Saturday, November 13, 2010

The Gullibility of the "Efficient Market Hypothesis"

Ian Cumming writes “Poetry, Science and Value Investing” in Todd Sullivan’s Values Plays Net Blog (HERE):

The Invisible Hand”

The Invisible Hand” first phrased by Adam Smith in his 1776 The Wealth of Nations, is the belief that the market prices all commodities and securities at correct valuations. The belief in the market’s ability to do this can likely be traced back to 5500BC, the time of the Sumerians. Friedrich von Hayak promoted the concept that price conveyed economic data in free markets and promoted free markets with fervor. More recently it has been reflected in the use of mathematics to analyze markets use price data. The belief that market prices reflect rational and fair values has led to Modern Portfolio Theory from Harry Markowitz and The Efficient Market Theory from Eugene Fama. In the past 60yrs these concepts have dominated finance studies and led directly to the use of computers, algorithms and an extensive Hedge Fund industry.
“The Invisible Hand” belief is carried by many, but once the business cycle has returned to recession it is the SP500 Support Value Index that identifies “The Invisible Hand” as myth rather than reality. If investors were long term oriented and aware of the cyclic nature of markets, they would never be caught buying into market bubbles at tops nor would they be selling into market panics near lows. They would carefully take a valuation tool like the SP500 Support Valuation Index and make carefully considered investments.

But, this is not how markets work and it is not how most investors think but for a few who think like Ian Cumming (…and Warren Buffett and so on…). Most investors believe that the markets fairly price the value of the economy. As long as employment is rising they buy stocks and as long as employment is falling they sell. The markets appear only attractively priced at the lows using long term economic trends. In all other periods markets appear to be over priced and correlated to economic activity with most investors apparently believing in “The Invisible Hand”.

For Ian Cumming and other Value Investors “The science is in the “In”. The poetry is in the “Out”

Neat exposition of the mania involved in the ‘efficient markets hypothesis’. Wherever the idea came from, it never came from Adam Smith.

Market prices are not invisible. If they were, how do we explain prices, which are visible to all attentive players – otherwise, if prices are invisible, how do we know the price of anything? No matter how fast they change, at any one moment, somebody can see its price – they cannot see what that price will be at any future moment.

There is no invisible-hand that ‘leads’ them to that unknowable future price. It’s weird beyond explanation that there is such an actual phenomenon, and believing that there is anything more to the myth is a curiosity, except among the gullible.



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