It isn’t your imagination. The stock market really is getting crazier – at least, according to one of the investment industry’s most prominent number crunchers.
Cliff Asness, who holds a PhD in finance and runs AQR Capital Management in Greenwich, Conn., made his name (and a couple of billion dollars) by devising ingenious investing strategies based on deep dives into data. In line with most other financial researchers, he has always argued that markets are efficient – in other words, that they excel at collecting all the pertinent information about stocks and then pricing each stock at a rational level.
But maybe not so much any more. In a new paper called The Less-Efficient Market Hypothesis, Mr. Asness argues that markets have grown increasingly erratic in recent decades.
“My contention [is] that for the relative pricing of different common stocks, the market has gotten less efficient over my career,” the 57-year-old billionaire writes.
This is a bit like the pope conceding that the heathens have a point. For more than a half century, finance professors and educated investors have worshipped at the altar of the efficient market hypothesis (EMH). This is the idea that stock markets are reliable and rational judges of value.
Index investing is the practical embodiment of EMH. People who invest in index funds believe it is silly to try to beat the market, because the market in aggregate is likely to be more accurate at assessing a stock’s value than an individual investor.
Value investing also reflects a belief in EMH. People who buy cheap stocks typically do so because they assume the market is efficient and will eventually recognize its mistake in pricing the stocks too low.
If Mr. Asness is correct that markets are becoming less efficient, the implications are profound for these investing strategies. He acknowledges, though, that market efficiency is difficult to measure and that his concerns may be “the harrumphing of an old man.”
Still, he builds an interesting case. It rests in large part on the “value spread” – the ratio of how pricey the market’s most expensive stocks are compared to the market’s cheapest stocks.
This ratio is usually fairly stable, but there are exceptional periods when the value spread spikes far above its usual level. At these points, investors are paying a massive premium for their favourite stocks.
This willingness to pay through the nose signals exuberance. It may even indicate a bubble: The value spread spiked around 1999 to 2000 during the dot-com mania. It did so again around 2020, when the COVID-19 pandemic disrupted markets and helped meme stocks of low quality, near-bankrupt companies briefly soar before crashing.
Two major bubbles in 20 years suggest “markets have gotten more disconnected from reality over time,” Mr. Asness writes. And he sees little evidence that the disconnect is going away.
Right now the value spread is still very high. Mr. Asness measures it a couple of ways, using simple price-to-book ratios in one example and a more wide-ranging set of valuation yardsticks in another, but the upshot is the same: The top 30 per cent of stocks are selling at unusually lofty prices compared to the bottom 30 per cent.
Mr. Asness argues this top-heavy structure cannot be explained simply as the result of a boom in a handful of technology stocks. The phenomenon seems rooted in something more structural.
He points to three possible candidates. The first is indexing. The widespread adoption of indexing strategies may have rendered the market insensitive to how cheap or expensive a stock is. The second is the impact of ultralow interest rates for much of the past 15 years. Maybe easy money has helped encourage a giddy, what-the-heck approach to valuing hot stocks.
Then there is a third candidate, Mr. Asness’s favourite. It’s the impact of social media and gamified, instant, low-cost stock trading on the market. “Has there ever been a better vehicle for turning a wise, independent crowd into a co-ordinated, clueless, even dangerous mob than social media?” he asks.
It’s an excellent question and one that leads on to an even more intriguing puzzle: What can a rational investor do in a market that is showing signs of increasing irrationality?
Mr. Asness offers a nuanced answer. On the one hand, rational investors should be able to reap unusually large rewards by capitalizing on the prevailing irrationality. On the other hand, those rewards may take an awfully long time to materialize. There is no guarantee that an increasingly giddy market will recognize the true worth of an undervalued stock this year or even this decade.
A fine example of persistent irrationality is how pricey U.S. stocks have become in relation to stocks in other countries. In theory, investors should be able to prosper over the long haul by buying cheaper non-U.S. stocks. In practice, though, U.S. stocks have dominated all others for close to 30 years, prompting many investors to abandon non-U.S. markets.
Mr. Asness suggests investors should stick with international diversification and other rational strategies, but be realistic about the patience that may be required to make these strategies pay off.
In an increasingly erratic market, “I think the ups and downs will be bigger and last longer, making more money for those who can stick with it long term, but making it harder to do so,” he says.