Sunday, June 7, 2009

Culprit found for market crisis!!!!

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.


Anonymous said...

Professor Damoradan,

A clarification: When Mr. Grantham refers to “our financial leaders,” he is primarily referring to two figures: his self-described “arch villain,” Alan Greenspan, and, to a lesser extent, Ben Bernanke. (See his October 2008 quarterly letter, “Reaping the Whirlwind.”)

And why is the efficient markets hypothesis to blame for the “lethally dangerous combination of asset bubbles, etc.”?

It is to blame because it provided the intellectual foundation for our financial leaders to make disastrous policy decisions. As Grantham writes:

“It was why Greenspan and Bernanke were not sure that bubbles – outbursts of serious irrationality – could even exist…it was why Bernanke could dismiss a dangerous 100-year bubble in U.S. housing as being nonexistent.”

(See his January 2009 quarterly letter, “Obama and the Teflon Men”)

Indeed, Mr. Grantham’s arguments are controversial. But his arguments are best read directly, without the distortions caused by Joe Nocera’s paraphrasing.

Aswath Damodaran said...

Here is my problem with the Greenspan-Bernanke link to efficient markets. If Greenspan had a problem, it was not an undying belief in efficient markets but hubris: the belief that the Fed could create and manage a real estate bubble. Incidentally, that action goes against everything that an efficient market theorist would have believed.

Unknown said...

“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”.

Cheap shot Prof. I’m afraid you don’t know what you’re talking about.

The CXO writer admitted that “his forecast sample size is very small, as is our confidence in this score.” It also concedes that “his (Gratham’s) forecasts are generally long-term” so there’s no point in looking at how his forecasts performed over 21, 63, 126 and 254 trading days. CXO also admit that his funds “have performed fairly well”.

Grantham is a long-term value investor, not some dodgy forecaster like Jim Cramer (the likes of whom CXO typically does a better job of debunking). He was buying small caps in 1974; he was a long term bull in 1982; he foresaw the 1989 Japan crash and the dotcom crash in 2000; as for the financial crisis, this is what he said in July 2007 - “overstretched, overleveraged financial system…In 5 years I expect that at least one major “bank” (broadly defined) will have failed and that up to half the hedge funds and a substantial percentage of the private equity firms in existence today will have simply ceased to exist…The feeling I have today is that of watching a very slow motion train wreck.”

That record of long term success is presumably why Grantham’s GMO manages over $78 billion in assets.

You’re free to disagree with his efficient market musings if you wish. However, your piece reads like it was penned in a fit of academic pique. A little more objectivity wouldn’t go amiss.

Anonymous said...

Perhaps I may not be contributing to the discussion on hand, but the academic pique does make for some interesting reading.

The central debate I guess would be on what "efficient(cy)" implies. In my understanding it says that prices reflect all known information and rapidly change to reflect new information. But doesn't the human psychology run counter to that - isn't there a tendency to extremes of paronia and optimism that can cause inertia in some cases, and extreme volatilty in others?

from the other side of the world

LT said...

Heard a segment on Marketplace yesterday that touches on this notion of efficient/rational market theory somehow being discredited... Maybe in his book Mr. Fox nuances his argument more, but from the interview sounds like another instance of misunderstanding what efficient market theory actually does - and what it does not - imply about market behavior.

Sacha Singh said...

In a very clear way EMH had been telling us that financial companies are likely to go under.

Financial services companies had been giving far superior returns than other firms. If Fed and other "financial leaders" actually believed that the markets were efficient then they would have concluded that these companies are very very risky and would have taken appropriate steps.

Clearly the leaders failed to see it because they did NOT believe in EMH.