Vanguard News Network

By George Lenz

In the 1980s mathematical finance began to be widely used at the Wall Street for the first time. The fallout is still being felt today. Prudential Securities, which for years boasted that “the most important thing we earn is your trust,” apologized for having systematically defrauded hundreds of thousands of investors who bought its limited partnership deals. Banks and insurance companies bankrolled so many new buildings that the excess in commercial property has been worked out only by the year 2000. As we beginning to enter one of the worst era in modern U.S. financial history, it is a good time for a look back. It is not widely recognized, but humanistic profs with mathematical background played an important role in the 1980s debacle, providing theories full of advanced mathematics and statistics to justify some of the worst excesses. One such concept, efficient market theory (EMT), contributed to the damage then and, in its various mutations, continues to do so today.

Even if you are not a student of financial economics, the phrase “efficient market theory” sounds right. After all, the stock market is crudely efficient: markets set the minute-to-minute value of stocks, the spreads between bid and asked prices are very small, and commissions are as little as two cents a share.

Efficient Market Theory (EMT), however, posits something more radical. The principal version, states that we can trust the pricing of stocks all the time. Supposedly, competition among sophisticated investors enables the stock market to price stocks “accurately” – that is, in accordance with our best expectations of companies’ long-term prospects; and the trading by nonprofessionals is said to be random and of no net effect. Supposedly, too, all relevant publicly available information is analyzed by investors, and new data, such as releases, are quickly noted, digested, and then reflected in the share prices. In short, stock prices, while not perfect, are as perfect as can be, and there are no better estimates of the fundamental value of a company and no systems for beating the market. A corollary is that the wisest of us can do no better than to buy the market as a whole; the rest of us can do far worse.

EMT rests on several controversial assumptions, the most striking of which is the very convenient but circular assumption that mispriced stocks cannot long exist because if they did, investors/arbitrageurs would already have eliminated them. This when-all-else-fails assumption, so central to the EMT, is also the source of the sad joke about two economists walking across the road who spy what seems to be a twenty dollar bill. As the younger economist leans forward to examine it, his older colleague restrains her. “If it really were a twenty dollar bill,” he says, “someone would already have picked it up.” Given the assumption that patience and intelligence are of no consequence, even a super-investor like Warren Buffett should not be able, certainly not with any consistency, to find loose money lying on the table. In fact, it would be a waste of his time to look.

Like a fire, EMT has spread far beyond its origins as a scholarly study of the trading market: it has not only contaminated issues and analyses in Wall Street, but also in executive offices on Main Street, that would not have seemed to have been at risk, and in ways that are poorly understood. Scholars might harbor reservations about EMT, but with their encouragement and never a word of doubt much of America now takes EMT as much for granted as the light bulb in the ceiling.

So what were the practical consequences of the spread of EMT? EMT as we will see has done the following:

1) provided the intellectual cover for the excesses in junk bonds and takeovers in the 1980s, ignoring the mounting evidence, visible even then, that important sectors of the economy were in jeopardy;

2) encouraged investors and executives to indulge the fantasy that they can “trust prices” to balance risk and reward and thereby save themselves the enormous bother of analyzing businesses;

3) justified a theory of dividend policy that encourages wasteful corporate investment and expansion.
As a result, financial market has become detached from real economic activity, setting stage for an economic and financial crisis, the unwinding of which we are beginning to witness. Let’s look further in the detailed effects of the EMT.

For mathematical financiers, the merger boom of the 1980s was the stuff of dreams. Since 1932, wen Adolf Berle and Gardiner Means first described the separation of ownership and control in the modern, publicly-held corporation, observers had wrestled with the dilemma that corporate democracy did not work, that these dispersed shareholders had limited power, and that corporate managers were able to avoid any serious oversight or discipline. Then at the beginning of the 1980s there blossomed a shiny new economic model, affectionately called the market for corporate control, which saw the emerging takeover boom as a natural selection device for replacing the poor performers. The model is an appealing one. Given an efficient stock market, of which few economists then had any doubt, poor managerial performance would drive down a company’s stock price to the point where it would pay a more talented group to bid a substantial premium for control, fire the incumbents and run the business themselves. Indeed, in a market as efficient as the one in the model, there could be no other systematic reason for takeovers.

The humanistic profs with mathematical background, who created this theory and their converts, including Ronald Reagan’s Council of Economic Advisers ignored the perverse incentives and palpable imperfections that drove this market, eventually to wild excess. The basic system for takeovers and leveraged buyouts worked like this: take a not-too-glamorous business, but one with decent prospects, and buy it with as much borrowed money as the banks will lend. As the market heated up, however, even these standards deteriorated. The investment by the new owners became hard to find, and under the pressure to make ever more deals, the prices became absurd. Structured with no room for a disappointment of any kind, these takeovers left many viable businesses and once-loyal workers and communities on the dole. How did it happen? EMT provided the justification. In an efficient market, one in which the stock market could not undervalue corporate assets in any meaningful way, efficiency/productivity enhancement justifies takeovers: the basic implication was that higher bidders can manage assets better and that the higher share price is the measure of the prospective improvement.

On a modest scale, hostile takeovers were a useful idea, but the gaps in the theory were evident:

1) If target company managements were not striving to do the best for their shareholders, how sure could one be that bidder managements were doing so for their own?

2) The extraordinary availability of borrowed money was soon allowing promotional buyers, having no operating experience and little resources of their own, to acquire major industrial/commercial enterprises.

3) The tax gains generated by the substitution of debt for equity accounted for a substantial portion of the “value” being created in these buyouts.

4) The premium prices being paid by bidders, averaging at times as much as eighty percent over the prevailing price in the market, should have raised concerns as to the likelihood of such consistently large efficiency gains.

5) The unprecedented level of fees being earned by bankers and EMT promoters, which soon dwarfed everything else on Wall Street, suggested that efficiency gains may not have been the sole, or even primary, object of the game.

Alas, EMT had blinded humanistic profs and mathematical finance practitioners to what was now painfully clear in the marketplace: the deals were not making sense to anyone but the middlemen. All through the latter part of the 1980s, when most takeovers were happening, the prices being paid for significant targets, on average, were over fourteen times earnings before interest and taxes. That amounted to a return of seven percent, even while the bidders were then paying on average ten to eleven percent for capital. The rule-of-thumb was ninety percent debt, ten percent equity.

The damage has been long lasting. In financial terms, the loss was not just the high default rate, the failed savings and loans associations and other direct costs. In human terms, it was a story of workers and middle managers who had long ago invested their careers in the various target companies of the day, but who, unlike senior management, could not protect themselves.

Remarkably enough, there has not been a single serious effort by humanistic profs – defenders of EMT – as Harvard financial economist Michael Jensen, Nobelist Merton Miller, or other mathematicians qua financiers to retrace their steps, to see how it was that excessive debt increased risk, instead of merely rearranging the risk as their models had forecast. The best the practitioners of classical finance got, and it is really not good at all, are concessions that mistakes were made, but they learn from mistakes and are not likely to repeat those particular ones again.

Ever since Benjamin Graham and David Dodd wrote in the 1930s, we have known that the traders and other professionals on Wall Street by and large lack the temperament to invest money on a rational, long-term basis. Graham early on, others of us later on, preached the rewards of ignoring the stock market except when the manic/depressive behavior occasionally offered opportunities to buy or sell on an advantageous basis. Given the uncertainties affecting any business and its competition, they concluded that there was not a sufficient basis for calculated mathematical projections. As business people (and stock pickers), we take the next best, much more comfortable course. We assume that the present state of the world represents a state of equilibrium that will continue indefinitely into the future until something happens to disturb it. We assume, too, that stock market valuations reflect everything there is to know about business realities and prospects, and that they will only change as new information appears. EMT offers up a sacramental blessing to those who would like to believe the Wall Street dogma: “Don’t argue with the tape.”

Far from approving of this myopia, the classical financiers were deeply concerned. For them, it is indeed discouraging to see supposed scholars dignify, with complex algebraic formulas and computer run-offs, the notion that it is foolish to argue with the tape, that thinking is a waste, that we should not pick stocks.
So were did EMT led? First, to the extraordinary growth of index funds. A fund manager, persuaded that stocks are as correctly priced as can be, saves herself the bother and buys the market as a whole, or an index such as the Standard & Poor’s 500, as a proxy for the market. Indexers rely heavily on the history that stocks, on average and over time, have performed much better than, say, bonds. But theirs is a truncated view of history, one that at best ignores the proven importance of buying in when market values are at historically sustainable levels. Are the levels today sustainable? Sorry, the question is out of order, one that an EMT-indexer is sworn not to ask.

Indexing confounds the essential logic of a discriminating capitalism – that capital and assets are moved to higher valued uses. We all know not to put all our eggs in one basket. But EMT goes far beyond the usual dictates of prudence. Quoting John Maynard Keynes, who had a stellar investment record with several insurance company and Kings College funds:

“To suppose that safety-first consists in having a small gamble in a large number of different directions, as compared with a substantial stake in a company where one’s information is adequate, strikes me as a travesty of investment policy”

It is even more odd that not one EMT theorist has seen fit to study Buffett. Since he began managing money independently, first at the Buffett Partnership and now at Berkshire Hathaway, through strong markets and weak, he has produced average annual rates of return of over twenty-seven percent. For nearly fifty years he has been steadily mining the imperfect prices that EMT says do not exist!

The response to Buffett has been either a deafening silence or a clumsy attempt to avoid the engagement. He is said to be a five-sigma event – someone whose performance is five standard deviations superior to the norm – so that as a statistical matter he can safely be ignored. The idea seems to be that if we believe pitchers are now so “efficient” that no one can hit .300, we should study large numbers of average hitters, rather than a star who has systematically studied the pitchers and the elements of hitting, and best of all is willing to impart that knowledge.

EMT thus has been destructive of that basic aspect of capitalism, watching the managers in the store. For an indexer, of course, stocks are homogeneous commodities, as finance teachers say, and there is no need to name the companies in the portfolio, much less know or monitor them. Do they inquire into company-by-company prospects and performance? Do they watch the managements? No, that is not what they do.
The second erroneous creation of mathematical finance is called capital asset pricing model (CAPM). CAPM, in essence, creates or stocks a measuring stick of risk and then calculates the trade-off between risk and expected returns. Starting from the appealing principle of no-free-lunch, CAPM states that not only is risk measurable, but that the expected payoffs, the rewards, are mechanically commensurate. Increase your risk, as CAPM measures it, and your rewards will grow apace.

Just how pervasive CAPM has become can be seen from a recent newspaper survey of mutual funds, according to which each fund falls into one of five categories of risk. How can they know, I wondered? The answer was in the footnotes to the table. The newspaper, like almost everyone else, has accepted the standard wisdom that prospective risk can be measured. It has assumed the existence of precise arithmetic yardsticks for the outcomes of such uncertain matters as investments in the global telecommunications, discount retailing, pharmaceuticals, which are subject to political, competitive and other factors that quite clearly are not measurable.

All versions of CAPM assumed that prospective long-term business risk can be measured by looking at stock market fluctuations over the short term – in this case, the monthly prices. Thus CAPM confuses the past with the future and the long- with the short-term. It stubbornly refuses to acknowledge that in the typical business, there is no quantifiable risk, but only immeasurable uncertainty: as Frank Knight explained a long time ago, these are two very different phenomena.

The beta of Capital Cities/ABC is 1.0, the same as that of the market index, but what could we possibly learn from that? The company owns a variety of media properties, including newspapers and the ABC network. Do we really believe that a computer, this remembrance of stock prices past, can tell us that a business with an emerging technology and in a changing regulatory environment will be no more or less risky over the next decade than the market as a whole? Or to put it differently, it is not simply that the calculation would be laborious, but rather that very little rational basis may exist for numerical calculation and comparison of any kind.

But CAPM goes still further. It says that the beta, or some similar proxy for risk, measures not just the risk, but the expected returns as well. If you want better than average results, buy a bunch of super-risky, high beta stocks such as the new issue of the latest trendy restaurant chain or biotech start-up. Encouraging money managers to substitute betas for careful research and analysis is like offering Jack Daniels to an alcoholic. It is far too tempting. And it has succeeded so well.

One of the creators of CAPM, Eugene Fama, recently announced that the empirical basis for it had dried up. He had not given up the search for a computerized proxy for measuring business risk, but he was now ready to look elsewhere. What followed is truly sad: each humanistic prof with mathematical background said, well, CAPM may not be correct, but we will continue to use it until something better comes along. And so have money managers, for whom a bad model seems to be better than none at all. How are we to think about risk, they say, without some computer-based, arithmetic proxy? While a beta may not mean much, it has the one advantage that it is readily calculable.

The third erroneous creation of mathematical finance was Miller-Modigliani firm value theory (MM). For a company on Main Street USA, owned by, say, ten shareholders, the issue of when to pay dividends, and how much, would seem fairly simple. Putting to one side the question of the investors’ need for current income, the central issue would be whether the surplus – the freely available earnings of the company – would earn more for shareholders if left in the business or if distributed to them. If the reinvestment opportunities were not particularly attractive, shareholders would rightfully expect to see substantial payouts. And even if the performance has been good, some level of dividends would probably be in order. This normal pressure for dividends would be a useful check on management.

Sounds obvious, but humanistic profs with mathematical backgrounds have managed to distort even this most basic issue of whether to keep the money in the corporation or return it to the owners. Through their reductionist lens, excessive cash will have no effect on how much is reinvested, and the normal desire of shareholders for an income on their investment is seen as an “irrational prejudice.” “Not only does it seem wrong,” one particularly arrogant mathematical finance prof wrote, “it is difficult to believe that sensible folk could have held such beliefs. More importantly, they have reinforced the obvious preference of corporate managers to do what they are only too willing to do, namely, to keep dividends as low as possible.
The problem began about thirty years ago, with a creation of MM. The concept of MM was that the value of the company in the market should not be affected by whether the dividend rate is high or low, or even whether dividends are paid at all. Assuming among other things that a company’s investment program is known, and assuming, too, that the financial markets are efficient, the value of the company has been fixed and shareholders should be indifferent to whether the current earnings are reinvested at the assumed rate of return or are paid out. Mathematical financiers speak of the MM thesis as if it were a law of physics: EMT will guarantee the “conservation of value” regardless of how the corporate pie is capitalized or distributed.
The MM thesis is a basic tenet of mathematical finance, and literally hundreds of papers and books have been written on the subject. The underlying problem – and the error – is that economists and finance people would like to think only about the impact of dividend policies on stock prices, ignoring their impact on the business itself. MM promoters and their followers simply assume that, whether the payout is high or low, whether the company is broke or awash in cash, the size of the corporate jet and of management’s acquisition spree will remain the same. In the “rational” world of finance, the rich and poor behave alike. The potential for mischief here is considerable. If dividends are irrelevant, finance scholars say, to incur the tax on dividends is a waste. Better for the company to keep the money, all the money, they conclude. CEOs, of course, will agree – many of them being only too ready to expand the present business, buy-and-try a new one, or just feel as cozy as one can only feel with plenty of cash in the drawer. The MM theory, legitimate these self-serving preferences.

The consequences of the wide-scale application of these three erroneous creations of mathematical finance were the heavy damages that had been inflicted on American industry, commerce and agriculture. Most of it had been inflicted willfully, or at least with a reckless disregard for the consequences. With no sign of remorse of behalf of mathematical financiers, the possibility of further even greater harm could not be ignored. Graham and Dodd, who taught security analysis at Columbia, liked to say that the stock market is not a weighing machine, but only a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion. Mathematical financiers still cling to the weighing machine as an established, “proven” concept, so much so that, according to none other than a Columbia professor of security analysis, Graham and Dodd are “hopelessly” out of date. Confronted with their failings, the response of humanistic profs with mathematical background has been to fine tune the “weighing machine” concept, arguing that the contrary evidence only takes small bites out of it or that EMT ought still to be used until “someday,” when something better will come along.

Mathematical finance practitioners have always had deep disdain for accounting and financial analysis. Thus a respected finance text, fed to once-innocent business school students, still states as dogma that, “investors gain little benefit from corporate financial statements because they contain no new information”. They are driven by a search for elegance, a word that crops up again and again in their books and research papers. “Elegance” reflects desire for overarching solutions, algebraically expressed, that will provide the key to a host of issues, and in any season, rather than the messy, context-sensitive responses that most other social sciences produce. Indeed, mathematical financiers tend to reject the label “social science,” although that is obviously what finance is.

Friedrich von Hayek had something similar in mind in his Nobel lectute of 1974, when he criticized economists for straining to mimic the quantitative precision of the physical sciences. In so doing, he observed, they were ignoring the fact that theirs is a complex social study in which quantitative data would be hard to find. He might as well have been referring to mathematical finance and the like when he chided economists for ignoring what is important in favor of that which happens to be accessible to measurement.
So what can the respected readers make out of this article, useful to themselves? First, markets are not efficient, and thus the more time is allotted to study of them by an investor, the better he is likely to do. Markets, if studied consistently and accurately, are a good source of income for a WN investor.

Second, it is more profitable and less risky to invest into individual stocks than in mutual funds: the thesis to which I have adhered to for all my professional life. It is better to find an honest and reliable practitioner of classical European finance, and to set up a stock portfolio best suited for individual needs, than to put money into mutual fund, seldom fully suitable for individual tax and investment needs.

Third, it is better not to take interest- bearing loans at all, and if taken, to use them sparingly for investment purposes only. The regular answer to a banker, who is all too willing to sell you a loan this days shall be a polite, but resolute “no”, no matter how good the prospects of a venture might look at the first glance: living within one’s means and gradual saving will make more money for you, while taking business loans is likely to force you making all the money for the bank. That’s the most important part of my advice, and I hope respected VNN readers would follow it.

Some of the respected readers have noticed that I stopped giving market advice a month ago – for a time. The reason for this was that I was preparing for correction: I closed most stock positions, keeping only a few financial and energy stock positions. Instead, the market rallied, although the fundamentals pointed to the fact, that there was no basis for it and it was based on greed, not on hard data. So I closed most of my remaining positions, advised my clients to do the same and sit hard awaiting a correction. I have not been disappointed, but I saw frightened me: the financial markets have become much more interdependent, than they used to be: the lag between trends on global and national markets is nor longer hours, but minutes! This increased volatility is the direct result of lifting capital controls, and crisis in any large economy is likely to have very painful immediate effects in any part of the world. The market (DJIA) are going down, between 12 000 – 12 150 at the moment, although fundamentals do not justify valuations above 11 500 – 11 750 – and this means further correction is likely to occur. But since trend (although still tricky) is easier to forecast at the moment, I will resume providing stock picks next week. At the moment my advice would be to close remaining positions in weak stocks – even if this means losses, and patiently wait for the bottom of correction below 12 000 to resume stock purchases.

The macroeconomic reason for correction is that the U. S. economy is entering recession, and both the stock market and the exchange rate are anticipating it. The dollar exchange rate is going down, to 1.32 against the euro, and is likely to continue to recede at least to 1.33-1.34.