Below, I've highlighted some of Jeremy Grantham's thoughts on efficient markets, bubbles, and the 2013 Nobel Prize in Economic Sciences from his section of the letter:
"Economics is a very soft science but it has delusions of hardness or what has been called physics envy. One of my few economic heroes, Kenneth Boulding, said that while mathematics had indeed introduced rigor into economics, it unfortunately also brought mortis. Later in his career he felt that economics had lost sight of its job to be useful to society, having lost its way in a maze of econometric formulas, which placed elegance over accuracy.
At the top of the list of economic theories based on clearly false assumptions is that of Rational Expectations, in which humans are assumed to be machines programmed with rational responses. Although we all know – even economists – that this assumption does not ﬁ t the real world, it does allow for relatively simple conclusions, whereas the assumption of complicated, inconsistent, and emotional humanity does not. The folly of Rational Expectations resulted in ﬁve, six, or seven decades of economic mainstream work being largely thrown away. It did leave us, though, with perhaps the most laughable of all assumption-based theories, the Efﬁcient Market Hypothesis (EMH).
We are told that investment bubbles have not occurred and, indeed, could never occur, by the iron law of the unproven assumptions used by the proponents of the EMH. Yet, in front of our eyes there have appeared in the last 25 years at least four of the great investment bubbles in all of investment history."
To me, this latest letter is Grantham at his best.
(His section begins on page 6.)
Well worth reading in its entirety.
Grantham goes on to describe the four bubbles that, for many, will hardly be unfamiliar:
1) Bubble in Japanese Stocks - By 1989 stocks were selling at 65 times earnings (on what may be not so great accounting). Grantham points out, before that, stocks had never peaked at more than 25 times earnings. Japanese stocks would go on to fall 90%.
2) Japanese Land Bubble - This bubble peaked a couple of years later in 1991. Grantham describes it this way:
"This was probably the biggest bubble in history and was certainly far worse than the Tulip Bubble and the South Sea Bubble. And, yes, the land under the Emperor's Palace, valued at property prices in downtown Tokyo, really was equal to the value of the land in the state of California. Seems efﬁcient to me..."
3) U.S. Equity Bubble in 2000 - This one peaked at 35 times earnings but that doesn't even begin to describe how expensive certain stocks had become. For perspective, earnings peaked at 21 times earnings in 1929.
4) The Housing Bubble - According to Grantham this was the first bubble that was truly global.
Grantham notes that, according to EMH, these annoying real world occurrences should happen something like once every 10,000 years.
He also makes the point that "this efﬁcient market nonsense" certainly didn't hurt value managers like himself.
"...so I should ﬁnd time to thank all those involved for producing and passionately promoting the idea. During the 1970s and 1980s I am convinced it helped reduce the number of quantitatively-talented individuals entering the money management business."
Warren Buffett has previously made a similar point.
Max Planck understood well the resistance of the human mind, even among those who happen to be very smart, to new ideas. He understood how that tendency impacted scientific advancement.
Buffett has said the same applies to finance.
Well, one of the more disappointing -- even if unfortunately not exactly surprising -- aspects of what has happened over these past decades is this:
"...the proponents of the EMH not only promoted their theory, but via the academic establishment the high priests badgered academic researchers into leaving, resigning themselves to non-tenure, or getting religion, as it were."
Much later in the letter, Grantham talks more specifically about the 2013 Nobel Prize in Economic Sciences:
"So, economics has been more or less threadbare for 50 years. Pity then the plight of the Bank of Sweden with all that money to give away in honor of Alfred Nobel and in envy, perhaps, of the harder sciences. If you had $1.2 million to give away but few worthy recipients, what would you do? I would suggest making it a once-every-three-year event..."
His primary reason?
To make it more likely that only "the Real McCoys" win the prize and to prevent "so many ordinary soldiers" from getting it.
That's unlikely to happen anytime soon, but that doesn't make it any less unfortunate that the Bank of Sweden did the following:
"...to further prove how completely they have lost the plot, they gave two-thirds of the prize to two economists who attempted to prove market inefﬁciency and one-third to another who claimed it was efﬁcient and seriously efﬁcient at that. What a farce. And to read all these genteel descriptions, or rather rationalizations, as to why this made sense is to realize to what extent the establishment is respected, regardless of its competence level."
The economists he is referring to are Eugene Fama, Robert Shiller, and Lars Peter Hansen.
"Robert Shiller at least served society – Kenneth Boulding would have approved – by loudly warning us of impending doom from the Tech Bubble with his superbly timed book Irrational Exuberance in the spring of 2000. Not bad! He also warned us well in advance of the much more dangerous housing bubble..."
Grantham is, not surprisingly, not quite so complimentary of Fama:
"As for Fama, who conversely provided a rationale for all of us to walk off the cliff with conﬁdence, the less said the better. For believers in market efﬁciency and all the assumptions that go along with it, the real world really is merely an annoying special case."
Grantham has mentioned this so-called "special case" before.
Now, to get an idea how Eugene Fama looks at bubbles, consider what he said back in 2010 in this interview.
When Fama was presented with the following:
"Many people would argue that, in this case, the inefficiency was primarily in the credit markets, not the stock market—that there was a credit bubble that inflated and ultimately burst."
He responded this way:
"I don't even know what that means. People who get credit have to get it from somewhere. Does a credit bubble mean that people save too much during that period? I don't know what a credit bubble means. I don't even know what a bubble means. These words have become popular. I don't think they have any meaning."
That comment from Fama just might help begin to explain how such bad ideas and assumptions have been able to maintain their widespread -- and rather more than a little bit damaging -- influence for so long.
From later in the same interview:
But you are skeptical about the claims about how irrationality affects market prices?
"It's a leap. I'm not saying you couldn't do it, but I'm an empiricist. It's got to be shown."
Naturally, there's nothing inherently wrong with needing it "to be shown", but somehow, at least for Fama, insufficient evidence has been supplied by these recent bubbles.
So this means Fama continues to think, more or less, that coldly rational efficient markets exist in the real world.
Shiller, of course, does not.
Fama, in fact, seems to have an almost unflappable confidence that EMH (and related) provides a useful way to understand how financial markets work.
Not long after their Nobel Prize was announced Shiller was interviewed on CNBC. In the interview, Shiller called Fama the "father" of efficient markets as a theory and most responsible for popularizing it over the years.
Shiller also said the following about Fama's rather consistent, if nothing else, view that markets are mostly quite efficient and rational:
"When you hatch a theory, you don't easily let go, that's where he [Fama) is. I think he's a -- he's a brilliant man...but he's rather involved in this theory."
CNBC Video: Robert Shiller on Eugene Fama
Maybe, just maybe, the reason Fama doesn't see the empirical evidence relates, in part, to Shiller's explanation.
In fact, that doesn't really seem a stretch at all.
I happen to be rather convinced that the influence of efficient markets -- and the many related ideas and assumptions that have descended from EMH -- have been anything but a good thing for civilization.
To me, the sooner they lose their influence the better.
Well, in any case, these three empiricists have won a big prize.
It's the Data, Stupid!
No doubt winning it involved lots of hard work by what are well-intentioned and smart people.
Maybe, down the road, it will become more obvious how much at least some of these recently honored contributions will be of benefit to world.
I'd certainly like to see their work prove to be useful but, at least for now, consider me a bit skeptical much of it will end up having a truly significant and favorable impact.
Others might have a more optimistic view.
Efficient Markets - Part II
Risk and Reward Revisited
Modern Portfolio Theory, Efficient Markets, and the Flat Earth Revisited
Buffett on Risk and Reward
Beta, Risk, & the Inconvenient Real World Special Case
Black-Scholes and the Flat Earth Society
Buffett: Indebted to Academics
Superinvestors: Galileo vs The Flat Earth
Max Planck: Resistance of the Human Mind
* Also published in Barron's.