax controls? The financial services sector, the most controlled and regulated sector in the economy, was the one that precipitated this crisis.
- Pernicious incentives? I don't disagree, but how can you blame the efficient market hypothesis for compensation contracts that tied traders' pay to how much profit they made in a yer.
- And wickedly complicated instruments? Sure, but there would be no point to these instruments in an efficient market, since everything would be fairly priced. It was people who believed that markets were inefficient who created these instruments with the intent of exploiting inefficiencies.
I guess I must be a dreamer to even think that efficient markets have a shot in the face of Grantham's well thought out arguments. After all, in an efficient market, active portfolio managers will, on average, under perform the market, returns will decrease with trading activity, equity research analysts will provide little value added to investors and market strategists will be useless appendages at investment houses, making meaningless forecasts about future market movements. Never mind! I think I have made my case.