Market efficiency is time variant: book review

With predictable cognitive dissonance, I have for a long time held two seemingly distinct views: (1) the market does a very good job of pricing stocks, and (2) participants (ideally yours truly) in the market can outperform.

A recent read by Paul D. Sonkin and Paul Johnson called Pitch the Perfect Investment (the title is almost as bad as the classic by Joel Greenblatt, You Can Be A Stock Market Genius) provide a helpful model for reconciling these views. Paul S and Paul J begin from the hypothesis of market efficiency and then show that, given the assumptions for efficiency, at some points in time efficiencies can break down as the assumptions are undermined. If investors can properly identify the efficiency breakdowns, they can outperform.

Eugene Fama first used the term “market efficiency” in 1965 but most simply described the phenomenon in a 1991 paper “Efficient Capital Markets II”:

I take the market efficiency hypothesis to be the simple statement that security prices fully reflect all available information. — Eugene Fama

From this starting point Paul S and Paul J define information and availability thereof, before stating three conditions to describe an efficient market (that is, where all available information is reflected in the price).

Efficient market flow chart

The wisdom of crowds, in their view, implements these rules. While crowd wisdom itself is a fascinating phenomenon – capable very much of being wiser than the sum of its parts because, assuming independence, diversity offsets average individual error – perhaps the more interesting conclusion from Paul S and Paul J is how mispricing occurs because the above inputs can be undermined.

This is where behavioural finance models are helpful: they explain how the requirements of efficient pricing can be undermined, leading to mispricing. Behavioural finance does not contradict the efficient market hypothesis, it complements it.

What then should we look for as investors? Here is a helpful summary from the book in diagram form:

Inefficient market flow chart

In the search for what the fund manager Michael Steinhard popularised as a “variant perspective”, Paul J and Paul S recommend asking – and answering in any stock pitch – the following:

  1. Is your view different from the consensus?
  2. Are you right?
  3. What is the market missing?
  4. How and when will the situation change?

One of the few sure ways to make money in the market is to have a view that is off consensus and have that view turn out to be right. — Michael Steinhardt

In their clear discussion about some fundamental themes, Paul J and Paul S provide a helpful tool in thinking about mispricings and some of the questions that any investment case should answer. It is a model applicable to investments wherever they may be found – whether inside the proverbial castle or buried deep in the muck at the bottom of the moat.

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