Issue No. 19 June 1999 Posted 15.VI.1999
But, following the creation of the new currency, the reality has been sobering for the optimists.[Continue]
Half a century from now, when someone sits down to write a history of The Great Millennium Wall Street Crash, the Efficient Markets Hypothesis (EMH), Random Walk, and their offspring Modern Portfolio Theory (MPT) and "beta", will be found everywhere lurking among the root causes of the stock market mania that we are currently living through. [Continue]
In America, there is no doubt that Alan Greenspan knows that
the US stock
market is a bubble. He said as much in the past, when the overall market
was much less overvalued than it is now. His famous reference in 1996 to
"irrational exuberance", and subsequent remarks were
astonishingly reminiscent of the Federal Reserve's attempt as early as
1925 to use "moral suasion" to curb excessive stock market
speculation. And equally ineffective. So now that the fears that he
expressed have been realised, why is nothing being done to deal with the
problem? Perhaps it is hoped that some method can be found to deflate the
bubble in a controlled way, but I do not think that that is likely. Asset
bubbles always end sharply and spectacularly. No, I think that the
strategy now is to hold it all together long enough for the rest of the
global economy to stabilise and become strong enough to withstand the
shock, without triggering a global depression. Such a strategy means that
nothing will be done that may risk bursting the bubble until the members
of the FOMC are confident that economic recovery elsewhere has progressed
far enough.
But there is a spectre haunting them now. Its still a ghost
that has not
materialised, but its haunting presence is there - inflation. The trend is
now looking real:-
RECENT US CPI DATA:-
YR/MO........INDEX.........Annualised.........Yr-on-yr.
Despite an extended period of rapid growth in the money supply accompanied
by low interest rates, the US has enjoyed unprecedented inflation-free
growth for some time. A number of factors - with a strong dollar, global
excess capacity and weak commodity prices, above all of oil, the US has
imported disinflation - and the excess money supply has driven up the
stock market instead of consumer prices.
If there is a surge in inflation, the bubble is at risk of being popped.
But the cure for inflation, significant interest rate hikes, almost
certainly will do that too. This makes it very difficult for Alan
Greenspan to pull it off - he has to maintain continuing steady
non-inflationary growth for some time yet. His strategy will be to
raise interest rates a little, reversing last years sharp defensive
cuts, whilst reassuring the markets that this is a pre-emptive move
that will forstall inflationary pressure, and hence avoids the need for
a prolonged series of hikes later. Nothing will be done about the
bubble.
An unexpected ally has also appeared. The weak euro. The euro
has
fallen 13% against the dollar in under six months, and looks set to
decline further. See [LINK]. International bond
market data suggest that investors are giving up and increasingly
liquidating their euro portfolios. The US market has long benefited from
the Yen carry trade, and now will benefit in a similar way from capital
flight out of the euro, and this is will help the FOMC to protect the
stock market somewhat longer than otherwise would have been possible.
There is also room for some increase in interest rates without triggering
a crash. Investors know that rates were sharply reduced last year, and a
reversal of 25 or 50 basis points will be seen as positive for stocks
because it will be an anti-inflation move. That is provided that it is not
perceived as the start of a series of interest rate increases.
But meanwhile recovery in the rest of the world is more apparent than
real,
being largely little more than the return of portfolio investors and
investor confidence, unaccompanied by real economic recovery or even, so
far, much in the way of returning business confidence. I do not see much
hope that the global economy will be able to weather the shock of a Wall
Street crash. The potential severity and extent of the damage done by a
crash is also getting bigger as equity valuations reach ever more absurd
heights.
What can we expect in the meantime for interest rates and
the bond market
in America? Since 1981 we have been in a long secular bond bull market,
and, despite the current episode of rising yields, I believe that the
bond bull market will continue. This is not unprecedented: there was
another great
bond bull market in America which began in 1920 and lasted right through
the Roaring Twenties, the Great Depression, and the Second World War. It
did not end until 1946. There were
two significant, but short-lived, reversals in this long trend, both
directly associated with the Federal Reserve raising interest rates. The
first was
in
1929, when the discount rate was raised as high as 6% in a by then
ineffective
attempt to
slow the out-of-control stock market bubble. The second occasion
was in late 1931-early 1932 when Fed rates, which had been substantially
reduced in the intervening period, were again jacked up, this time in
response to the growing outflow of gold
bullion from the US. Both episodes proved to be good buying opportunities
both for government bonds and for prime corporate
bonds. I believe that the current bond bear market will turn out to be
another similar event, rather than being the end of the secular bull.
That will not happen until yields and interest rates bottom out some time
after the Wall Street bubble pops.
Now there is no longer any serious talk that the euro will challenge the
dollar internationally in the foreseeable future, and its performance in
just five months is sufficiently weak that European central bankers and
some politicians are starting to worry. But only Hans Tietmeyer,
Bundesbank president, is as yet prepared to admit as much on the
record.
Naturally, there are efforts to present this weak performance as nothing
to worry about. In 1Q99, the total of new bond issues denominated in
euros exceeded the recent average of total issues in the eleven legacy
currencies, and there was healthy international demand for
euro-denominated paper, making it possible to argue that there has been
rapid acceptance by the international bond markets. But is such an early
flurry meaningful given the surrounding initial euphoria? In early June,
data began to emerge that non-euro-area investors were starting to give
up, and pull out. Their currency losses are too high in relation to the
investment yield. We will have to wait and see what happens next. And in
trade weighted terms the euro is only down approximately 5%-6% against the
dollar. But using the trade weighted average in this way is a misuse of
that number: investors and portfolio managers do not measure their gains
and losses in trade weighted monies. Another facile argument is that the
euro has merely retraced the gains made by its constituent currencies over
the past year. True, but that means that it is not after all greater than
the sum of its parts, which surely supports the view of the skeptics
rather than the euro-bulls. Whatever arguments the apologists put
forward, the harsh fact remains that a currency that loses 13% against the
dollar in only five months is a risky and volatile vehicle for anyone's
investments. It is not to be trusted, and I for one, would demand a big
risk premium above the existing euro interest rates to persuade me to
switch funds from dollars and pounds into euros.
If you read typical mainstream commentaries from a year ago, you will find
that a lot of emphasis was placed on the mere size of the euro-area as the
factor that would support the new currency unit. The size argument is that
the more transactions that are done in a particular currency, the lower
average transactions costs should become. The lower the costs, the more
incentive to use it in business transactions, and to hold it as a
portfolio component. Also bonds denominated in the currency have
increasingly greater liquidity, leading to lower costs and lower yields.
These things are true, but as I pointed out at the time, are helpful but,
by themselves, not crucial. Much more emphasis should have been placed by
the markets on the other factors: these are more important and ought to
have prompted serious questions because they were already being undermined
long before the euro came into existence. All of this is documented in the
May 1998 Issue hotlinked above.
More details have emerged in recent months of how weak the
economic underpinnings of the euro are. In 1998, according to a just
published European Central Bank report only three small euro-zone
countries out of eleven ( Finland, Ireland and Luxembourg) met the EU's
Stability and Growth pact requirement that budgets should be close to
balance or in surplus. The Stability and Growth pact was put in place to
ensure the budgetary discipline essential for the success of monetary
union. "All the remaining member states were still relatively far
from the targets that they had indicated in their programmes."
Italy, one of the worst cases, for example, had a government debt of 120%,
double the limit agreed in the Maastrict Treaty. And its 1998 budget
deficit of 2.7% of GDP took creative accounting to a whole new level of
brilliance - unless you believe that a deficit of nearly 7% in 1996 really
was reduced that quickly. It has been also revealed in the past few days
that Wim Duisenberg was so concerned about the EU's economic condition
that he wanted the euro's launch delayed for two years.
The euro was launched at a time of economic recession and currency
volatility, which has exacerbated the negative effects of inadequate
foundations. On April 8th, barely three months after launch, the ECB was
obliged to reduce interest rates by 50 b.p. to 2.5% in an attempt to
stimulate the economy, but further undermining the euro.
All these are fairly obvious straightforward issues, and they
alone would be expected to weaken the currency. But there are also deeper
economic forces in play on the broader global stage that are adding
greatly to the problem, and which no one seems to recognise. They arise
from the changing behaviour of currencies as the world moves from the
inflationary environment of the past several decades into today's more
deflationary one.
In this context, it is worthwhile quoting at length from the
October 1998 (No.14) Skeptical Investor
MARKETS AND GLOBAL ECONOMY: OVERVIEW
With most of the world's crisis economies now having achieved, albeit
I expect only temporarily, a degree of stability, it is no longer events
in Asia, Russia and Latin America that are driving the next stage of the
extraordinary global economic drama that we are witnessing. Wall Street
has now taken centre stage, whilst a new actor, whose wider significance
in the drama is only being dimly grasped, has appeared on stage in 1999 -
the euro.
1998 09 .....163.6 ...... 00.734% ...... 01.426%
1998 10 .....163.9 ...... 02.200% ...... 01.486%
1998 11..... 164.2...... 02.196% ...... 01.546%
1998 12..... 164.4...... 01.462%...... 01.607%
1999 01..... 164.6...... 01.460% ...... 01.605%
1999 02..... 164.7...... 00.729% ...... 01.604%
1999 03..... 165.0...... 02.186% ...... 01.789%
1999 04..... 166.2...... 08.727% ...... 02.277%
THE EURO AT FIVE MONTHS
At launch, the markets valued the euro at approximately $1.18. It briefly
traded up to $1.1877 but has fallen consistently since. On June 3rd,
it traded as low as $1.0305 during the session, and is now hovering
around $1.04, down almost 13%. It has lost a similar amount of ground
against sterling. There is no sign that the decline is ending.What has gone wrong?
Faith in the strength and stability of the new currency was based on (a)
the size and vigour of the euro-area economy and market, and (b) belief in
firm underpinnings provided by the Growth and Stability Pact and the
mandate of the central bank. But, by May of last year, more than six
months before launch, legitimate questions could already be raised about
every one of these factors. We now know that there was more hype than
substance, and the critical analysis made at the time in the May 1998 Special Euro Issue has turned out to be
correct in all substantive respects.
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" For reasons that are quite well-known . . . during a
deflation investors seek safety of their capital by moving into cash and
cash-equivalents such as short-term government bonds. The yields on such
instruments will fall relative to yields on riskier financial instruments,
leading to widening yield spreads, and will normally fall in absolute
terms too. But, given that currencies themselves are now risky
investments, the investor will expect a return on investment that will
compensate him for that risk. This will tend to drive up the deposit
interest
rate needed to attract him, and incidentally make the holding of hard
cash
under the mattress less
attractive than it otherwise ought to be. But then consider how central banks will adjust interest rate policy. In recent history, we have become used to high interest rates being used as a tool to smother inflation, but deflation is a very different animal. Lower interest rates are widely used in an attempt to stimulate the economy (probably unsuccessfully - as in Japan since 1990 - but that is another story. The point is that CBs will attempt to end deflation by lowering rates). See the problem? As the world economy slides downhill, it experiences increasing instability and volatility as it adjusts. Forex rates become unstable: we saw just how unstable in the early stages of the crisis last year - to the extent that what was then happening in Asia was widely misinterpreted as a currency crisis. And we have seen it again recently in the USD and the Yen. But one of the tools most likely to be used by governments and CBs to try to arrest the process, lower interest rates, will make the problem even worse. Indeed, as deposit interest rates and yields on government bonds and notes approach zero, holding them becomes more and more nothing but a currency play. In their attempt to reduce currency risk, in an environment where offered yields are too low to compensate them for it, investors will be pushed into moving from currency to currency. Volatility will increase further, hence even more currency exposure risk. A vicious cycle."
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Indeed there is little inflationary pressure in the euro-zone; the latest data put it at only 1.1% per annum. But that is not what is driving things now: it is interest rates. Re-read the quote above: is what was predicted there not exactly what the ECB did do on April 8th, and has not the outcome also been as anticipated? The 50 b.p. decrease in April significantly widened the previous interest rate differential with sterling and with the dollar.
At this stage of the deflationary cycle, past credit creation has resulted in a huge pool of international liquidity. Because of the economic slowdown and global overcapacity, there are too few sound investment projects to absorb this capital. It is seeking out the best returns, and that is not the measly yields now available on euro-denominated financial instruments. At the same time inward business investment into Europe is relatively insignificant due to the economic slowdown, so that is not a balancing factor. What we are seeing therefore is simply a large capital flight from the euro.
Although more euro interest rate reductions are not expected, the likelihood of an increase in the near future to stabilise the currency is effectively zero. At the same time dollar rates are believed by the market to have bottomed and the next move is widely expected to be up, and sterling rates too are generally thought to be at or near the bottom.
The economic stability pact is almost worthless, and the markets see that. No matter what its intent or provisions, it will never be enforced in a credible way and political considerations will always win out instead. "The scant safety margins built into budgets so far and the time profile of the adjustment envisaged do not auger well for the capability of public finances in the euro area to withstand a severe turnaround in economic prospects." (ECB report). The two largest euro economies - Germany and France - are, the ECB points out "less than rigorous" in pursuing deficit targets. Even worse, the stability pact is not merely being massaged but may be breaking down. On 25th May even the nominal target was abandoned for Italy which was given permission "in the event of a serious economic downturn" to overshoot its 2% budget deficit target to 2.4%.
There are no definate mechanisms in place to react quickly and aggressively to a currency crisis. The ECB would have to raise interest rates sharply, and are not going to do so until it is too late.
But, it is not necessary for there to be a collapse for there to be profound global implications. International capital flows were deeply involved in all the economic crises of the last two years, particularly those flows resulting from the strong dollar and weak yen: which are also stoking the US bubble. The euro has suffered a significant devaluation against the dollar, 16% if it reaches parity which is easily possible now. A 16% devaluation in such a short time is extremely serious, almost a crisis in itself, and is certain to accelerate capital flight into dollar assets. The increased demand will inflate the bubble further, suggesting that the current Wall Street insanity will continue for some time yet.
Similar investment portfolio capital flows are behind the strength of sterling. Both sterling and the US dollar continue to look healthy and offer very competitive interest rates. The euro is very unattractive: a much higher interest rate (risk) premium is needed to make holding any euros sensible for most global investors.
And, as an aside--not all euros are created equal. The interest rate spread on Spanish government debt v. German government bonds is getting wider.
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Anyone who has a suitable internationally portable way of making a living, or is able to rely on an investment portfolio or retirement pension, can in most cases immediately double his income by becoming a PT. Move to some low cost tropical paradise and he can likely halve or quarter his spending too. That is why you do not need to be a multimillionaire to do it. Retirees who have never heard of the term "PT" have been doing precisely this for decades. Examples are the retired gringos clustered around Lake Chapala, Mexico and the self-styled "Ancient Britons" living the good life in Cyprus. Quadruple or more your spending power legally and without risk: PT is the second-best (legal) investment strategy there is (I'll tell you about the very best investment strategy another time). In fact, PT is such a good idea that I will devote a regular section to it.
Readers who are already familiar with the philosophy will know that PTs tend to spend their time in wonderful playgrounds and hideaways such as Belize, Mexico, Hong Kong and Thailand. In the past two years I have been enjoying myself visiting and researching these and other places, and will be reporting on them in future Issues. But this month I want to start out with a brief look at a country that is not usually thought of as a PT haven: Great Britain. This is to show that it is possible to be a PT almost anywhere. Anywhere that is except your own country (i.e. where you hold citizenship.). This is the beauty of the concept: governments exploit and oppress their own citizens, not usually visitors. Especially visitors who are merely Passing Through. Tourists and other visitors are encouraged to come, not exploited. They can too easily vote with their feet, whilst the locals are trapped. PTs choose to position their affairs so that they can vote with their feet everywhere. And, as tourism becomes more and more important throughout the world the situation is actually getting better. Carry a good passport - e.g. New Zealand - which gives you hassle-free (visa-free) temporary entry to most countries, and the world becomes a smorgasbrod of places and possibilities and a level of personal freedom beyond the imagination of most people.
Obey the local laws of course! And the local customs: that is simple decency and courtesy. The PT philosophy of freedom is not about harming or hurting anyone. It is exactly the opposite. Live and let live.
Well, its not perfect. But nowhere is. You cannot live entirely tax-free in Britain. Value Added Tax on most purchases sees to that. And everyone except those living off the largess of taxpayers will have to stump up a local Council Tax. Then there is a particularly annoying special tax you have to pay if you have a television. But, for those who are able to live off an investment portfolio, or have an international business that can be run from an appropriately structured offshore entity, it is possible (and perfectly legal: I am not advocating tax evasion) to live comfortably here and pay relatively little in tax. The trick is to keep your annual spending below #12,450 ($19,920) (double that for a couple). The tax system permits you ways to make that amount of annual income to live off without becoming liable to tax on it. And, you can take considerably more income each year if you wish to at a fairly reasonable 23% marginal tax rate.
But why would a PT thinker consider Britain at all when is is perfectly possible to live tax free, and much more inexpensively, elsewhere? The reason is that one of the big problems for many potential PTs of moderate means (the very rich can live in whatever way they want to anywhere) is that settling down on some remote island tax haven, or a footloose life moving every few months from one country to another, doesnUt suit them. The PT philosophy and way of life is about personal freedom and choice, and many prefer to stay put most of the time and live in a place that offers the benefits of western civilisation.
The United Kingdom is one of the world's great nations and places to spend your time. With its rich history, world-class culture, varied scenery, natural history and its sporting events and traditions it can offer almost anyone whatever they want. And all packed into a small island and within easy reach: nowhere is more than 60 miles from the sea. London is an international airline hub with perhaps the cheapest discount air tickets available anywhere. Domestic and continental bus and rail links are good to excellent. Britain has a superb postal service and telecommunications. A reasonably business-friendly legal framework, and England has its Common Law legal tradition. Not having a written Constitution to rely on, Britons demand proper treatment from the authorities instead. They expect, and get, one of the highest levels of corruption-free public service in the world. The police are relatively well-behaved here: unlike some of the homicidal uniformed thugs in other places that I have lived.
British immigration law is complex and has changed several times during the process of retreat from Empire and the absorption into the European Community. If you have a parent or grandparent who was the national of one of the EC member nations, you may be entitled to a Passport from that country: any EC Passport gives you unrestricted right of entry to the UK under EC law. In certain cases, special rules apply. The Republic of Ireland for instance is very generous in granting Irish Passports to individuals able to prove even somewhat remote Irish ancestry. Nationals of the Isle of Man, which is not a member of the EC, have the right of abode in the UK. Commonwealth ancestry and connections are unfortunately more problematic: it depends very much on the case particulars and British Consular Officials seem to have some discretion in these matters due to the unavoidable complexities left over from Empire days. I have a Canadian friend whose father was born in China the son of a Welsh missionary there. His birth was registered at the British Embassy in Peking (Beijing). His father had moved to Canada before 1947, and became a Canadian Citizen by right, but did not ever apply for a British Passport. If he had, my friend would now be automatically entitled to a British Passport, but because he didn't this right lapsed. What happened was that my friend was given the right to enter and work in the UK on his Canadian Passport and, should he now go ahead and do so and then demonstrate his commitment to Britain - in practice that means living there for four years - he may apply for a Passport. The lesson is: if you want to become a UK resident and can find any EC or Commonwealth connection in your recent ancestry you have a chance. It is worth investigating further. Assemble your documentation and contact the nearest British (or other appropriate EC) Embassy or Consular Office. Play the game and show your enthusiasm for moving to the UK permanently and you can usually expect a sympathetic hearing. Expensive immigration consultants ought usually not to be necessary, though they may be of value in very complex or marginal cases.
The Internet is starting to be a wonderful tool for tracking down your ancestry. Genealogy has become the third most popular use of the WWW (after finance and erotica). The Genealogy Website of the Mormon Church is a good place to start your search.
The way to minimise your tax burden whilst living here is to utilise the various tax-free allowances to generate your living costs, and leave the rest of your assets invested in suitable offshore investments* to grow untaxed as capital gains until you eventually leave the United Kingdom permanently. There are offshore roll-up investment funds structured for this very purpose. Under existing UK tax law this is legitimate: you have to be careful about the specifics and the details of course, and getting those right may involve the services of a professional tax expert. I am pointing to a strategy, not tactics. (* there are also domestic tax exempt vehicles - ISAs - which can be used for a small amount of capital).
The following allowances are per person and refer to the current (1999/2000) Tax Year. (#sterling converted to US$ at x1.60.)
You can take up to #7,100 ($11,360) annually in Capital Gains tax-free, and you have a personal earned income allowance of #4,335 ($6,936). In addition you can put up to #20,000 into Premium Bonds which should on the average generate approximately 3.25% - #650 ($1,040) in tax-free returns (unfortunately Premium Bonds very recently became somewhat less attractive than they used to be. More about them below) and #10,000 in tax-free National Savings Certificates currently offering 3.65% pa - #365 ($584). That gives you #12,450 ($19,920) per year per person to live off, without paying any Income Tax at all.
One way to utilise the annual CG exemption is to invest in Zero-Dividend Preference Shares of Split Capital Investment Trusts-":Zeros" for short. These are investment trust shares, but with a fixed life of up to ten years, a fixed redemption price, and first call on the total assets of the trust. They offer capital gains only, no income, so by selling shares worth less than your annual CG exemption each year you generate a tax-free income in effect. Take care though--some of them are poor investments.
Depending on how long you intend to remain in Britain, you could also consider buying a house or flat to live in. Prices are reasonable right now in many parts of the country (well down from their peaks of several years ago), and, should you in due course sell at a profit that too is not subject to tax.
If you really want to spend more than #12,450 you can take up to an additional #28,000 ($44,800) paying a 23% tax on it (for employment income only, the first #1,500 of this only attracts 10% tax). Or, for unexpected needs, cash in (this is tax free) some of those Premium Bonds, National Savings Certificates or--see below--ISAs. The remainder of your capital can be invested tax-free. ISAs--introduced in the current Tax Year to replace certain other plans--permit you to put up to #7,000 during the tax year in cash, bonds, equities and insurance investments. The rules governing which vehicles and mix of investments are a bit complicated, but it is worth mentioning that equity investments are not confined to European equities. ISAs grow and can be withdrawn at any time tax-free. You can also put as much as you wish into offshore "roll up" unit trusts (which is what the British call mutual funds). These are treated as capital gains and do not attract tax in Britain until liquidated. The tax liability on such roll up funds can be eliminated by either (a) only cashing up to your #7,100 per person capital allowance each year, or, if you plan to leave the UK in due course--as most PTs will--simply hold until after you cease to be a UK taxpayer (this is perfectly legal and legitimate within Inland Revenue rules--the only proviso being that if you return to become a tax resident within five tax years you will be liable to tax on any capital gains you took during that period. So--don't come back!). By the way, the opposite applies to ISAs: these should be cashed before you leave because they become taxable to non-residents.
WARNING! United Kingdom tax and residency law and rules can be complicated. You will have to research thoroughly before making any decisions, and professional tax advice may be warranted. A good place to start though is the Inland Revenue website: take a tranquilliser, then point your browser to:-
The maximum holding of bonds is #20,000 per person, and there are many people in Britain who hold that much. Until this month, the total annual payout in prizes was 4% of the pot, but unfortunately this was reduced in June 1999 to 3.25% making Premium Bonds less attractive as an investment. But they are very safe and secure, and they can be cashed in at any time: it takes only a few days to get your money. Being backed by the UK government, your capital remains safe: there is no risk of a capital loss (other than from adverse exchange rate movements). And you might win a million!
The EMH and its mathematical formulations are taken for granted and used almost universally by financial analysts and the investment industry. They are the basis for the asset allocation models pushed at the investing public by the banks, mutual funds and other financial firms. You know the ones - fill in your age, income, tolerance for risk and so on and you are presented with a recommended balanced bespoke portfolio that will maximise your returns for your level of risk tolerance, let you sleep soundly at night and - rarely explicitly but certainly implicitly - effortlessly retire rich at fifty-five. And these sort of financial mathematics are typically behind the allocation strategies of the mutual funds themselves. In fact they turn up almost everywhere when you look closely.
It will come as a shock to most "ma and pa" investors when they learn that these theories are wrong. Or, at best, fatally flawed. Real life experience has proven it. Faced with the facts, a new generation of academics, armed with 20:20 hindsight, has already discounted them and is busily publishing new models attempting to explain why markets behave as they actually do. And, whereas the conventional theories can be and are used to convince millions of retail investors to continue blindly pouring their hard-earned money into the stock market - EMT and MPT lie behind "dollar cost averaging", " there is no bad time to invest in the market because stocks always go up over the long term" and much of the rest of the sales pitch - many people in the financial services industry know that these academic constructs are flawed and largely baseless.
The EMH was fatally wounded more than ten years ago by the 1987 crash. The academic debate that has gone on since then has been conducted in the pages of the professional journal literature and at obscure conferences attended only by working economists and financial analysts. This is perfectly right and proper for formal research, but of course it means in practice that most of the investing public is not even aware that thre is a debate. But some of this work is now emerging in the more accessible pages of the serious press, in magazines such as Scientific American or in reports in the Wall Street Journal and the Financial Times where it can be read by all.
Serious investors should be aware of and understand the implications of the case against the EMH, MPT and related theories. I do not recommend that anyone swallow whole what I say below, but in today's market conditions these issues are too crucial to ignore except at ones peril. The theoretical underpinnings of so much of what investors are being told and are acting on is at best open to very serious question.
But if the EMH is true, then the 1987 crash did not happen. How could corporate America have been worth 22% less the day after Black Monday - October 19th 1987? The fall cannot be ascribed to bad news: the proximate cause of the crash is still debated and this event has never been satisfactorily explained. It is such sudden, large changes in prices where these are unaccompanied by a significant, unexpected explanatory piece of news, that demolishes the Efficient Market Hypothesis. They are frequent and normal phenomena: market crashes are only the most spectacular examples. Dr Benoit Mandelbrot cites another clear instance - the share price behaviour of the French telecommunications equipment manufacturer Alcatel. Alcatel shares became very volatile in September 1998. Again inexplicably the shares fell 46% over two trading sessions, then gained 10% the next day.
Dr Mandlebrot has been working on applying his famous work on fractals in an effort to understand these issues better. His findings are summarised in the February 1999 Scientific American. I have extracted salient parts below, but I recommend the article to all serious investors. It is written in the usual serious but clear language of that excellent periodical.
A major starting premise of the mathematical treatment is that the price changes of a financial asset are distributed in a pattern that fits the standard statistical bell curve. The width of the bell curve (as measured by its standard deviation) depicts how far prices diverge from the mean: that is what looked at as the volatility or risk of the asset. But the extreme ends of the curve, outside the 95% limits, are ignored by the statistics They are simply defined away as being too rare - improbable - to be taken into account. Market crashes simply do not happen in this mathematical world. Or, as Mandlebrot aptly puts it, it is a world in which sailors do not carry lifejackets because typhoons have been defined as too rare to be considered to exist.
Another fundamental premise of the statistics is that the price changes of an asset are independent of one another. This is the Random Walk - today's price has no influence at all on tomorrow's price. And thus prediction of future market movements is impossible.
What Dr. Mandlebrot has done is first to compare, using rigorous mathematics, actual records of market price changes with the patterns that would be generated if such assumptions were true in the real world. And he shows that the data do not fit the assumptions behind the EMH and MPT:-
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" Charts of stock or currency changes over time do reveal a constant
background of small up and down price movements - but not as uniform as
one would expect if price changes fit the bell curve. These patterns,
however, constitute only one aspect of the graph. A substantial number of
sudden large changes - spikes on the chart that shoot up or down - stand
out from the background of more moderate perturbation. Moreover, the
magnitude of price movements (both large and small) may remain roughly
constant for a year, and then suddenly the variability may increase for an
extended period. Big price jumps become more common as the turbulence of
the market grows - clusters of them appear on the chart."
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Fractals are descriptive: Mandlebrot's mathematical models of market price behaviour do not purport to explain the causes of the price patterns observed, and are not able to be used to predict future price movements. But they are of great value because they do create a very much more realistic picture of market risk.
There is another piece of academic research that goes much further in a plausible effort to explain, rather than merely describe, market behaviour:-
This work is a collaboration between an economist (Lux) and an electrical engineer (Marchesi). It was published in the reputable British science journal Nature, which will be taken by most central public libraries, and all university libraries. The authors begin their work from that of Mandelbrot and others which describes the actual behaviour of financial prices. This behaviour shows universal characteristics that resemble those characteristic of physical systems in which very large numbers of units interact.
The past two decades have seen enormous strides in our understanding of the behaviour of complex, interactive, multi-agent systems. This was made possible by the advent of supercomputers: before they came on the scene it was impossible to make the billions of calculations necessary to mathematically model such systems. They have subsequently been used to model and hence better understand the behaviour of systems as diverse as stars and galaxies, and local weather patterns. What Lux and Marchesi did was to apply these successful modern computer simulation approaches to model financial markets as pricing assets in a similar way - from the interaction of a very large ensemble of market participants.
They found that the actual behaviour of markets does agree with this model, and can be simulated in their computer models by assuming two kinds of players in the market:-
FUNDAMENTALISTS: who analyse shares based on the underlying performance of the company, and base their buy(sell) decisions on their belief that the actual market price in below(above) the fundamental value.
"NOISE TRADERS": this is the term used by economists for participants who follow trends and charts, and base their buying and selling decisions on these and also on what other participants are doing.
The contrast between an interactive, multi-agent model of the market, and the EMH is enormous. Lux and Marchesi came to the following conclusions about the way the former behaves:-
1. Rational information about securitiesU values is not, as predicted by the EMH, incorporated rapidly: it takes a long time to be absorbed by participants. Share prices in the long-term reflect true value, but can shift rapidly and turbulently both above and below that value.
2. The "noise traders" are the real force behind market movements.
3. Because of the presence of "noise traders" in the market, changes in sentiment by just a few players can precipitate a shift in the entire market mood and cause a stampede.
4. During periods of high volatility, more of these "noise traders" enter the market. This amplifies the volatility.
5. And, depending on what everyone else is doing fundamentalists can change into "noise traders", and vice versa.
In short, prices are determined mainly by herd instinct.
This work can be attacked because simply dividing market participants into two groups may be too simplistic, but its predictions are very much in conformity with commonsense and with observation, and it does offer us an equally academically rigorous alternative to the prevailing EMH. It must be noted though that it does not offer any method for predicting the markets, but because it helps us to understand, and have confidence in our commonsense and reason, it is very reassuring to value investors in particular.
Portfolio risk is for most investors higher than the the statistical basis of portfolio design predicts. The statistics use historical volatility as a measure of risk, but that is invalid. It is largely why the troubled hedge fund Long Term Capital Management got it so badly wrong by the way.
But the other side of the coin is that it is possible to identify good buys. If modern academic research does not support the idea that markets are efficient, and, instead, there is evidence that markets are inefficient and driven by herd instinct, then it follows that assets even in a huge liquid market such as the US stock market can be wildly mis-priced.
The almost universal use today of one particular group of mathematical models, the Efficient Markets Hypothesis and its offspring is one of the forces driving the stock market bubble. Many of todays investors are doing the equivalent of crossing an ocean in a small boat without a lifejacket because typhoons donUt happen often.
Be aware of the theories behind much of what you are told by the money industry and by financial advisors. The assumptions and premises are not even there in the small print! A specific example: "risk:reward" is often used in a way that is imprecise, more rhetorical than accurate. What is usually meant is "the recent historical volatility of the asset:expected return". Which is different. And buy-and-hold strategies are not as safe as you are told.
And, finally, there are now credible, testable models of the markets that not only allow asset bubbles, but actually predict that bubbles will happen from time to time. The implications of that, today, are obvious.
Copyright© 1999 Max Moseley and The Skeptical Investor, All Rights Reserved.