April 09, 2005 | Graham

Rational markets

I first came across the “efficient markets” thesis which says that stock prices always embody and fairly price all the information known about the stock , in the ’80s, but never paid much attention to it. Stock markets are an efficient way of resolving the arguments between investors as to what price they should pay for a share, but if they always priced them correctly, how do some investors, like Warren Buffet, do much better than others? It can’t be all gambler’s luck.
Still, I’m always keen to seek out alternative views, and, let’s face it, if markets always trade at the right price, then my job in managing our small family portfolio would be a lot easier – just “set and forget”, put your feet up and open a stubby! So, when the latest edition of The McKinsey Quarterly carried an article for which the blurb claimed:

Behavioral-finance theory suggests that irrational investors can over- or undervalue shares and that rational investors can’t always correct these mistakes immediately. Our research, however, suggests that such discrepancies aren’t common enough to affect financial decision making in a major way.

I just had to have a look.
The essay called Do fundamentals—or emotions—drive the stock market? is worth reading, although it tends to confirm what it apparently denies, so no feet up stubby in hand while the money just walks in the door.
The authors identify a number of situations where obvious mispricing occurs, but then explain that this isn’t really mispricing. There is the case of 3 Com which floated 5 percent of its Palm subsidiary at a price which valued the subsidiary at more than the price of 3 Com including the subsidiary. Why, they ask, didn’t investors go short Palm and long 3 Com? Their answer is that the number of available Palm shares was very small, and there was a risk the company float wouldn’t succeed, so this option wasn’t open to investors. Well, maybe not, but it doesn’t prove the pricing was rational – the 5% of Palm shares were held by some idiots who thought they were worth far more than they actually were. So, if the thesis of the article was correct, the Palm float would never have even gotten off the ground – the shares would have been shorted before they were even issued!
They also look at the issue of Royal Dutch/Shell – two companies in a joint venture which share profits in fixed proportions – where the companies have traded on both the London and Amsterdam markets, at prices which vary by as much as 30% from theoretical parity. This is explained away because over time the disparity has become smaller, and because in some cases where similar arrangements have resulted in mergers, the share prices have converged! To me that’s good proof that the original mispricings were in fact irrational, not the reverse?
The authors also point to a period on the ’70s when shares were priced on an average P/E of around 10 and another in the ’90s when they were priced on an average P/E or around 30 as examples of mispricing which the market solved. They say that the P/E ought to normally be around 15, leaving you wondering just how wrong markets have to be before efficient market proponents will admit that perhaps their theory has a few holes. Apparently evidence of over-pricing by 100% or a divergence between low and high of 300% doesn’t count.
Of course there is an inherent conflict between efficient market theory and consultancy – how is McKinsey to earn its keep if the best advice is just to let the market do it all for you? So, not surprisingly the article contradicts itself at the end by offering public company executives some advice in the event that their company’s shares are mispriced. Advice such as, if they are over-priced, try to buy other people’s companies using your own shares as consideration rather than cash! But if markets were efficient, who’d be stupid enough to take the shares as consideration in the first place? If there is a market in consultancy advice I suspect it isn’t particularly efficient either, except at lining consultants’ pockets.

Posted by Graham at 7:33 am | Comments Off on Rational markets |
Filed under: Commerce

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