GMO founder Jeremy Grantham decided to take “Ignoble Prize” winner Eugene Fama to the woodshed yesterday, ridiculing “the most laughable of all assumption-based theories, the Efficient Market Hypothesis (EMH),” in his quarterly letter to shareholders.
In contrast, he praised Fama’s fellow Nobel laureate Robert Shiller for accurately predicting both the tech and housing bubbles and lamented the failure of central bankers to listen to his warnings. Advisors, individual investors and homeowners might also have benefited if they had listened to Shiller's warnings.
Not only is Fama simply wrong; he and his fellow University of Chicago economists are responsible for another major disservice to the planet, in Grantham’s view. Worse yet is the theory of Rational Expectations that gave birth to the EMH. “The folly of Rational Expectations resulted in five, six or seven decades of economic mainstream work being largely thrown away,” Grantham writes.
Even economists know humans aren’t rational and now concede as much—witness the ascent of behavioral finance. But the rational expectations and EMH gang would have us believe that bubbles never occur, Grantham implies.
How then can one explain that four of the greatest investment bubbles in all history have occurred in the last 25 years? Some observers would attribute it to the proliferation of information, most of it imperfect.
In 1989, Japanese stocks traded at 65 times earnings, which the EMH crowd justified by different accounting standards. Nonetheless, they tumbled 90 percent over the next few decades, Grantham notes. How about the Japanese land bubble, which assigned a higher value to the Emperor’s Palace in Tokyo than all of California? “Seems efficient to me,” Grantham writes acerbically. In 2000, the U.S. equity bubble peaked at 35 times earnings and was justified by improved productivity, even though it compared with 21 times earnings in 1929, when the U.S. economy was growing twice as fast, Grantham observes.
These three bubbles all paled compared to what took place in 2007, the first “truly global bubble," encompassing virtually every asset class including equities, art, collectibles, gold and housing. Until then, the U.S. housing market had been remarkably stable, thanks to its diversity. Though Grantham doesn’t say it outright, U.S. housing prices actually appreciated in a stable enough fashion from 1950 to 2001 to actually support EMH. Then “Greenspan got his hands on it. Compared to previous ultra-stable data, this measured as a 3.5 sigma event, which according to the EMH assumption of perfect randomness, should have occurred once every 10,000 years.” Oops.
Grantham doesn’t even give Fama much credit for indexing, noting that when he and his partners offered it at Batterymarch in 1971, they already knew investing was a zero-sum game. However, he thanks Fama and his acolytes for promoting all this “efficient market nonsense.”
Why? He is convinced that during the 1970s and 1980s, EMH proponents strongly discouraged “quantitatively talented” individuals with PhD’s in particle physics from wasting their education and entering the asset management business. Consequently, value investors like him faced little in the way of quality competition.
In 1981, Grantham says there was a ray of light that entered the academic cloisters of financial theory. He was named Robert Shiller and he developed a theory that assumed total clairvoyance and asked “what were markets worth back in 1880, 1915, 1961, etc., if you knew both the long-term market return or the discount rate (in the 6 percent or 7 percent range after inflation) and, more importantly, you also knew the complete and accurate future stream of dividends?”
Grantham notes that a simplified version of Shiller’s theory reveals that the S&P 500 is within plus or minus 19 percent of its long-term trend about 67 percent of the time. This has provided value investors with a valuable tool to detect when equities are truly cheap since short-term earnings fluctuations sometimes mask what a company's true economic earnings are.
Equities don't appreciate upwards in the same steady, stable pattern that U.S. housing prices 'before Greenspan got his hands" on the housing market after the tech bubble burst. This has made career risk the major concern of professional money managers and encouraged them to make certain that when they are wrong, they have plenty of company and that most of their rivals will have already fallen of the cliff before they do.
Did Shiller’s simple experiment prompt the overconfident, group-thinking EMH boys to second-guess themselves? “Not for a second,” Grantham writes. “It was batted away like a bothersome fly for reasons I cannot explain with a straight face.”
Shiller served society by warning of both the equity and housing bubbles. If Greenspan and Bernanke had listened, the global economy might be in much better shape today. “As for Fama, who conversely provided a rationale for all of us to walk off the cliff with confidence, the less said the better,” Grantham writes.