Efficient Market Theory: Do Humans Really Behave Rationally-Seek out Relevant Information & Then Process Information With Good Judgment?/GIS

1.  General Mills:  GIS, a recently acquired position Bought GIS, raised its forecast for its fiscal year ending May 31st to $3.87 to $3.89 from its prior forecast of $3.78 to $3.83. The company also expressed comfort with the consensus forecast of $4.15 for the next fiscal year.

I see no reason to make a decision on whether to sell my shares purchased at $48.52, unless the stock approaches $60 within the next few months, which would be less than 15 times this fiscal years estimated earnings.  Did investors correctly process information about the last earnings report from GIS?

2.  Past is Prologue?: One of the many dominant and dangerous themes in investing revolves around those who predict the future based on the recent past.  Barron's will frequently feature those financial gurus who believe that financial Armageddon is upon us, and who recommend selling stocks and buying long dated treasuries. This would have looked smart last year, when the Barclay's 20 year treasury index gained 33.72%, and many of those gurus continued to recommend long treasury paper in several interviews featured this year in Barron's.  But, so far this year, that index has fallen 22.94% this year, according to an article in Sunday's NYT. NYT

Recently, I highlighted a debate between Robert Arnott and Jeremy Siegel above whether stocks or bonds had better long term risk adjusted returns.

To Professor Siegel: Time for a Re-Think

Siegel v. Arnott: Both Have Winning and Losing Arguments for Me in my Dynamic Asset Allocation

It is interesting that an investor would have done just as well or better  buying a 20 year treasury bond near the start of the great secular bull market in stocks, which started in August 1982, and then rolling it over into another 20 year treasury at maturity, rather than investing in the S & P 500 (actually it is worse than that, since I have seen statistics that date the outperformance of that bond back to 1968 through 2/09: page 3 Stocks Through a Wide-Angle Lens - Barrons.com Duality of Long Term Risks/Stocks Under $5: Per Se Lottery Tickets/)

But you can not draw the conclusion based on that experience that Siegel is wrong about the future. The 20 year treasury was yielding over 10% in the early 1980s, and over 14% for a brief period back then.  If I could go back in time, I would have just bought the 20 or 30 year treasury yielding over 14% and forgot about stocks.  The 20 and 30 year treasury are not yielding 14% now but around 4%, so the same prediction obviously can not be made about the future based on what happened in the past period relied upon by Arnott. So, now, I would have to go with stocks to beat bonds, at least based on the bond's current yield. Then, I will have to reassess that conclusion when and  if circumstances change, such as the the ten year bond moving to an 8 to 10% yield after stocks double in five years from the current level, which is what David Kelly from J P Morgan says is possible in this week's Barron's.  Barrons It pays to stay flexible and not to be hide bound to the past. 

3.  Efficient Market Theory and Mutual Fund Managers:

Efficient market theory originated in academia at the University of Chicago. It is the kind of academic theory that might even win a nobel prize. As with many theoretical constructs, however, it looks much better on paper and in theory than tested by the rigors of the real world.  Under this theory,  the stock market can not be beaten on a consistent basis since all available information is known and reflected in existing stock prices. This theory and its problems are explained by Joe Nocera in his recent NYT column.  NYT

Some argue that the failure of mutual fund managers to beat their relevant benchmark on any consistent basis is proof of the efficient market theory.

With mutual fund managers, failure is an epidemic with no known cure. The question is not whether mutual fund managers are worth anything, clearly they are mostly worse than worthless. Instead, the issue is simply how much on average will their effort cause a deviation from the relevant performance benchmark.   If one of the wizards actually beats their benchmark, it  is often a momentary and fleeting phenomenon worthy of much advertisement in financial publications, followed by a less than stellar performance that reverts to the mean of mediocrity.  

Some argue that efficient market theory is proven by the failure of the wizards as a class to beat dumb indexes with any consistency. I would not assume that this failure is tied to the validity of the theory but to other factors.   I would simply postulate the following to provoke some thought on the subject:

a. All individuals have to make decisions about stock selections based on inadequate and sometimes erroneous information about the present. Since stock pricing is based more on about predictions about the future, which include a variety of unknown, uncertain and even unknowable variables, then any decision now is at best a prediction based on inadequate information.   

b. What information is known will be processed and evaluated by individuals in different ways, with large numbers of individuals drawing erroneous conclusions from the information which is available. I could give thousands of examples.  How many people including the "professionals" correctly processed information about the mortgage crisis as it developed in 2007? A well known mutual fund manager rode C B Richard Ellis down from the high 30s reached during the bull market in real estate to a recent price of two and change, and then bought more shares when CBG needed to raise cash by selling shares at a distressed price. Did that expert process information about the macro variables impacting CBG correctly in 2007 and 2008? Or, there was a bond fund manager touted frequently by Morningstar that was buying securities in the first half of 2008 from companies most at risk to the unfolding credit crisis and real estate meltdown. The same information may be available to anyone willing to look, but most do not bother looking, and those who bother to find out will frequently draw the wrong conclusions or make erroneous judgments based on what they find out.  

c.  Economic models based on the rationality of human beings acting collectively are flawed from the outset. Do human beings behave rationally?  Really?  Maybe, they do occasionally. I would not rule it out completely.  For the most part, it is better to assume that my fellow investors, including the Masters of Disaster and assorted financial wizards, are not acting rationally. Irrational behavior has many causes. It may result from human emotions overcoming reasoned analysis of all existing information. In some cases, simple individual greed may distort the rational analysis of all available information which explains a great deal about the decisions made by the Masters of Disaster at AIG's Financial Products Unit, London division, and by the denizens in the investment banks such as Merrill Lynch, Lehman and Bear Stearns. Some may make an irrational decision to act based on an abstract mathematical model that, while potentially worthy of a nobel prize for its brilliance, has no relationship to the real world. Paul Wilmott & The Need for Nerd Therapy/Valero/Bernanke Testimony Herd behavior and fear of being left behind can influence the creation of bubbles in asset valuation.

The formation of a bubble in an asset price is inconsistent with rational analysis. How many bubbles have rational investors created just in the past decade, starting with the parabolic rise in stock prices in 1999, particularly on the Nasdaq and the impossible to fathom dot-bombs? Fear of the unknown and unknowable can be far more powerful in setting security prices compared to any rational and reasoned assessment of known information. How much reasoning was done in the pricing of Aegon and ING preferred issues in early March 2009, when they were priced to yield in some cases over 60% per year.

So, if you combine individuals making irrational choices into a collective, you get what exactly-a rational decision by the collective? 

d.  While it is true that most money managers fail to beat the index on a consistent basis, this is not proof of the efficient market theory, but has more to do with the failures of human being to process information correctly and in a rational manner, or the exact opposite of efficient market theory.  So, rather than being proof of an efficient market, it is more proof of a market that is incapable of being efficient for any length of time, at least when you break it down security by security.   This means that an individual investor, capable of making rational decisions after gathering all relevant information and assessing it without any preconceived beliefs, has a better opportunity to beat the indexes than those who do not follow the process.  And, part of that process is that the individual can not be constrained by style boxes, buying large cap growth or small cap value stocks.  Instead, the individual has to be willing to go anywhere and buy just about anything based on the opportunities presented by the market.  This is one of many advantages that an individual has over mutual fund managers. 

4.  Cramer and Sallie Mae:  Readers of this blog know that I have been waffling back and forth for months about my ownerhsip of OSM, an exchange traded bond issued by Sallie Mae (SLM), that pays a floating rate of interest tied to a 2% spread over CPI, and matures in 2017.  My concern has been, and still is, whether or not SLM will survive to pay me the $25 par value in 2017.  That is both the beginning  and end of my interest in SLM.  The interest rate paid is currently low because of the decline in CPI, and may stay at a low level for several more months.  I would expect inflation to move all over the place during the years prior to maturity of this bond in 2017.  I also know that I juice the yield to me by buying any bond at a substantial discount to par value.  But, to me, the interest paid is just icing on the cake and my main pay day is capturing the spread between my cost and par value at maturity.  This requires me to constantly assess the likelihood of SLM surviving OBAMA and the Democrats and paying me the $25 par value in March 2017.  www.sec.gov

Cramer's analysis of SLM's prospects during the Mad Money show last Friday simply convinced me to end my waffling now, and just wait and see what happens. Cramer & Sallie Mae:/ I am still concerned about it.  If OSM rose in the coming weeks to say $18 to $20, I would seriously have to consider selling my shares since I would then be capturing more than 1/2 of what I consider to be the most important part of my potential return from OSM. This security is currently trading at around $11.5 this morning, up about eight cents from the close on Friday. The common stock, SLM, is receiving a bump from Cramer's recommendation, up over 10% in early trading this morning.

I currently own 150 shares of OSM and may buy 50 more for a retirement account. I would prefer putting it in my regular IRA so I could include it in a ROTH conversion in the event it fell significantly in price. I have temporarily run out of funds in that account and will have to sell something before buying 50 of OSM.