How an academic scribbler ate your pension plan
Recently, watching a Congressional hearing to determine the fate of the mark-to-market rule, I was reminded of what John Maynard Keynes had said:
Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.
Over the last six month, trillions of dollars of the life savings of hundreds of millions of people across the globe have been devoured by plunging security prices.
People want to know why. Who is to blame? Is it Barney Frank? Chris Dodd? George Bush? Greedy Wall Street Executives? Franklin Raines? There are many candidates. The mob is running amuck. There is talk of strangling the children of AIG executives with piano wire. The tumbrils are rolling through the streets. There is madness in the air.
Words matter, especially economists’ words
Keynes was right. The instigator of today’s economic mess was none of the above. The culprit, the one really responsible, seems to have been a college student, jotting nonsense in a doctoral thesis forty years ago. This nonsense was published in 1965 in the Financial Analysts Journal. Here is the deadly screed that has led to all this damage:
An efficient market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.
These words became known as the “Efficient Market Hypothesis” and, over the years, became the justification for index funds, mark-to-market accounting rules, Morningstar’s rating system of mutual funds, executive compensation based on stock prices, total return reporting rules of the Securities and Exchange Commission, and much, much more.
These words put the smug, self-assured smile on the face of the FASB board member testifying before Congress, defending the mark-to-market rule.
Everyone is to blame
Of course, Eugene Fama, the college student in question, should not be blamed for a youthful indiscretion. After all, he was only a student and his teachers were there to set him right, but didn’t. We should shift our attention to the professors, who praised his work, and to the editors of Financial Analysts Journal who published this dangerous notion to the world.
But is it fair to blame them? After all, they were only academics, imaging what the real world was like from their ivory towers. If they were wrong, shouldn’t market participants have set them straight? How about real world security analysts, the experts at Standard & Poor’s, the bankers and the fund managers … didn’t they know better?
A convenient lie
The truth is that the Efficient Market Hypothesis has saved Wall Street billions of dollars in research costs over the years. If market prices reflect intrinsic value, why waste money doing research?
Securities analysis is hard work. It is much easier and cheaper just to look up the stock price on Yahoo. Let’s just sell unmanaged index funds. Let someone else do the research.
The “Efficient Market Hypothesis” provides cover for fiduciaries who increase their take home pay by avoiding the high cost of research.
Way, way back to basics
By 2008, the world finally came to understand that, in truth, nobody knows how much most securities are really worth.
The market has become too complicated, the products too confusing, and essential research and analysis has become too costly and has been farmed out to someone else, who has done the same.
The government of the United States, with trillions of dollars in resources, is simply unable to figure out how to value securities. Without the “Efficient Market Hypothesis” and without market prices, the United States Treasury Department has become lost in confusions and quandaries.
We must reject needless complexity and enshrine commonsense.
That’s easier said than done.
The pain of withdrawal
Unfortunately, the “Efficient Market Hypothesis” is a silent killer that lurks in thousands of financial products, laws, rules, regulations, tax provisions, and marketing schemes.
Hundreds of thousands of market participants, company executives, and securities floggers would have their lives turned upside down if the world were suddenly to back off from this deadly notion.
The arguments about mark-to-market rules and fair market accounting are all based on the assumption that markets, even markets dominated by panic and fear, are the best measure of intrinsic value and that forcing banks, pension plans, and investors to sell securities and raise new capital as prices plunge is the best medicine.
The Financial Accounting Standards Board is lost for lack of an alternative hypothesis. Accountants must put a number on assets or “investors won’t be protected”. Years ago, before the FASB existed, investors judged securities on the basis of commonsense.
- How big a dividend does the company pay?
- How fast is this dividend growing?
- Are dividend yields on risk common stock higher than bond yields of the same company?
- Isn’t a dividend today better than hoping to sell a stock to someone else at a higher price thirty years from now?
But commonsense has fled securities markets. It will be a long time before it will come back. Too many people are still enthralled by the “Efficiient Market Hypothesis”. The withdrawal pains will be severe.
There is a solution, of course: investors and financial institutions must get back to doing their own research, like Warren Buffet and Bernard Baruch in the old days. Financial products must be simplified.
Dividends must replace “total return” as the prime investment goal.
Company executives must give up stock options and buybacks and concentrate on paying higher dividends.
Regulators must rely less on accounting standards and economic theory, and more on commonsense.
Will this happen? I don’t know, but I hope so and the sooner the better.
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