It is with great relief then to find an imperforate debate on the topic which incorporates the leading economic minds on market efficiency. HT Mark Thoma, please see what Rajiv Sethi has to say: 

The Invincible Markets Hypothesis, by Rajiv Sethi: There has been a lot of impassioned debate over the efficient markets hypothesis recently, but some of the disagreement has been semantic rather than substantive, based on a failure to distinguish clearly between informational efficiency and allocative efficiency. Roughly speaking, informational efficiency states that active management strategies that seek to identify mispriced securities cannot succeed systematically, and that individuals should therefore adopt passive strategies such as investments in index funds. Allocative efficiency requires more than this, and is satisfied when the price of an asset accurately reflects the (appropriately discounted) stream of earnings that it is expected to yield over the course of its existence. If markets fail to satisfy this latter condition, then resource allocation decisions (such as residential construction or even career choices) that are based on price signals can result in significant economic inefficiencies.Some of the earliest and most influential work on market efficiency was based on the (often implicit) assumption that informational efficiency implied allocative efficiency. Consider, for instance, the following passage from Eugene Fama’s 1965 paper on random walks in stock market prices (emphasis added):

The assumption of the fundamental analysis approach is that at any point in time an individual security has an intrinsic value… which depends on the earning potential of the security. The earning potential of the security depends in turn on such fundamental factors as quality of management, outlook for the industry and the economy, etc…

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.

Or consider the opening paragraph of his enormously influential 1970 review of the theory and evidence for market efficiency:

The primary role of the capital market is allocation of ownership of the economy’s capital stock. In general terms, the ideal is a market in which prices provide accurate signals for resource allocation: that is, a market in which firms can make production-investment decisions, and investors can choose among the securities that represent ownership of firms’ activities under the assumption that security prices at any time “fully reflect” all available information. A market in which prices always “fully reflect” available information is called “efficient.”

The above passage is quoted by Justin Fox, who argues that proponents of the hypothesis have recently been defining efficiency down:

That leaves us with an efficient market hypothesis that merely claims, as John Cochrane puts it, that “nobody can tell where markets are going.” This is an okay theory, and one that has held up reasonably well—although there are well-documented exceptions such as the value and momentum effects.

The most effective recent criticisms of the efficient markets hypothesis have not focused on these exceptions or anomalies, which for the most part are quite minor and impermanent. The critics concede that informational efficiency is a reasonable approximation, at least with respect to short-term price forecasts, but deny that prices consistently provide “accurate signals for resource allocation.” This is the position taken by Richard Thaler in his recent interview with John Cassidy (h/t Mark Thoma):

I always stress that there are two components to the theory. One, the market price is always right. Two, there is no free lunch: you can’t beat the market without taking on more risk. The no-free-lunch component is still sturdy, and it was in no way shaken by recent events: in fact, it may have been strengthened. Some people thought that they could make a lot of money without taking more risk, and actually they couldn’t. So either you can’t beat the market, or beating the market is very difficult—everybody agrees with that…

The question of whether asset prices get things right is where there is a lot of dispute. Gene [Fama] doesn’t like to talk about that much, but it’s crucial from a policy point of view. We had two enormous bubbles in the last decade, with massive consequences for the allocation of resources.

The same point is made somewhat more tersely by The Economist:

Markets are efficient in the sense that it’s hard to make an easy buck off of them, particularly when they’re rushing maniacally up the skin of an inflating bubble. But are they efficient in the sense that prices are right? Tens of thousands of empty homes say no.

And again, by Jason Zweig, building on the ideas of Benjamin Graham:

Mr. Graham proposed that the price of every stock consists of two elements. One, “investment value,” measures the worth of all the cash a company will generate now and in the future. The other, the “speculative element,” is driven by sentiment and emotion: hope and greed and thrill-seeking in bull markets, fear and regret and revulsion in bear markets.

The market is quite efficient at processing the information that determines investment value. But predicting the shifting emotions of tens of millions of people is no easy task. So the speculative element in pricing is prone to huge and rapid swings that can swamp investment value.

Thus, it’s important not to draw the wrong conclusions from the market’s inefficiency… even after the crazy swings of the past decade, index funds still make the most sense for most investors. The market may be inefficient, but it remains close to invincible.

This passage illustrates very clearly the limited value of informational efficiency when allocative efficiency fails to hold. Prices may indeed contain “all relevant information” but this includes not just beliefs about earnings and discount rates, but also beliefs about “sentiment and emotion.” These latter beliefs can change capriciously, and are notoriously difficult to track and predict. Prices therefore send messages that can be terribly garbled, and resource allocation decisions based on these prices can give rise to enormous (and avoidable) waste. Provided that major departures of prices from intrinsic values can be reliably identified, a case could be made for government intervention in affecting either the prices themselves, or at least the responses to the signals that they are sending.Under these conditions it makes little sense to say that markets are efficient, even if they are essentially unpredictable in the short run. Lorenzo at Thinking Out Aloud suggests a different name:

…like other things in economics, such as rational expectations, EMH needs a better name. It is really something like the “all-information-is-incorporated hypothesis” just as rational expectations is really consistent expectations. If they had more descriptive names, people would not misconstrue them so easily and there would be less argument about them.

But a name that emphasizes informational efficiency is also misleading, because it does not adequately capture the range of non-fundamental information on market psychology that prices reflect. My own preference (following Jason Zweig) would be to simply call it the invincible markets hypothesis.

This is a remarkable step towards stronger financial reform. Until this announcement the US has been lenient when dealing with the banks and has hinted at introducing only feeble new banking regulations in the form of larger capital requirements. The plan will likely pave the way for the international community to follow suit. Indeed George Osborne has indicated that any future Conservative government would impose similar regulations in the UK.

The regulation is necessary because since the government bailouts the same institutions have been deemed too big to fail. These firms have received  explicit government backing in the form of deposit insurance and lender of last resort facilities. The financial institutions therefore benefit from cheaper borrowing conditions which in turn provides a competitive advantage. The plan aims to suppress the moral hazard that arises from this situation and to ring fence “casino banking” operations. In this way losses from proprietary trading etc can lead to failure but more importantly retail banks cannot use funds from retail depositors to place risky bets that earn abnormally huge profits, at the same time knowing that should those bets fail that it has the safety net of government backing.

Of course the plan is missing a lot of details. Buttonwood raises some of the obvious questions:

But is this plan practical? How would one separate prop trading from business done on behalf of clients? If a big client wants to sell 1m shares in IBM does the bank have to match buyer and seller? If instead the bank takes the position on its book until it finds a buyer, is that prop trading? Will it depend on how long it holds the stake? Or makes a profit? And if the banks do withdraw from trading, what does that do to spreads? The market will be less liquid, raising costs for the rest of us.

And what does sponsoring a hedge fund mean? Being a prime broker? Advising clients to invest in one? Lending it stock? There is a lot of detail to be fleshed out.

No one really knows the extent of Obama’s plan. Banning banks from having a floor with proprietary trading desks is one thing, but completely separating retail banks from investment banks is quite another. As Robert Peston points out, the implications for UK banks differs greatly between the two:

By contrast, in the UK that distinction between letter and spirit would be crucial. Because none of our banks are huge in the areas spelled out by Obama: Barclays has a private-equity fund specialising in the takeover of medium-size companies and tells me it closed down its prop trading desk a few years ago; RBS announced a few months ago it would be pulling out of prop trading.

If however Obama means – in a more general sense – that he wants to prevent banks that receive any kind of explicit or implicit taxpayer support from speculating for their own account and benefit, rather than on behalf of clients, well that would represent a profound cultural and economic shift for all the world’s biggest banks.

The bill has yet to go through congress and financial institutions have exceptional lobbying power. The end result could be far from a “profound cultural and economic shift”, instead we could just as likely have a bill which limits very specific activities (like trading from a proprietary trading desk within a commercial bank), and installs measures which financial institutions can easily find “innovative” ways to sidestep.

Obama has said that he is willing to battle the Wall Street bankers. “If these folks want a fight, it is a fight I am ready to have”. Let’s see how tough Obama really is.

When we use the three-factor model to explain the monthly percent returns of the aggregate fund portfolio for 1984-2006, we get,

RPt - Rft = -0.07 + 0.96(RMt - Rft) + 0.07SMBt - 0.03HMLt + eit,

where RPt is the return (net of costs) on the aggregate mutual fund portfolio for month t, Rft is the riskfree rate of interest (the one-month T-bill return for month t), RMt is the cap-weighted NYSE-Amex-Nasdaq market return, and SMBt and HMLt are the size and value/growth returns of the three-factor model.

The regression says that the aggregate mutual fund portfolio has almost full exposure to the market portfolio (a 0.96 dose, which is close to 1.0), but almost no exposure to the size and value/growth returns (0.07 and -0.03, which are close to zero). Moreover, the market alone captures 99% of the variance of month-by-month aggregate fund returns.

In short, the combined portfolio of all active mutual funds is close to the cap-weighted market portfolio, but with a return weighed down by the high fees and expenses of actively managed funds.

What surprises me in this data  is not that active managers still can’t beat the stock market portfolio (we all knew that), but that they fail to take significant advantage of the anomaly that is value investing, which is evident from the negative coefficient on the HML factor*.

Value investing is investing at time when the price of a stock is well below its intrinsic value. You do not need the brains of Fama and French to realise that value investing is the way forward. Warren Buffet is a chief advocate of value investing and also widely recognized to be the most successful investor on the planet; surely this is evidence enough of the power of value investing. Value investing is one of the only areas in finance where the academic community and stock market participants agree that an anomaly exists and can be utilized to achieve higher returns. So why (as the above article points out) is its power not being harnessed by active mutual fund managers? With millions of fund managers trying to follow in the footsteps of known and successful value investors such as Warren Buffet and Anthony Bolton, my conclusion is that the bulk of these disciples are too poorly disciplined to be adequate value investors in the face of volatile market conditions and incentives for short term performance. Value investing is an easy concept to understand but very difficult to apply in practice. In fact, one of the characteristics of a successful value investor is that you act contrarily to other market participants and invest in unloved areas. It seems that active managers find to too difficult resist the latest craze when bargain investments are scarce. The data shows further evidence that fund managers just don’t understand that when stocks are going up they should be hoarding cash rather than risking capital. Value investing is about making large bets at the maximum point of pessimism, something it seems that fund managers just don’t have the nerve to do. So what do they do? Well as the regression shows, they simply invest in a wide range of assets and mimic the market. If a manager gets a return that is similar to the market index and other funds, he is unlikely to lose clients, so why stick his neck on the line?

To all of my readers, I give you this advise: Do not invest your money with a money manager. Fund managers are generally expensive and useless. Also, disregard any advise given to you by a financial advisor, they will advise you to invest in securities which offer them the most commission, which tend to be the useless money managers! Most private investors are better off with ETF’s which track market indices, you get the diversification required to keep volatility low and  no manager is paid to lose your money for you which makes it a cheap alternative. However there is another way…

I’ve just discovered an easy way to be a successful value investor and because you are my beloved readers I am going to share it with you! Go to the Securities and Exchange Commission’s website and look up the filings of Berkshire Hathaway Inc, the holding company owned by Warren Buffet (or just follow this link), find the 13-F documents which list investments of  Berkshire Hathaway Inc. These are great stocks to buy. If you had invested in these stocks over the 31 years from 1976 to 2000, simply by visiting the SEC filings as they’d been declared, you could have earned an average return of 24% a year over the entire period. This would have outperformed the market (the S&P 500 produced an average return of 11%), it would have also cost you nothing in management fees and given you the peace of mind of knowing that that world’s most successful investor deems your portfolio to be the best available. Of course past performance is no indication of future performance, but if Warren decides to add to this list in the future, its well worth treading on his coattails.

*For those of you who are unfamiliar with the Fama-French three-factor model I apologize. Basically, the regression shows that managers are not getting returns from using value investment techniques because if they were, the coefficient of the HML factor would be nearer to 1 that 0.

There was the prospect of a high profile leader with political clout when Tony Blair was the frontrunner for the newly created position of president of the EU council. Tony Blair would have been an ideal candidate to represent Europe on the world stage. Europe needs a bold leader to avoid sliding into irrelevance as the likes of China, Brazil and India emerge as new world powers and influence the future of global politics.

That prospect vanished on Thursday when Herman Van Rompuy, Belgium’s prime minister, was chosen for the top job. Van Rompuy may prove to do a great job in the position but this is man who is more of a populist consensus builder than a forceful policy maker. Lady Ashton was a last minute choice as chief of foreign policy. If you have just heard these two names for the first time you are not alone. These two figures are relatively obscure politicians, in Lady Ashton’s case, even in her home country.

European leaders have chosen relatively unknown politicians with little or no experience of international affairs. It is quite clear that Angela Merkel and Nicolas Sarkozy are trying to re-establish a German-French alliance and do not want somebody in Brussels challenging their authority. In fact, the whole delegation of jobs within the EU has been a complete farce. Rather than filling the positions with the best candidates, each country is bartering to have at least one representative in a top role. Michael Barnier, former French foreign minister, is set to be in charge of the European single market, while Axel Weber, president of Germany’s central bank, seems to be eyeing the role of Jean-Claude Trichet as president of the European Central Bank when he steps down in 2011. This is why neither country put forward a candidate for either the presidency or the position of foreign policy chief.

The lack of a figurehead leader is a crushing blow to US hopes that the Lisbon treaty would help the EU evolve into an equally capable ally on the world stage. It is also a blow to the UK, and disappointing for the EU as a whole.

Most countries have floating exchange rates, which means the value of their currency is allowed to fluctuate against the value of other currencies as the demand and supply for the currencies change.  In China however this is not the case, the Chinese government intervenes in the foreign exchange markets by buying dollars and selling yuan to keep the Renminbi artificially depreciated. The Chinese government  buys $30 million every hour to keep the exchange rate pegged against the dollar, and has accumulated over $2.2 trillion in reserves.  As the dollar’s value has fallen this year, the yuan has also fallen sharply.

Many criticize China’s undervalued currency as a beggar-thy-neighbour strategy for economic growth. By keeping the yuan cheap, Chinese exports become more competitive in foreign markets while other floating currencies have soared in value. The Brazilian  real has gained 42% since march, hurting its competitiveness  so much that it has been forced to implement a tax to discourage foreign direct investment.

The strategy also exacerbates the other problems caused by China’s large trade surplus.  While Chinese imports are so cheap, consumers will purchase them at the expense of buying those goods from other sources. China’s economy is primarily export led with American consumers doing most of the buying. This cannot continue indefinitely, China must save less and consume more for its own good as well as for the good of the world economy. China should want to wean itself off the American consumer to ensure stable and self sufficient economic growth in the future. A stronger yuan would help increase the purchasing power of households and raise the labour share of income which would boost domestic consumption. It would also tighten corporate profits which are a major cause of the boom in domestic savings. The effects of these changes would drastically curb China’s dependency on the American consumer and allow Americans to spend more in their own economy. Also by pegging the yuan to the dollar, China is importing US monetary policy which (with near zero interest rates) is currently too loose for the Chinese economy in its return to high levels of growth.

China’s current account surplus is expected to have fallen markedly this year. However this reduction is only temporary. The global recession caused a plunge in world trade and because Chinese exports were so much bigger than imports before this collapse, the gap between exports and imports has shrunk. Therefore this current account correction is only a temporary side-effect of the economic downturn. Work towards a permanent solution needs to begin.

Lets not forget why this is so devastating to the economy. First of all it interrupts transaction efficient; carrying around more and more, larger denominated notes is inconvenient and inefficient. Inflation also causes opacity in price signals, i.e. the appropriate cost of goods becomes unclear when price levels are changing at a faster rate. Inflation causes larger volatilities in prices levels which creates difficulties when making policy decisions such as setting the nominal level of interest rates. When inflation becomes a problem borrowing and lending becomes impossible. Effectively the entire financial system will struggle to operate.

Will the UK government create too much money? We have already seen £175bn enter the economy through QE and there is a possibility that the Bank of England could increase this figure. So is there cause for concern about inflation?

Fortunately most economist believe inflation poses little fret. There are two good reasons to believe them. Firstly, the recession has been devastating to output. The output gap (the difference between productive capacity and actual output) is now big enough to constrain inflationary pressures for the next few years. Until output increases and the economy approaches full employment wages will remain suppressed by the excess supply of labour.

We can also look at how inflation normally occurs. Historically bouts of inflation have been preceded by two changes in the economy:

1. There is a budget crisis. Fiscal borrowing increases normally due to economic upheaval.
2. The government becomes increasingly unable to borrow the money it needs to finance its debt.

Fortunately we have not met both these conditions yet. We certainly have a budget crisis in the UK, however, there is little evidence that the government will be unable to borrow money in the near future, for the time being there are many sources which are happy to lend to it. Therefore I think that the threat of imminent inflation is minimal. The government is still able to borrow, and what’s more, yields are still low and it can therefore borrow without excessive cost either.

Of course this may not always be the case, if the scale of a governments debt grows to an unsustainable level, lenders will invariably start to panic and stop buying governemnt debt. But even if this situation were to arise, the circumstances which instigate inflationary pressures will take time. It takes months for the public to adjust their real money balances, or to negotiate higher wages and barter arrangements or to introduce the use of foreign currencies.

I therefore believe that this economy will not be hit by inflation in the near term, but this does not mean that central bankers should ignore their duty to contain inflation. Monetary policy takes around two years before its effects are felt in the economy. If inflation arrives before the MPC begins the process of increasing interest rates, it will already be too late.

The FT reported:

The rise in unemployment in the UK slowed significantly in the three months to August, giving hope that the worst job losses may be over as the economy shows signs of recovery.

The number of people out of work rose by 88,000 to 2.47m, compared with the previous three months, the lowest quarterly rise for 13 months.

The unemployment rate remained unchanged at 7.9 per cent of the workforce compared with a month ago.

The rate contrasts with recent figures of 9.8 per cent in the US and a 9.1 per cent average across the European Union.

The number of 16- to 25-year-olds out of work, far from rising above 1m as some forecasters had expected, fell by 1,000 to 946,000.

The number of people claiming job seekers allowance rose by 20,800 to 1.63m in September, the smallest rise since May last year.

These figures give us something to smile about, if the rate of unemployment growth is slowing, we may not have 3m people (10% of the workforce) unemployed by 2010, which economists had previously forecast. However the positives end there, I mean lets face it, the numbers are only slightly better than expected and we still face a unemployment hike which is destroying lives all over the country. Over 60% of people unemployed for over a year may never find work again and being unemployed makes people unhappy beyond the loss of their monetary income, people also lose their pride and sense of purpose. A  job gives more utility to a worker than just the utility from the increase in marginal wealth which employment creates.

There are implications for the macro economy too. An extra 20,000 people claiming jobseekers allowance each month is still an enormous burdon on the governments fiscal debacle. With government debt at unprecedented levels (it has now surpassed £800bn) public spending cuts are deemed necessary as soon as early 2010, which will hamper the chances of a return to the levels of economic growth which we had come to take for granted. More importantly the numbers hint that the UK faces a “jobless recovery”, which ultimately means that the large numbers of unemployed constrain consumer demand for years to come. Any route to economic prosperity will have to come via an export led recovery where foreign demand from emerging markets takes up the slack while domestic consumers continue to deleverage and firms rebuild their balance sheets. The recent weakening of the British Pound aids the transition to a trade surplus but this cannot replace strong consumer demand and high public spending. The recovery will be weak and drawn out.

With a jobless recovery on the horizon, the economic outlook for the UK is bleak at best.

The government, which has a 43% stake in Lloyds, is thought to be supportive of the deal and is likely to subscribe to the issue. This means that the Treasury would have to cough up £6.5bn in order to prevent diluting its stake in the company. Therefore, should the issue go ahead, Lloyds will find itself in a position where it could avoid participation in GAPS (which Lloyds believe to be an expensive way to insure against future losses), but it would still have British taxpayers as a majority shareholder, which means the government would have a say on how it conducts business and manages its lending, something it desperately wants to avoid. Essentially Lloyds is stuck between and rock and a hard place, either way the government will have Lloyds on a short string for the foreseeable future.

Lloyds is not the only bank to be tapping investors for equity at the moment. With risk-appetite increasing European banks are also seizing the chance to increase their capital ratios. Banco Santander is raising £5bn to invest in Brazil, while BNP Paribas and SocGen, two French Banks are raising roughly £4bn each to repay state support. With investor confidence rising and equity prices still comparatively low, now is excellent time for savvy CEO’s to raise the capital they need to enter the post-crisis era of prudent banking.