When the game changes

“In a free market, the price and quantity of an item are determined by the supply and demand for that item.”


In their efforts to jam the square peg of financial theory into the round hole of human nature, economists have perpetrated some pretty stupid things. But few of them are dumber than the efficient market hypothesis. EMH states that it is impossible to beat the market because the efficiency of the market means that prices always incorporate and reflect all relevant information. Why was the Dow Jones Industrial Average worth 22.6% less on Tuesday October 20th 1987 than it had been the previous day ? Why is Warren Buffett worth $67 billion ? Must be all that efficiency.


George Soros (estimated net worth: $25 billion) is also a pretty good refutation of the efficient market hypothesis. As a student at the LSE, Soros chose the Viennese-born philosopher Karl Popper as his tutor. Popper argued that empirical truth can never be known with absolute certainty; scientific laws can never be conclusively proved, they can only be given provisional authority, until some better theory intercedes. No amount of confirmation is sufficient. One failed test is enough to falsify.


“While I was reading Popper I was also studying economic theory and I was struck by the contradiction between Popper’s emphasis on imperfect understanding and the theory of perfect competition in economics which postulated perfect knowledge. This led me to start questioning the assumptions of economic theory.”


Buffett’s refutation is less elegant, but equally effective:


“I’d be a bum on the street with a tin cup if the markets were always efficient.”


EMH and its bastard cousin CAPM, the Capital Asset Pricing Model, continue to send students of finance down intellectual blind alleys. CAPM is a model that describes the relationship between the risk and expected return of an asset in a diversified portfolio. CAPM requires reality to be bent using what can politely be termed “assumptions”, including the assumptions that:


  • All investors are of the species homo economicus, i.e. they are seeking to maximise returns


  • All investors are rational and risk-averse


  • All investors are well diversified across a broad range of investments


  • All investors have an equal and non-influential relationship with prices


  • All investors can lend and borrow without limit at a risk-free rate


  • Transaction costs and taxes do not exist


  • All assets are liquid and perfectly divisible


  • All investors have identical expectations


  • All investors have access to infinite information simultaneously.


These assumptions are, of course, nonsense. And yet EMH and CAPM continue to be taught. Perhaps there are business schools out there that still advise their students that the Earth is flat.


Perhaps CAPM’s silliest assumption is that all investors are the same. It requires only a superficial acquaintance with the financial markets to know that this can hardly be the case. The financial markets are where sovereign wealth funds interact with private investors. The former can often be insensitive to price; the latter, never. Within the financial markets pension funds, with a theoretical investment horizon of decades, rub up against computer algorithms looking to front-run other investors by fractions of milliseconds.


And clearly, different investment entities have different objectives. The motivation of a central banker is likely to be distinct from that of a robot (assuming they are not one and the same).


In his latest Epsilon Theory newsletter ‘Hobson’s Choice’ (hat-tip en passant to Ruffer’s Duncan MacInnes), Ben Hunt touches on the fundamental belief systems involved in being an investor in public markets in the financial world of 2016:


“The damaging impact of negative interest rates on bank earnings and all that is very true and very real. But far more damaging is the impact of negative interest rates on these basic IDEAS about what it means to be an investor in public markets. If you see the world as principally a market of ideas and memes, rather than as a market of capital and labour.. then I don’t see how you can’t be freaked out by what’s happening today. Certainly it’s why I’ve gotten much more alarmist over the past few months in what I write. We are seeing huge chunks of stone being taken out almost daily from these central idea pillars of public markets. As market participants lose faith in the idea that time is on your side, as they start to question the idea that there’s an inherent up-and-to-the-right arrow to any price-over-time chart.. the entire financial advisory world is going to burn.”


Weird things happen when interest rates hit zero, and then keep falling.


“What is negative carry? It’s time working against you. It’s the price you pay to carry or hold a position. Investors HATE negative carry, because almost all investment conventions are based on the assumption that time works for you, not against you. What’s the basis of “stocks for the long haul”? Time working for you. What’s the basis of compounding, which is nothing less than the most powerful investment idea in all of human history? Time working for you. What’s the basis of retirement planning, saving, and – in a very real sense – the entire concept of investment? Time working for you.”


There was once a time when central bankers fought inflation like the very devil. Now central bankers are desperate to create it. Should we bet against them ?


When the game changes, we have a choice. Try to adapt, or stop playing.


Hunt offers the following conceptual responses for adapting to a ZIRP world in which central banking omnipotence is not what it used to be:


Source: Salient Partners / Ben Hunt


It’s not just that we’re entering uncharted waters; in a world of negative interest rates and negative bond yields, the entire investment landscape has changed. Investment strategy must reflect that. Although a risk-free rate no longer exists, we should probably still try and steer close to the shore, even if we may not be able to see it.


If the game has changed, learn the new rules.


With the financial weather now a function of economic policy, different laws apply. Old investment models are obsolete.


And within a policy-controlled market, genuine diversification – of risks, as well as anticipated returns – will matter more than adherence to a traditional asset allocation template that is no longer fit for purpose, because it was formulated in a positive carry world.


“The really crucial action, though, and it’s an action we can all take inside our own heads even if we’re not able or not allowed to actually do short selling, is to step back and reconsider all of our investment menu choices if time no longer works so clearly in our favour. That’s the existential issue every investor, allocator, or advisor needs to wrestle with, no matter how painful that is.”


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One reply on “When the game changes”
  1. says: MrVeryAngry

    Excellent. If I make a comment?. The EMH should not be taken as an absolute. It can be used as a tool, not an answer. That is – markets are not necessarily efficient every day, but the purpose of the market is to seek efficiency in the prices of [securities]. Thinking like this should stop you being a slave to the EMH and the CAPM come to that. In the same way you can think of capitalism as system for delivering more for less every day. That’s the ideal. But like EMH it is not always true. And in both capitalism and EMH government monopoly money and other interventions screws up the whole thing.

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