Stock Valuation and the Efficient Market Hypothesis: Two Jeremy's Slug It Out
Stock valuation is a broad term. Some form of stock valuation should take center stage when you're deciding whether to invest in a particular stock or in the stock market in general (e.g., a stock index fund). It's important to know that at any given moment a stock is either undervalued, overvalued or (rarely) valued just right.
(I just finished four posts talking a bit about Warren Buffet's 7 Rules of Successful Investing. It talks a bit about stock valuation.)
If this past year's crisis and collapse in stock values taught anything, I hope it taught people not to put a lot of money into stocks when their valuations are simply too high.
Now, isn't this just commons sense? When you buy anything, don't you try to get it for not just a fair price, but also for a "bargain" price? You want to pay less for something, not more, right? And you certainly don't want to pay more than something's "worth" - right?
Of course there are exceptions. People who are hooked into the "consumer culture" will pay more for some items when they're "hot." I can remember so many times at Christmas when people flocked to stores, even waited on line, to buy the hot toy or game of the season. Some would even pay a premium for the item. It's foolish, to say the least. But, hey, it's your money.
And, in the same way, there are times when a stock becomes "hot." Again, it's pretty much foolish to invest in a "hot" stock, but people do it. Google's been a hot stock in recent years. People will pay a lot for it, just like they pay for hot toys and games. Apple may be the hottest stock of all right now.
But I'm not talking about hot stocks here. I'm talking about your everyday, garden variety stock that people buy and sell day in and day out. Isn't it common sense to buy stocks when they're undervalued rather than overvalued? But, in fact people frequently don't follow their common sense.
Why people do buy when stock values are high is a surprisingly complex subject. One reason they do is the Efficient Market Hypothesis (EMH). This academic theory, originally put forward by Eugene Fama, states that, at any given moment, the price of a security reflects all known information that impacts its value.
This theory has supported the assertion that it's always a good idea to buy and hold stocks "for the long run."
But after the recent collapse in the stock market, we found two famous Jeremy's who've taken opposing sides on the whether EMH was discredited by last year's disaster.
No less a figure than Jeremy Grantham, super-star institutional investment manager, stated in a recent quarterly letter that, "The incredibly inaccurate efficient market theory (caused) a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives, and wickedly complicated instruments (that) led to our current plight."
I'd say Grantham isn't a big fan of EMH.
In response, we have Jeremey Seigel, author of the highly acclaimed and highly influential book, "Stocks for the Long Run," claiming that Grantham doesn't understand EMH. Siegel claims that while EMH says that "at any given moment, the prices of securities reflect all known information that impacts their value," it does not claim that the market price is always right. Siegel even takes this one step further and says that it really says that the prices in the market are mostly wrong. It's simply hard to know far off they are at any given moment in time.
Question: Does this really matter?
It does in this sense: EMH has tremendous influence in professional money management circles. That doesn't mean just the elite managers who run insitutional money like pension and endowment investments, but also the managers who run mutual funds, which are bought primarily by "retail" investors - plain folks who invest their 401k's and some of their other money in the stock market.
So whether the efficient market hypothesis is true or not, and how it is viewed and incorporated into the philosophy and process of professional money managers does impact most of us in some way, shape or form. The two Jeremy's disagreement captures an ongoing debate in that money management community, brought to a head by the recent stock market collapse.
My own experience is that most investment professionals - especially those who manage money - believe in the Efficient Market Hypothesis. Many believe - as opposed to what Jeremy Siegel said above - that the market indeed prices things "just right" at any given moment in time. Some, on the other hand, understand what Siegel is trying to say.
A growing number, though, are questioning EMH, or, like Jeremy Grantham, rejecting it altogether.
Why should this matter to us? It matters because EMH supports the idea that you should always be invested in stocks for the long run - no matter what the valuations happen to be at the moment. But if some supporters of EMH will admit that the market can be wrong in how it prices a stock, why would they say you should always stay invested in stocks (or any other security, for that matter)? It's always puzzled me.
In other words, if EMH isn't always right, shouldn't there be some other way or ways to determined whether stocks are priced right. Shouldn't your method of stock valuation help you decide whether investing in stocks at all makes sense right now (or any other time)?
The cynical side of me steps in now. Wall Street makes its money pushing stocks. So maybe that prevents a lot of people from stepping back and being more objective. After all, if you say you've always got to be invested, then it justifies always having people's money in stocks all the time.
This kind of gets to another theme I've been following: why money management will have to change in the future. So we'll have to look at this particular subject more closely at some point...
(I just finished four posts talking a bit about Warren Buffet's 7 Rules of Successful Investing. It talks a bit about stock valuation.)
If this past year's crisis and collapse in stock values taught anything, I hope it taught people not to put a lot of money into stocks when their valuations are simply too high.
Now, isn't this just commons sense? When you buy anything, don't you try to get it for not just a fair price, but also for a "bargain" price? You want to pay less for something, not more, right? And you certainly don't want to pay more than something's "worth" - right?
Of course there are exceptions. People who are hooked into the "consumer culture" will pay more for some items when they're "hot." I can remember so many times at Christmas when people flocked to stores, even waited on line, to buy the hot toy or game of the season. Some would even pay a premium for the item. It's foolish, to say the least. But, hey, it's your money.
And, in the same way, there are times when a stock becomes "hot." Again, it's pretty much foolish to invest in a "hot" stock, but people do it. Google's been a hot stock in recent years. People will pay a lot for it, just like they pay for hot toys and games. Apple may be the hottest stock of all right now.
But I'm not talking about hot stocks here. I'm talking about your everyday, garden variety stock that people buy and sell day in and day out. Isn't it common sense to buy stocks when they're undervalued rather than overvalued? But, in fact people frequently don't follow their common sense.
Why people do buy when stock values are high is a surprisingly complex subject. One reason they do is the Efficient Market Hypothesis (EMH). This academic theory, originally put forward by Eugene Fama, states that, at any given moment, the price of a security reflects all known information that impacts its value.
This theory has supported the assertion that it's always a good idea to buy and hold stocks "for the long run."
But after the recent collapse in the stock market, we found two famous Jeremy's who've taken opposing sides on the whether EMH was discredited by last year's disaster.
No less a figure than Jeremy Grantham, super-star institutional investment manager, stated in a recent quarterly letter that, "The incredibly inaccurate efficient market theory (caused) a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives, and wickedly complicated instruments (that) led to our current plight."
I'd say Grantham isn't a big fan of EMH.
In response, we have Jeremey Seigel, author of the highly acclaimed and highly influential book, "Stocks for the Long Run," claiming that Grantham doesn't understand EMH. Siegel claims that while EMH says that "at any given moment, the prices of securities reflect all known information that impacts their value," it does not claim that the market price is always right. Siegel even takes this one step further and says that it really says that the prices in the market are mostly wrong. It's simply hard to know far off they are at any given moment in time.
Question: Does this really matter?
It does in this sense: EMH has tremendous influence in professional money management circles. That doesn't mean just the elite managers who run insitutional money like pension and endowment investments, but also the managers who run mutual funds, which are bought primarily by "retail" investors - plain folks who invest their 401k's and some of their other money in the stock market.
So whether the efficient market hypothesis is true or not, and how it is viewed and incorporated into the philosophy and process of professional money managers does impact most of us in some way, shape or form. The two Jeremy's disagreement captures an ongoing debate in that money management community, brought to a head by the recent stock market collapse.
My own experience is that most investment professionals - especially those who manage money - believe in the Efficient Market Hypothesis. Many believe - as opposed to what Jeremy Siegel said above - that the market indeed prices things "just right" at any given moment in time. Some, on the other hand, understand what Siegel is trying to say.
A growing number, though, are questioning EMH, or, like Jeremy Grantham, rejecting it altogether.
Why should this matter to us? It matters because EMH supports the idea that you should always be invested in stocks for the long run - no matter what the valuations happen to be at the moment. But if some supporters of EMH will admit that the market can be wrong in how it prices a stock, why would they say you should always stay invested in stocks (or any other security, for that matter)? It's always puzzled me.
In other words, if EMH isn't always right, shouldn't there be some other way or ways to determined whether stocks are priced right. Shouldn't your method of stock valuation help you decide whether investing in stocks at all makes sense right now (or any other time)?
The cynical side of me steps in now. Wall Street makes its money pushing stocks. So maybe that prevents a lot of people from stepping back and being more objective. After all, if you say you've always got to be invested, then it justifies always having people's money in stocks all the time.
This kind of gets to another theme I've been following: why money management will have to change in the future. So we'll have to look at this particular subject more closely at some point...
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