Poking Holes in a Theory on Markets

As it turns out, Mr. Grantham was an early advocate of index funds, mainly for unsophisticated investors who have no hope of beating the market. But he also believes that professionals should do better precisely because, as he puts it, “the market is full of major league inefficiencies.”

“There are incredible aberrations,” he told me over lunch not long ago. “The U.S. housing market in 2007. Japan in the 1980s. Nasdaq. In 2000, growth stocks were three times their fair value. We were quoted in The Economist in 2000 saying that the Nasdaq would drop by 75 percent. In an efficient world, you wouldn’t have that in a lifetime. If the market were truly efficient, it would mean that growth stocks had become permanently more valuable.”

As Mr. Grantham sees it, if professional investors had been willing to acknowledge these aberrations — and trade on the fact that the market was out of whack — they should have been able to beat the market. But thanks to the efficient market hypothesis, no one was willing to call a bubble a bubble — because, after all, stock prices were rational.

“It helped mold the ‘this time it’s different’ mentality,” he said. Indeed, professional money managers who tried to buck the tide wound up losing their jobs — because everybody else was making money by riding the bubble for all it was worth. Meanwhile, government officials, starting with Alan Greenspan, were unwilling to burst the bubble precisely because they were unwilling to even judge that it was a bubble. “Our default reflex is that the world knows what it is doing, and that is extravagant nonsense,” Mr. Grantham said.

But as much as I’ve admired Mr. Grantham’s writings over the years, I think the truth, in this case, is a little more subtle. Given the long history of bubbles, I suspect this crisis would have taken place with or without the aid of the efficient market hypothesis. People thought “it’s different this time” in the 1920s, long before anyone was writing about efficient markets. And over the course of history, professional money managers have been just as fearful of bucking the trend as they were during the Internet bubble.

Mr. Fox sees it somewhat differently. On the one hand, he says, the efficient market theoreticians always assumed that smart market participants would force stock prices to become rational. How? By doing exactly what they don’t do in real life: take the other side of trades if prices get out of whack. Their ivory tower view reflected an idealized market that simply doesn’t exist.

On the other hand, Mr. Fox says, what was truly pernicious about the efficient market hypothesis is the way it allowed us to put asset prices on a pedestal that they never deserved. Stock options — supposedly based on a rational price — became prevalent in part because higher stock prices were supposed to be the rational reward for good performance.

Or take the modern emphasis on market capitalization. “At some point in the early 1990s (or maybe it was in the late 1980s), market capitalization became accepted as the best measure of a company’s importance,” Mr. Fox wrote me in an e-mail message. “Before then it was usually profits or revenue. I think that’s a classic example of the way efficient market theory seeped into popular discourse and shaped how we perceived the world. It wasn’t entirely stupid — profits and revenue are flawed, limited measures, and market value does tell you something useful about a company. But it was another one of the ways in which asset prices came to rule the world, which eventually turned out to be a bad thing.”

A few days ago, I called Burton G. Malkiel, the Princeton economist, to ask him what he thought of Mr. Grantham’s theories. Mr. Malkiel is the author of “A Random Walk Down Wall Street,” surely one of the greatest popularizers of any academic theory that’s ever been written.

“It’s ridiculous” to blame the financial crisis on the efficient market hypothesis, Mr. Malkiel said. “If you are leveraged 33-1, and you’re holding long-term securities and using short-term indebtedness, and then there’s a run on the bank — which is what happened to Bear Stearns — how can you blame that on efficient market theory?”

But then we started talking about bubbles. “I do think bubbles exist,” he said. “The problem with bubbles is that you cannot recognize them in advance. We now know that stock prices were crazy in March of 2000. We know that condo prices were nuts.”

I thought to myself: if a smart guy like Burton Malkiel had to wait for the Internet bubble to end to realize we had been in one, then maybe Mr. Grantham has a point after all.

This story originally appeared in The New York Times

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