Time to Throw Out the Efficient Markets Theory

Over the last few months, I've not been surprised to read that recent events have thrown a bit of doubt on the Efficient Markets [EM] theory. As defined in an article this weekend in the Financial Times, EM is "the theory ... that market participants are governed by rational expectations and markets are self-correcting."


[Thanks to Greenwichroundup.blogspot.com for the image.]

If I understand this theory correctly, the correlation in practicality is that the most prudent long-term investment portfolio for the modest, ordinary investor, i.e. the one with the best risk-security ratio, would be something with a lot of Dow-type common stocks, because the collective markets take all factors into account quicker than any individual can do it.

The evidence behind this theory was provided, in part, by Jeremy Siegel of the Wharton School at the University of Pennsylvania in 1994, in a book entitled Stocks for the Long Run. Siegel analyzed data going back to 1802. According to another article this weekend in the Wall Street Journal, he based his statistics on data provided by two other economists, Walter Buckingham Smith and Arthur Harrison Cole.

However, the WSJ article points out two problems with Siegel's argument: (1) the stock samples chosen were "cherry-picked" and not "comprehensive," and (2) as of June of this year "U.S. stocks have underperformed long-term Treasury bonds for the past five, 10, 15, 20 and 25 years."

Oops.

Ever heard Benjamin Disraeli's phrase, "There are three kinds of lies: lies, damned lies, and statistics"?

I've always had a suspicion about the EM theory. It just seems too pat, too profitable to the Wall Street types, and not really adapted to the little guy: the forgotten men and women who just want to hold onto their hard-earned savings and gain a little real income from them.

I observe that Wall Street market players are not long-term thinkers who spend even a nanosecond worrying about the future of Western Civilization. They're the ultimate Instant-Gratification Kids, worried only about their next buck. "To hell with tomorrow," or such esoteric concepts as the "Forgotten Man."

Even more so today, as we slide into this second phase of our current recession, we realize that the Efficient Markets Theory--and even its supposed alternate, the "Treasury Bond Theory" (I'm inventing the name)--may both have failed us. This will be especially true if inflation hits us, as some predict (and I believe it will, when it comes time to put the Federal Reserve and Treasury credit genies back into the bottle).

The truth of the matter is that there is no stasis. No theory works all the time. As we slide up, over, and down the recessional curve, the corresponding statistical charts will prove first one theory and then the other, depending on where you start and where you stop the x axis.

So where does that leave us?

I would be very interested in some research comparing three model portfolios since approximately 1900 (more precisely, a year in which the market can be considered to have been healthy and balanced): an Efficient Markets portfolio, a Treasury bonds portfolio, and a Gold portfolio (one invested primarily in good gold stocks). To be fair, we would allow modification of common stock, bond, or gold stock picks, but only over the longer range to insure diversification, company soundness, and regular dividend issuance, and only according to some strict rule.

But such research is not easy to come by. Current advisers are not thinking in terms of the erosion of the dollar. Most of them take the dollar as the only game in town.

There was a fellow who tried his best to give us good information: Economist Edward C. Harwood. Up until his death in 1980, he took the position that inflation was the most pernicious waster of wealth we had to face, and that any safe investment must insure against excessive business cycle fluctuations and loss of purchasing power through manipulation of the currency by inflationary monetary policy. For the latter part of his life (1950s to 1980), his investment research pointed to recommendations based on a high percentage of gold holdings. (Or course, we have to keep in mind that the world was on a gold standard until 1971, and he was not alone in seeing the then-coming collapse of the dollar.)

Today, the current strength in the "price" of gold (in fact, it's really not the price of gold, but rather the weakened gold-exchange rate of the dollar) demonstrates once more that the world has not forgotten the role of gold as a monetary metal and does not have blind faith in the dollar, in spite of what the central bankers would like us to believe; and that inflation and possible dollar weakness is still very much on our minds.

You've probably noted over the last few months that China and Russia have made quite a show of recommending the return to gold as a store of value in place of the U.S. dollar. (See this Financial Times article, and my previous post about the Russian fellow Sterligov.)

These outbreaks, although embarrassing to the U.S., don't seem to worry anyone just yet. However, it would be a mistake to write off the sentiment behind them, which is probably shared by more Westerners than our politicians would like to believe. Note also that even our central bankers have slowed their gold sales in recent months. (Do you suppose they themselves are aware of its present and future potential "price"?)

There is a risk in holding gold. Roosevelt gave us the precedent: in the 1930s, he simply made it illegal for American citizens to hold any gold and forced them to accept the dollar. Nothing excludes that from happening again, especially with popular sentiment against "the rich" and "the speculators."

The dollar may have a few more years in it; but in the longer run, it may be just such market sentiments that will force our politicians and academic theoreticians to recognize the simplicity and efficacy of gold as a monetary metal, in some future international role.

I would love to believe that this must happen in my lifetime; and if it does, gold will find its true "price," well above what it is today, Efficient Market theory be damned (and along with it Modern portfolio theory).

I could be pipe dreaming. Meantime, my mantra still holds:

You can take gold out of the standard, but you can't take the standard out of gold.

The Central Banker Credibility War

Every weekend I turn to three sources of bearish information, having been fed to the gills all week long with bullish Wall Street candy.

My three favorite permabears are:

PrudentBear.com
SirChartsAlot.com
The-Privateer.com

This week, it's this July 8 article by Gary Dorsch at SirChartsAlot.com that got my attention.

He points out that stagflation is here, just as we all expected it would be.

He also notes that today's global game is one of central bank credibility, a game that the US, the UK, and a few others are losing.

Back in the early 1980's, Paul Volcker, the then Fed Chairman, took the stagflation bear by the paws and wrestled it down to the ground in spite of the bitter deflationary medicine it required the US economy to take.

Today, "Mr. Volcker warned US Treasury chief Henry Paulson, and Fed chief Ben Bernanke against letting inflationary expectations become embedded once again." Unfortunately, neither "Strong-Dollar (Ha-Ha)" Paulson nor Helicopter Ben is listening.

Another inflation hawk, the Bank of International Settlements chief Malcolm Knight, said on June 24 that “'[t]here must be a forceful response to confront the danger that inflation expectations could rise appreciably, with all the attendant problems that would bring.... With inflation a clear and present threat, and with real policy rates in most countries low by historical standards, a global bias towards monetary tightening would seem appropriate, even though economic growth is likely to be hit harder than most observers expect....'"

He too is talking to himself.

Dorsch continues:

"So far, the Fed and US Treasury have ignored Volcker’s [and Knight's] advice, and instead, are pegging the fed funds rate at -2.25% below the inflation rate, while inflating the MZM Money supply at a +16.5% annualized rate, a prescription for hyper-inflation. [Meanwhile,] the Fed’s aggressive rate cuts have failed to stop the bleeding...."

Why are they ignoring such good advice? Well, here's one explanation: Apparently some of our Fed governors just don't get it:

"San Francisco Fed chief Janet Yellen told her audience ... 'I see inflation expectations as reasonably well anchored. There is little monetary policy can do about rising commodities prices. If rising commodity prices reflect supply and demand fundamentals, then the situation is not likely to turn around any time soon.'”

But what a big IF that is, my dear. There is a distinct possibility that people like Anna Schwartz and Milton Friedman are right, and that "inflation [rising prices] is always and everywhere a monetary phenomenon."

After all, why would food and energy prices suddenly and violently increase if they were caused only by supply and demand?

The increase in global demand for food and energy and the resultant tightening of supply are two forces that have been on the increase over more than a decade now, and that have been squarely in the sights of suppliers worldwide for at least that long. Why the sudden upward move over the last year?

The only credible answer is that the market is finally waking up to the fact that, Yes Dorothy, inflation IS, always and everywhere, a monetary phenomenon, and Yes, Dear, it's coming back with a vengeance.

Unfortunately, what our US and a few other central bankers seem to be losing is the only thing they ever had to bank on--lacking as they do any scientific foundation--and this is their credibility; and this loss is being hedged against by at least two who seem to have the guts our bankers lack: the central bankers of China and Europe.

China's bankers warned the stock market public that they intended to act no matter what; and they did.

Likewise in Europe, "on Dec 19th, 2007, Trichet was asked on German television channel N-TV if the bigger danger to the Euro zone economy was the banking crisis or inflation? 'The response is very clear. We have a mandate. The primary goal is to preserve price stability. We are alert, and everybody must know that we will do whatever is needed, to deliver price stability in the medium term, and be credible in that delivery. The single needle in our compass is price stability,' Trichet said."

Fortunately for him, the European Central Bank mandate is straightforward price stability, unlike our dual mandate of price stability and steady employment in the US. (For further discussion on this point, see this article of mine, Page 1, Page 2, and Page 3 at the Los Angeles Business Journal.)

On the other hand, "the ECB’s anti-inflation crusade is thwarted by the other G-7 central banks [Japan, UK, US, Canada], which are afraid to raise their interest rates to combat speculators in commodities. Legions of 'yen carry' traders have migrated over from the global stock markets to the crude oil markets, since the rescue of Bear Stearns in mid-March [and since Dorsch's article was written, they seem to be moving elsewhere]. A continuation of the 'Commodity Super Cycle' to new high ground could trigger another ECB rate hike to 4.50% in the months ahead, putting enormous pressure on Bernanke to lift the fed funds rate to defend the dollar, or surrender the last ounce of the Fed’s credibility."

The question is becoming, Does Bernanke have the economic argumentation, the political mandate, and/or the plain-old cojones to begin raising rates?

We'll see Tuesday.

My bet is, they'll forgo it "this time"; and they'll jawbone about the lurking dangers of inflation just in case anyone's listening. But market ears are becoming deaf ears; and soon, without action by the Fed, inflation will take over in earnest. Then, someone in that Naked Emperors' Court will be obligated to do something.

(Until then, don't sell your gold.)

Expectations Schmexpectations (Example No. 16 of Government Intervention Run Amuck)

I get so annoyed with our central bank governors when they talk about "market expectations," as though these were something they, the governors, controlled by a mere syllable or two, when in fact they don't even know what they are.


[Thanks to Dr. Leila R. Brammer at homepages.gac.edu/~lbrammer/ for the image.]

To get an idea of how truly flakey economists' understanding of inflation expectations really is, read this speech by Supreme Economist Fed Governor Bernanke himself. I applaud his candid approach to this subject; but the vacuum of scientific knowledge is scary when you think that the Fed Board controls the world economy.

Jean-Claude Trichet, the European Union central bank governor, says in his own most recent speech that "inflation expectations must be controlled."

Although Trichet has earned a reputation for putting his actions where his mouth is, Bernanke is now addressing the inflation issue mainly through jawboning, saying things like, "The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation."

Okay, talk on. We'll wait for the action.

What the monetary authorities seem to want to brush under the rug is the following point:

Not only the central bankers' words but their anticipated actions have become a part of the market itself.

Here's how it works: The market participants listen to what the central bank governors say, and then they act accordingly.

Now, this doesn't mean necessarily that the market players heed the words. It may mean that they speculate on the effect of the words first, profiting from the immediate market movement; meantime, they have judged for themselves what the actual actions and outcomes of the words will be. They know well that sometimes the actions and outcomes are diametrically opposed to the words our central bankers utter.

For example, when the U.S. central bank governors instruct the market that they intend to "control inflation," the market knows that the general public might believe them and this may cause certain indices to move in the short term. However, for the long term the market players may know better and suspect that the Fed will continue to inflate at the slightest sign of economic trouble.

The words have now have become a signal to some market players that there is profit to be made in the short-term swings of public reaction to the words; but that in the long run, they can expect the opposite actions and outcome.

Speculators take action accordingly. Company management listens to the Fed governors, even using the words as an excuse to withhold pay raises for their employees. After all, they say to themselves, "[d]espite rising energy and food prices, Trichet said it was vital for workers in Western countries to moderate wage increases, which economists regard as the best way to avoid an inflationary spiral."

Okay, so employees must tighten their belt? But why then doesn't this prevent some of the more savvy market players, e.g. management of larger corporations, from skimming off the profit cream for themselves, or from using corporate funds to indulge in speculative activities a la Sears Roebuck?

In this example, it could almost sound as though management and the central bankers are in cahoots against the wage-earning public.

This may sound far-fetched; but it describes pretty much what is going on. Central bankers are asking wage earners to forego a salary increase even though this is supremely unfair given that the speculators and corporate CEOs are reaping record millions.

This means that the average Joe and Jane get stiffed on the pay raise as the cost of their food and gas is doubling. Meanwhile, higher management with their gawdy salaries--and the central bankers with their political hubris--apparently don't see the irony, or the potential dangers.

I've made a point of listing examples of government intervention gone amuck. This has got to be one of the best.