Tuesday, January 31, 2012

There Sumner Goes Again: The EMH Canard

      He has chutzpah I'll give him that. He has a post out today entitled, "Are there any good arguments against the EMH?" Well actually yes. There are many.

      The better question would be "Are there any good arguments for the EMH?" to which the answer is "If there are he didn't mention them in this post."

       Sumner's whole argument here amounts to claiming that the year after year rate of returns of hedge funds are not very high. As if the only way you could possibly refute EMH are if hedge fund rate of returns are very high.

       For one thing if EMH was such a good theory why can't he offer any maroceconomic cases for it, the best he can do is the very crude comparison of the hedge fund rate vs. the S&P? To say that the S&P rate is 10% proves nothing either.

       It surely doesn't mean that everyone, or even most people who get into equities will realize a 10% return. Let's listen to his "irrefutable argument" for EMH:

       "Over the years I’ve swatted away lots of arguments against the Efficient Markets Hypothesis.  The question is not whether the EMH is “true,” how could it be?  Almost no economic model is precisely true.  The question is whether it is useful.  I find the EMH useful, and anti-EMH models to be almost completely worthless.  I’m still looking for the model that will tell me how to beat the stock market.  Just when I was starting to warm up to Shiller’s model, he missed the huge bull market of 2009-11."

      He finds it useful-for what exactly he never tells us. He says no economic model is precisely true but he doesn't even give it any economic analysis just claims that as Shiller didn't beat the market, EMH must be true. Very weak argument. Is Sumner himself a market participant? If not what use is he getting from EMH?

      Does he mean useful as a market participant or an economist?

       "There is no doubt that hedge-fund managers have been good at making money for themselves. Many of America’s recently minted billionaires grew rich from hedge clippings. But as a new book* by Simon Lack, who spent many years studying hedge funds at JPMorgan, points out, it is hard to think of any clients that have become rich by investing in hedge funds (whereas Warren Buffett has made millionaires of many of his original investors). Indeed, since 1998, the effective return to hedge-fund clients has only been 2.1% a year, half the return they could have achieved by investing in boring old Treasury bills."

       Since the top of the bull market in 2000 the S&P adjusted for inflation is actually lower now and the Nasdaq is of course much lower. I feel that that there are two different levels that he blurs the lines on-the EMH as a theory useful for economic models-his stock and trade-and as useful for a market participant-as far as I know not his stock in trade.

      Yet he argues that it is useful and doesn't explain how but the argument he employs is all about market returns not economic models.

      As is typical for Scott he is seizing on one thing-this time hedge fund returns-and assuming he can make his entire point from this one premise not realizing that even if we grant it to him he is far from in pay dirt.

      He did this when he was arguing against MMT-claiming that without the Quantity Theory of Money (QMT) you can't explain the price level-ergo QMT must be right and MMT must be wrong. Only problem is that MMT actually does believe in QMT-of a type; for them it holds but only over the long run-so even if we grant him that QMT is the only way to explain the price level he still hasn't laid a glove on MMT.

     So it is here that whatever you make of hedge fund returns this hardly proves EMH. As someone who has played the market both as a buy and hold investor at times and as a trader at times, I doubt you will find many on the trading floor who believe in EMH.

     I will say this about the two strategies-here implicitly Sumner is assuming that a successful buy and hold strategy proves EMH. You can't get rich playing buy and hold as even if you get the 10% return Sumner wants you to think you can this is not going to make anyone rich. At best it is a high yield savings account, but with considerably more risk.

     On the other hand you can make a lot of money at trading, you can in fact get rich, In 2008 it was possible to make a lot of money quickly going short the banks, etc. Since then starting in March, 2009 it has been a time of buy and hold. Still this is a strategy that few without deep pockets have been able to afford during this period.



  1. There are many criticisms to Sumner. First is, that the return on an S&P500 index is an illusory hypothetical return, while the Hedge Fund Returns are cash returns to investors, and further do not include the management fees (the ones that have made the hedge fund managers rich) See Quelle Surprise! It’s Better to Run a Private Equity Fund than Invest in One and How The Hedge Fund Industry Has Kept 98% of The Profits in Fees and Chasing the Mirage of Hedge Fund Returns

    To see why the S&P500 returns are illusory, see The Ten Truths of Wealth Creation

    Since 1958, the year after the S&P500 was created, an equity weighted 500 index (based on one the price of one share of every stock) would have outperformed the actual market-capitalization-weighted version (the total value of each company in the index) 60 percent of the time. In other words, most of the time the S&P 500 index presents a distorted view of investor sentiment and performance.

    One additional problem with the index is that companies are sometimes replaced in the index for what S&P calls "lack of representation." In other words, the S&P index committee believes that these companies no longer represent leading stocks in leading American industries.

    The number of companies dropped has escalated in recent years. But adding high fliers and deleting the lowly means an investor in the S&P500 is by default buying high and selling low.

    Index funds are a dangerous placebo, giving many the illusion that the stock market is a much safer place than it really is.

    Further the index returns never include the cost of cashing out, and the fact that only a very small proportion of shares outstanding can be traded at the "stated" prices of the companies that comprise the index. This leads to an inflated return to the S&P 500 index, and thus cannot be used in a comparison to judge funds that return cash. Hedge funds and VC funds, start with cash, and return cash.

  2. Thansk for checking in Clonal! Haven't seen you in abit. Stop in often!

    There are like you say many not to say limitless problems with putting stock in the S&P as proving the EMH. I honestly think that you take a successful say commodity trader he has no interest in the EMH.

    He presumes by instinct it's nonsense.

  3. I think Sumner does not realize, that there is a difference between investing $1000, and investing $100,000,000 and it has little to do with risk tolerance. It is hard to invest that money and get adequate returns (that are not paper returns.) If that sum was invested in an index fund, you could never liquidate that investment without taking a significant haircut. Hence the investment in hedge funds - maintaining liquidity.

    Unfortunately economists like Sumner continue to believe that the market valuation (stock price x shares outstanding) of a publicly traded company is what shareholders will get if they liquidated. If you are a major shareholder of a corporation, you will never be able to liquidate your holdings without having a major market impact. You can only do that slowly over a long period of time, or else take out a loan using the shares as a collateral. Both avenues will give you a below market valuation of your shareholdings.

  4. No doubt. He also holds up Warren Buffett as proof individual investors can get rich. But what happened to Buffett again has little to do with that the average investor will get.

    Don't get me wrong I have played the market but that experience didn't exactly prove EMH to me-to the contrary.

    IF there is anything I'm coninvced of it's that the market is not a rational adding machine.

  5. Take a unhedged S&P5 futures position, and buy and trade the futures as you would in fast paced day trading and then watch the fun. You will lose some money (maybe a lot,) but it is very educational! You will never espouse the EMH after that experience.

    This is in actual trading. You will not be able to recreate it if you are engaged in shadow trading!

  6. Yes, Sumner speaks like a guy who has never been a market participant. If you are such talk is simply irrelevant.

    As I suggested above he is an economist who likes EMH in his econoic models but is trying to use an appeal to the world of investing and trading-kind of a bait and switch

  7. My experience showed me very clearly how thin the S&P5 market really is. Not the futures market, but the actual stock market. The millions of shares traded per day are again an illusion!

    There are two sure ways to bring those billions of shares sold per day to perhaps just a few hundred thousand a day or maybe a few million shares a day.

    1) A Tobin tax
    2) Introducing uncertainty in the price at which a share will transact. Keep trading as currently is. But the price at which you buy or sell is determined by a weighted average price over a one hour interval CENTERED on your transaction (including your transaction of course).

    Either of these two strategies will cut the trading volume significantly!

  8. You think the Tobin tax would be that big a curve?

  9. It all depends on what the Tobin tax levels are. Before on line trading, broker commissions were fixed at 1% of the amount of the trade before 1975. In 1975, the United States Securities and Exchange Commission (SEC) made fixed commission rates illegal, giving rise to discount brokers offering much reduced commission rates. The reduced rates are what made day trading possible. For the brokers to make any profit in this environment requires much higher volumes. Higher volumes will of necessity lead to a much higher stock volatility. The high volume does not necessarily mean a high real volume. With no (low) brokerage costs to contend with, it becomes easier for large brokers, market makers to make it appear as if there is a huge demand for shares and stocks, by trading under the cover of multiple accounts, but only trading between accounts owned by very few real entities.

    So a Tobin tax of 1% would bring back the volumes of the early 1970's as would a one hour window. Generally one hour windows will not show more than a 1% rise or fall if the players involved don't know the final price at which the trade will transact. So yes, they should show a similar degree of impact.

    My feeling is that either of these two schemes will make the dividend come back into fashion! If either of these two happens, brokers will be clamoring to go back to a fixed percentage commission rate.

  10. It would largely price out the average person?

  11. Not really. It would prevent stock flipping. It would not prevent ownership of a stock by a person who saw value in a public company, which was either profitable and growing (hence needing retained earnings) or profitable, and giving dividends to shareholders. that was the situation before 1975.

    Day trading and manipulation of stock prices by brokers and market makers would be greatly reduced.

    You should also consider reading Deep Capture particularly the slide show talk