Efficient Market Hypothesis as Hokum/WBS NYX/Historical Perspective on S & P Gain Since March 2009

1. Webster Financial (WBS)-And the Efficient Market Hypothesis: My 50 shares position in WBS, bought at $4.58 turned into an unrealized long term capital gain last Friday. The stock closed Friday at $17.99 and is trading over $18 this morning. WBS is part of the basket of stocks contained in the Regional Bank Stocks strategy. The most recent table of those positions can be found at this update.

My purpose for bringing up my WBS quandary is to discuss my view of the Efficient Market Hypothesis (EMH) promulgated by Eugene Fama and others who are evidently unable to learn anything from the past 11 years, starting with the bubble in stock prices in the late 1990s. EMH is just hokum in my opinion, a form of academic snake oil. Efficient-market hypothesis

Notwithstanding lengthy periods of price inefficiency and irrationality, for both the market and individual stocks, the EMH thesis postulates the existence of a rational market that rapidly and accurately digests all relevant information. Markets are informationally efficient under this view, even though individuals, the ones making the market decisions, are palpably inefficient and prone to making irrational and frequently idiotic decisions. So, somehow, when you combine a very large number of frequently irrational humans into a decision making process, the result is both rational and efficient. Consequently, under this EMH theory, it is impossible to outperform the market on a consistent basis by acting on information that the market has already digested and reflected in a stock's price. This would be true for all information deemed material from both a fundamental and a technical perspective. Part of the proof of the EMH thesis is that virtually no one can outperform the market on a consistent basis.

There are a multitude of reasons why individuals can not outperform the market on a consistent basis that have nothing to do with the market being efficient or inefficient. I would not confuse the failure to outperform and the market's efficiency in pricing.

In the real world, I have to make literally thousands of decisions per day about my investments. The sheer multitude of decisions that have to be made correctly will cause a compounding effect which will result in most underperforming a stock index fund which makes no decisions. So, in that sense, most would be better off not making any decisions.

The S & P 400 rode WBS down to $4.5 and now back up to $18. I did not ride it down to $4.5 but I have managed to be on the up escalator. The same phenomenon is at work in a large number of stocks that I bought during the meltdown. Was I right and rational on those occasions or was the market right and rational?

How many decisions to I have to get right each day to beat the S & P 500 or the a total stock market index? I would say a lot but nowhere near all decisions have to be correct based on the subsequent history. In 2008 and 2009, and so far at least in 2010, I have beaten the market while making a multitude of mistakes. The sheer volume of mistakes is just staggering, mostly selling positions too early or failing to buy a reasonable number of shares in securities that multiplied in value because they were so obviously mispriced by the the market. And, to compound the errors, I recognized the mispricing when I bought an inadequate number of shares. Was AEB at $2.62 on 3/6/09 a rational price for example? AEB: Historical Prices Aegon Hybrids: Gateway Post No, it was extremely irrational. Having recognized that the pricing was a matter of irrational mob psychology, why did I buy just 350 shares, and not 500 or a 1000? Yet, the decision to buy AEB is one of the multitude of decisions that led to a 42% gain last year.

The reason that I outperformed or underperformed the market in prior years was not based on luck, or a lack thereof, which is how Fama or Taleb would describe it. Instead, it was the result of literally tens of thousands of correct decisions outweighing the ones which later proved to be wrong. I was successful last year and in many years prior to then. But I may end up faltering this year for reasons having nothing to do with the purported efficient and rational market. I underperformed the market in 1999 but I view the reasons for my underperformance to be rational whereas the market was the irrational and inefficient one. In my view, I was the rational one for refusing to buy securities being irrationally priced by the market, not for a day or two, but for over a year.

Take the 50 shares of Webster which have tripled in value since I bought them a year ago. How many decisions have I made on that one security? I have had to make a multitude of decisions which are unfortunately still continuing in a never ending cycle. I had to decide to buy it, how much to buy, and whether or not to sell it as it rose in value. I thought about selling it when it doubled in price but correctly decided to hold it until now. Now, I have another decision to make, do I sell now? If I sold I would want to invest in another regional bank that pays a higher dividend, certainly more than the penny a quarter that WBS is paying now. There are several pros and cons for selling and holding, all are rational, and have to be considered before dealing with any psychological issues which inevitably enter the decision making process even for the most rational of investors. One of the reasons for holding Webster is discussed in this post: /More on Regional Bank Strategy

Webster is just one immaterial position in a portfolio of 350+ securities (which includes a number of mutual funds). The reason that an individual fails to outperform the market on a consistent basis has nothing to do with the market being efficient or inefficient, but in the sheer number of decisions that have to be made by investors causing error creep. When that problem is compounded by a failure to perform research, or to process relevant information without information bias in order to make an informed rational judgment, the potential for errors increases dramatically. The more decisions that have to be made, the greater the potential for errors to accumulate and to cause underperformance. The failure to perform a rational investment process prior to making a decision simply increases the number of likely erroneous decisions. It certainly does not help that the decisions have to be made by fallible human beings who are far from omniscient about the future and who have a bevy of psychological factors pulling and tugging in a variety of frequently disparate directions. In short, most people, including the so called professionals, are not wired to be good investors. Part of that wiring is the willingness to spend the time researching and assessing the material and relevant information.

Even if I reduced my position to five stocks, I am making thousands of decisions on which to include and to exclude from that list, and a constant series of decisions on whether or not to keep them or to make a substitution. If I had Home Depot, why not TJX or Macy's or why have a retailer at all in my list of 5? All of those decisions have an impact on whether or not the investor will beat the market averages. If the investor underperforms the market with 5 securities or 100, it will not have anything to do with the market being rational or efficient, but in their own mistakes as an investor. The market can be without question inefficient and irrational and that can provide opportunities. However, since it is so difficult to make so many decisions correctly as a fallible human being year after year, this explains why so many fail at beating the market on a consistent basis.

Admittedly, some stocks are priced rationally most of the time. An example would be Proctor & Gamble. Still, there are periods, lasting for several months, where the price of even the most rationally priced stocks become inefficient and irrational. Those periods are intermittent, both on the high and low sides. At most, the inefficient pricing on the low side for a stock like PG will last a few months or weeks, most likely during a bear market or a period of market stress like the October 1987 crash. The high price period can last longer, maybe for several years. Coca Cola is an example of an irrationally high price when it was trading at over $80 in 1998, and the most irrationally low price was when I made my purchase at less than $39 in March 2009. I would view KO to be less rationally priced now than PG. The most inefficient and irrational markets during the recent bear market involved Trust Certificates and preferred stocks (both equity and trust preferred), starting around October 2008 and extending for several months into 2009.

2. NYSE Euronext (NYX) (Owned): Similarly, I have a decision to make about NYX. I bought shares on March 6, 2009 at $14.76 Buys of JWF KSA DIS and NYX That was certainly a better decision than Cramer made about this security. See Item # 12: NYX I want to sell the position. It has almost doubled in price, and I have not been impressed with the recent earnings reports. Earnings have been declining year over year.

While the dividend is currently good at my cost, it has not being raised since the June 2008 quarter, and I am concerned about the possibility of a dividend cut at some point. This distinguishes NYX from Webster, where I would anticipate a growing dividend in years to come , possibility returning years into the future to the level from 2007 which would give me a tremendous yield at my constant cost for Webster's shares.

The return on equity for NYX is far from inspiring.

Then there is the issue with competition in NYX's business. The following are just statements about competition made in NYX's recently filed annual report: "As a result of increasing competition, our share of trading on a matched basis in NYSE-listed securities has declined from approximately 45.6% in 2008 to 38.4% in 2009. . . . In Europe, MiFID, which went into effect in November 2007, promoted competition from alternative trading platforms, or MTFs. Subsequently, a number of MTFs have been launched, or will be launched during 2010. These platforms offer trading in the securities listed on Euronext and other European regulated markets and compete directly with us for market share. In 2009, our market share of our listed securities declined, and although we are taking steps to stabilize this decline, it may continue in 2010. If our trading share continues to decrease relative to our competitors, we may be less attractive to market participants as a source of liquidity. This could further accelerate our loss of trading volume." (page 25: e10vk)

A case for continuing to hold the shares was made by Michael Santoli in his Barrons column based on an increasing amount of revenue coming from derivative trading. Santoli summarizes the opinion of a Sandler O'Neill analyst who has a $34 target price on the stock. The stock is trading near book value. And the consensus analyst estimate is an E.P.S. of $2.33 for 2010 rising to $2.72 in 2011. A six month or a one year target of $34 appears reasonable to me, provided the economy continues to improve along with investor confidence.

So, that is a lot of information to process in order to make a judgment on whether or not to sell this stock today, lock in that long term gain, or to wait. I am inclined to wait, though I view the negatives as sufficiently persuasive that I would likely sell those shares at somewhere in the $32 to $34 area. Was the price of $14.86 a year ago rational? Was it the result of an efficient processing of all available information? Did Cramer process all relevant and available information when he recommended it as his growth stock of the year?

3. Interest Rate Changes Impact on Bond Prices: This month's T.Rowe Price Investor magazine has a chart that shows the impact on the value of bonds by maturity resulting from a 1% increase and decrease in interest rates. (pages 1213: T. Rowe Price Investor - March 2010 - Page 12-13) For a 30 year maturity, a 1% increase would cause a $1000 bond to fall to $856 and to $921 for a ten year maturity.

I think that it is important for bond investors to understand that there is a great deal of interest rate risk to bonds and bond funds at this present time.

4. Percentage Gains in the S & P 500-A Time Perspective: I noted this morning that the S & P 500 has risen 72.4% off its March 2009 low, gleaning that number from dshort.com. As you would expect, there are a number of articles being written that the market needs to correct after such a jaunt, the latest being The Trader column in this week's Barron's. I even saw that David Rosenberg was quoted in a article as saying the market is now overvalued as much as it was undervalued in March 2009, suggesting that he was bullish in March 2009 when he was expecting further carnage in the market.

If you take a different time reference than March 9.2009, the market's rise does take on a different appearance. On March 10,2008, the S & P 500 was at 1,273.37. ^GSPC: Historical Prices for S&P 500 So, rather than being up 72.4%, the S & P has fallen by 8.39% in a little over two years. Or, I could look at it by staring on March 9, 2000, which for us math challenged individuals is more than ten years ago. The S & P 500 closed that day at 1401.69: ^GSPC: Historical Prices for S&P 500 The S & P 500 closed last Friday at 1,166.59, (^GSPC) representing a 16.77% decline over that ten year period. That does not make me feel so giddy.

When you look at that kind of data, I would simply reach two conclusions about the 72.4% move off the March 2009 low. From a long term perspective, the percentage gain is a historically typical cyclical bull move within the confines of a long term bear market, similar to the movement off the 1932 and 1974 lows. By itself, it does not presage the start of a new long term bull cycle or a continuation of the long term bear market which I start in 1997. It is actually consistent with both. 1974 or 1982: Start of Cyclical Bull in a Long Term Secular Bear Market or the Start of Secular Bull Market? There was a 72% gain from the low in October 1974 to September 1976, yet the long term secular bear market continued for almost another six years. Second, I view these kind of moves to be primarily a correction of the catastrophic phase of the long term secular bear market. In other words, the market went too far down based on conditions actually prevailing or reasonably anticipated future conditions.

A possible third conclusion is that a move of 72% over a relatively short period of time will require a lengthy period of digestion, irrespective of whether a new long term bull market started in March 2009. The most recent parallel would be with the launch of the long term bull market which started in August 1982 and ended in October 1997. On August 12, 1982, which in retrospect was the start of a 15+ year bull cycle, the S & P 500 closed at 102.42. ^GSPC: Historical Prices for S&P 500 INDEX On June 22, 1983, the S & P closed at 170.99, roughly a 67% gain in less than a year. The market then went into a lengthy congestion phase. It did not go up or down much. By 1/14/1985, the S & P 500 closed at 170.51, almost a 1 1/2 years of going nowhere, yet the long term secular bull market had without question commenced in August 1982. The market then resumed a rise that culminated in the downdraft of October 1987.

As an aside, while reading the book "The Quants" over the weekend, I saw a reference to a study that was done many years after the October 1987 crash which established mathematically that the crash could not have happened.