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Howard Marks' Views On When Markets Will Be Efficient (Hint: Never)

Tyler Durden's picture




 

While the topic of Howard Marks' latest letter is the role of luck in everything from the life one leads to investing, the part we found particularly engaging was his discussion of (in)efficient markets, and why according to him inefficient markets are to be cherished, especially if one knows in advance just how rigged the game is and the skill of the other players.  Here is the key excerpt.

Let me say up front that I have always considered the reasoning behind the efficient market hypothesis absolutely sound and compelling, and it has greatly influenced my thinking.

 

In well-followed markets, thousands of people are looking for superior investments and trying to avoid inferior ones. If they find information indicating something’s a bargain, they buy it, driving up the price and eliminating the potential for an excess return. Likewise, if they find an overpriced asset, they sell it or short it, driving down the price and lifting its prospective return. I think it makes perfect sense to expect intelligent market participants to drive out mispricings.

 

The efficient market hypothesis is compelling . . . as a hypothesis. But is it relevant in the real world? (As Yogi Berra said, “In theory there is no difference between theory and practice, but in practice there is.”) The answer lies in the fact that no hypothesis is any better than the assumptions on which it’s premised.

 

I believe many markets are quite efficient. Everyone is aware of them, basically understands them, and is willing to invest in them. And in general everyone gets the same information at the same time (in fact, it’s one of the SEC’s missions to make sure that’s the case). I had markets like that in mind in 1978 when, on going into portfolio management, my rule was, “I’ll do anything but spend the rest of my life choosing between Merck and Lilly.”

 

But I also believe some markets are less efficient than others. Not everyone knows about them or understands them. They may be controversial, making people hesitant to invest. They may appear too risky for some. They may be hard to invest in, illiquid, or accessible only through locked-up vehicles in which some people can’t or don’t want to participate. Some market participants may have better information than others . . . legally. Thus, in an inefficient market there can be mastery and/or luck, since market prices are often wrong, enabling some investors to do better than others.

 

* * *

 

The Current State of Market Efficiency

 

Let’s compare the current environment for efficiency with that of the past.

 

  • Data on all forms of investing is freely available in vast quantities.
  • Every investor has extensive computing power. In contrast, there were essentially no PCs or even four-function calculators before 1970, and no laptops before 1980.
  • “Hedge fund,” “alternative investing,”
    “distressed debt,” “high yield bond,” “private equity,” “mortgage backed security” and “emerging market” are all household words today. Thirty years ago they were non-existent, little known or poorly understood. Today, as I say about the impact of the browsers on our mobile phones, “everyone knows everything.”
  • Nowadays few people make moral judgments about investments. There aren’t many instances of investors turning down an investment just because it’s controversial or unseemly. In contrast, most will do anything to make a buck.
  • There are about 8,000 hedge funds in the world, many of which have wide-open charters and pride themselves on being infinitely flexible.

It’s hard to prove efficiency or inefficiency. Among other reasons, the academics say it takes many decades of data to reach a conclusion with “statistical significance,” but by the time the requisite number of years have passed, the environment is likely to have been altered. Regardless, I think we must look at the changes listed above and accept that the conditions of today are less propitious for inefficiency than those of the past. In short, it makes sense to accept that most games are no longer as easy as they used to be, and that as a result free lunches are scarcer. Thus, in general, I think it will be harder to earn superior risk-adjusted returns in the future, and the margin of superiority will be smaller.

 

People often ask me about the inefficient markets of tomorrow. Think about it: that’s an oxymoron. It’s like asking, “What is there that hasn’t been discovered yet?” The markets are greatly changed from 25, 35 or 45 years ago. The bottom line today is that there’s little that people don’t know about, understand and embrace.

 

How, then, do I expect to find inefficiency? My answer is that while few markets demonstrate great structural inefficiency today, many exhibit a great deal of cyclical inefficiency from time to time. Just five years ago, there were lots of things people wouldn’t touch with a ten-foot pole, and as a result they offered absurdly high returns. Most of those opportunities are gone today, but I’m sure they’ll be back the next time investors turn tail and run.

 

Markets will be permanently efficient when investors are permanently objective and unemotional. In other words, never. Unless that unlikely day comes, skill and luck will both continue to play very important roles.

* * *

In hindsight, considering just how lucrative the past several years of straight line higher movement in the S&P500 have been to some market participants - especially those E-Trade babies with virtually zero grasp of that fundamental non-common sense concept called valuation (see GMO's letter earlier) -  one can therefore add one more distinction to Bernanke's legacy: creating the world's most inefficient marketplace.

For much more insight from the Oaktree chairman, read the full letter (pdf).

 

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Thu, 01/16/2014 - 21:39 | 4339737 jharry
jharry's picture

I agree, I think.

Thu, 01/16/2014 - 22:09 | 4339799 wintermute
wintermute's picture

The Bitcoin/Litecoin market is probably the most efficient and frictionless global market ever.

Thu, 01/16/2014 - 22:34 | 4339864 prains
prains's picture

.....hence the easiest to corrupt as well

Fri, 01/17/2014 - 01:38 | 4340150 Schmuck Raker
Schmuck Raker's picture

Hell Yeah!!! Get some!

And don't sell 'til Stolper says BUY!!!!!

Fri, 01/17/2014 - 06:00 | 4340281 James_Cole
James_Cole's picture

 

I have always considered the reasoning behind the efficient market hypothesis absolutely sound and compelling, and it has greatly influenced my thinking

...beginning with idiocy...

 

Markets will be permanently efficient when investors are permanently objective and unemotional. In other words, never. 

...and ending with absurdity.

Nicely played Marks. I pray the man is extremely well compensated for his grand insights. 

 

 

Thu, 01/16/2014 - 21:43 | 4339747 Dr. Engali
Dr. Engali's picture

I'm tired of thinking about this shit. I'm going to go hit my wife up for some sex to take my mind off of things. And if that doesn't work I'll have to go on to plan B.... Pour a stiff drink and watch some Gilligan's island.

Thu, 01/16/2014 - 21:51 | 4339762 Dr. Engali
Dr. Engali's picture

Well so much for plan A.......

Thu, 01/16/2014 - 21:59 | 4339780 Seasmoke
Seasmoke's picture

And the Professor died today. 

Thu, 01/16/2014 - 22:09 | 4339797 wintermute
wintermute's picture

Banksterism = inefficient markets

Fri, 01/17/2014 - 00:41 | 4340094 El Vaquero
El Vaquero's picture

Like that episode where Gilligan gets sick of being teased
And he breaks into the Professor's lab and makes some LSD
Peaks freaks and eats the Skipper's brains then beats Ginger with coconuts
As Mr. Howell and Lovey burn alive inside their grass hut
Oh he'll kill again that Gilligan they he should of let him be
And like a postal clerk I'll go beserk if you don't stop teasing me
See the trick is only pick on those that can't do you no harm
Like the drummer from Def Leppard's only got one arm

Fri, 01/17/2014 - 10:17 | 4340628 Joe Davola
Joe Davola's picture

Ginger or Mary Ann?

Thu, 01/16/2014 - 22:37 | 4339872 Ned Zeppelin
Ned Zeppelin's picture

Fitting, since the Professor departed this mortal coil this very day.

Fri, 01/17/2014 - 07:17 | 4340318 negative rates
negative rates's picture

A few more years of that and you'll wake feelin like a spring chicken, my mind told me so.

Thu, 01/16/2014 - 21:48 | 4339755 disabledvet
disabledvet's picture

my view is that under fiat regimes "efficient markets appear very suddenly." in other words the bad DEBT is expunged "almost instantaneously" as the lack of cash flow becomes readily apparent. I actually WISH the dollar would collapse quite honestly...but I would not bet against it....even with the "massive cost over run" hypothesis currently being deployed in order to get pricing power.

http://www.reuters.com/article/2013/05/20/utilities-southern-kemper-idUS...

(or perhaps because of the "massive cost over-run hypothesis" being employed. I would not be a buyer of Southern Company stock btw.)

http://www.reuters.com/article/2014/01/01/israel-natgas-idUSL6N0KB0RC201...

http://www.haaretz.com/business/.premium-1.567844

http://seekingalpha.com/article/1831292-noble-energy-lead-in-east-medite...

Twelve bucks as "cheap." https://www.middleeastmonitor.com/news/middle-east/6171-huge-natural-gas... Sounds like this could get messy.

Thu, 01/16/2014 - 21:59 | 4339774 q99x2
q99x2's picture

Fraud is important. And, when the vice president of a company tells you personally that his company will be bought out by such and such on such and such date that is important. There are other things that are important like being close to a member of Congress or a pentagon official and so on. These are all important things. There are many less explicit things as well like reading ZH and listening to Max Keiser. And listening to the Totus in May of 2009 when he told everyone to BTFD. He lies all the time but he is a killer. You have to know him to read him.

Thu, 01/16/2014 - 21:58 | 4339775 Dr Benway
Dr Benway's picture

A surprisingly poor article. I honestly thought Marks was more insightful than this.

Thu, 01/16/2014 - 22:38 | 4339873 SDRII
SDRII's picture

next article:

TBTF / moral hazard = cyclically inefficient

laughable

Thu, 01/16/2014 - 22:35 | 4339868 Ned Zeppelin
Ned Zeppelin's picture

Zzzzzzzz wake me up when Howard Marks has something to say.

Fri, 01/17/2014 - 00:41 | 4340095 RagnarD
RagnarD's picture

If luck not matter, explain Bryan twins (tennis), Williams sisters (tennis), Barber (twins?)bros (football), Gasol (twins?) basketball, those two twin US (gold medal?) male gymnasts from 10 or so years ago,   10,000 hours of kicking ass at what you are the dominant master due to your genetic make up.   Larry Bird - maybe he was awkward physically relative to MJ and Magic, but he had amazing court skills, shooting ability, passing skills, and game knowledge, and no doubt, a burning desire to win. Which of these were "taught" to him?

 

Fri, 01/17/2014 - 01:36 | 4340145 Schmuck Raker
Schmuck Raker's picture

“In theory there is no difference between theory and practice, but in practice there is.”

Actually, that was Einste... WHOA - "Meet Arab Singles" wow, get your 72 virgins and a reach-around right here on earth!

Fri, 01/17/2014 - 01:49 | 4340167 NIHILIST CIPHER
NIHILIST CIPHER's picture

That article was so bad, I'm going to another thread to look for fonestar.

Fri, 01/17/2014 - 05:44 | 4340278 Mario55
Mario55's picture

Mark Howard is the champion of platitudes and he excels in teaching what was a good buy or a good sell last year. Why give this guy so much visibility? 

Fri, 01/17/2014 - 08:26 | 4340358 GFORCE
GFORCE's picture

Most on Zerohedge should read this article every morning. Markets will never be efficient.

Success in investing involves spotting trends and jumping on... not bitching about the price should never be that high and missing the boat.

 

Fri, 01/17/2014 - 08:46 | 4340381 Jabotinsky_USA
Jabotinsky_USA's picture

Isn't Marks Jewish?  Where are all the Jew haters to pile onto him just for being Jewish?

 

 

Fri, 01/17/2014 - 10:29 | 4340664 rwe2late
rwe2late's picture

"Markets will be permanently efficient when investors are permanently objective and unemotional. In other words, never. Unless that unlikely day comes, skill and luck will both continue to play very important roles."

Author misunderstands the situation.

It is not really about what the author alleges.

"Objective"? How can one be objective when facts are withheld and misrepresented? How can one be objective when decisions are made by a few in secret?

"Skill and luck"? What about insider info, and self-serving manipulation of government policies, from regulatory capture to 'securing' foreign resources and markets?

"Unemotional"? About being deceived and swindled? About having to gamble one's livelihood on guessing or anticipating what the boys in the back room will do?

It is not emotionalism and objectivity about the imagined markets that is the problem. Rather, it is wrongly imagining what the "market" now is in the first place.

 

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