The less-efficient markets hypothesis

 

In a provocative paper, Cliff Asness argues that equity markets may have grown less efficient than 40-50 years ago. The one measure of market inefficiency is the presence of bubbles. They should not occur, yet they do although the term is often overused. HIs arguments are based on the observations that stocks have become more disconnected from reality based on the value spread. The value spread between expensive and cheap stocks has increased and reach extreme not much different from the dot-come bubble. 

His argument for markets being less efficient is based on three hypotheses or was to measure relative efficiency. 

One, indexing has ruined the markets. This is possible because if everyone is just investing in the market portfolio, who will make the markets efficient. Asness argues that more work has to be done on this topic. 

Two, very low interest rates for a long time. Low interest rates distort valuation, yet financial history does not seem to match well with this story. The tech bubble was not associated with low rates; however, financing was cheap. Still, low or negative interest rates will distort investment decisions.

Three, the effect of technology is backwards. The impact of technology which causes crowds not to be independent but provide a mechanism for positive feedback loops makes for situations where markets are less efficient.

Although markets may be less efficient, there are still opportunities for profit from good rational investing. Markets may deviate from some idea of fair value for longer time periods, but that does not mean they will be misplayed forever. Volatile may be higher especially volatility that is associated with forecast errors. The horizons may be longer for good investing, or the type of strategies employed may be different.