The Business Times, Wednesday 02 Apr, 2008

MONEY MATTERS

The inefficiency of markets

For those who took courses in finance back in school, most would remember the Efficient Market Hypothesis (EMH).

By JOSEPH CHONG (An abridged version of this essay appeared in the Business Times of 2 April 2008)

For those who took courses in finance back in school, most would remember the Efficient Market Hypothesis (EMH). This asserts that financial markets are "informationally efficient” i.e. that prices on traded assets, e.g., stocks, bonds, or property, already reflect all known information. According to the EMH, for which a Nobel Prize in economics was awarded, it is not possible to consistently outperform the market by using any information that the market already knows, except through luck.

The recent movements in markets have re-affirmed my cynicism of the EMH. Here are a few recent examples:

Bear Sterns:

This firm was trading at around US$82 (or a market value of US$10 billion) 30 days before becoming almost worthless recently. How can US$10 billion be destroyed so quickly if the market was efficient? Whether by rumor or manipulation, Bear became insolvent within a few days as most lenders suddenly refused to lend to Bear anymore – something which had never happened before in the past 90 years. Rumor and misperception (and not any true information about the company as required by the EMH) created their own reality of insolvency very quickly as credit lines were withdrawn in unison.

Inflation:.

The commodity and bond markets are saying different things about inflation. Looking at the soaring price of commodities, one could assume that we would be having persistently high inflation over the next few years. However, the bond market appears to signal that this jump in inflation would be transient. 10 year bond yields in the US, Europe, Japan and Singapore have stayed low despite the recent inflation numbers. If the market believed that inflation would be persistently high, yields would have soared. Indeed, inflation protected securities are signaling that inflation would stay around 2 to 2.5% globally over the next 10 years.

The current bout of high inflation is concentrated in energy (especially crude oil) and food. In order to diversify from petroleum, the US doled out big subsidies for farmers to produce ethanol from corn. Acreage which was previously used for food and feed production was converted to ethanol production - creating a food supply squeeze. We are skeptical about the demand story - that Indians and Chinese are gorging more. Indeed, the high prices in energy and food would be their own cure eventually because it is now very profitable to invest in supplying food and energy.

I would be careful on all commodities in general as the parabolic rise in prices is difficult to justify given the level of sustainable demand. A good example is gold. According to the World Gold Council, physical demand for gold in 2007 versus 2006 rose only 4% but prices soared by 50%. The rationale that gold is a hedge against inflation and the falling USD may be true but the price move has been exaggerated. Indeed, the biggest component of demand is for jewelry, which is about 70% of total demand and this hardly grew in 2007. However, gold ETFs (which is speculative demand as there is no yield on this instrument) now account for 7% of total gold demand from nothing a few years ago. It should be noted that global physical demand for gold at 3500 tons translates into a small market of only USD 110 billion per annum or about 3 days of trading turnover at the NYSE or 3 months at the SGX. It is therefore fairly easy for a number of large speculative funds to drive prices higher quickly.

Valuations:

The annualized ten-year rate of return for the MSCI World Index, including after-tax dividends re-invested, has fallen off the cliff to merely 4.59% as of 27 Mar 2008 as price-earnings ratios compressed.  This is an all time low for the MSCI World despite the sound economic fundamentals worldwide ex-USA.  Please see accompanying chart of the analysis of 10-year rolling returns for the MSCI World Index up to 31 Dec 2007 performed by my colleague Stanley Sim. 

Returns on global equities theoretically should track dividend yields plus nominal world GDP growth.  This has been more than 9% in the past ten years.  Indeed, the average annualized return of the MSCI World Index for the last 38 years from 31 Dec 1969 to 31 Dec 2007 has been 9.91%.

But why have valuations worldwide fallen so low and in unison despite the sound economic fundamentals?  Fear is one possible answer.  The other more likely primary cause is the sudden disappearance of liquidity in many areas of the debt markets.  Investors who need to raise cash for their portfolios for one reason or another have been forced to sell what they can and not what they want to.  Unfortunately, global equity markets have stayed liquid and therefore have borne the brunt for the need to raise cash.

I believe that reversion to the mean will eventually occur but the timing is uncertain.  A return of merely 4.59% corresponds to world economic growth of about 0 to 1% into the foreseeable future.  Unless, one believes that the world economy is about to fall into a permanent state of near recession, mean reversion must eventually occur.  Otherwise, equity valuations will continue to compress until they become giveaways – which would be illogical.  Should returns revert back to the mean, the implication is a rise of more than 40% in global equity markets.

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I believe the catalyst for this reversion to the mean is the sharp build-up in liquidity in the financial system.  Since the big 1.25% cut in US Fed rates in mid January, US money supply measure M2 has taken off like a rocket.    Please see the accompanying plot of the data from the US Federal Reserve.  M2 is now considerably in excess of US nominal GDP growth.  Meanwhile, money market funds have grown by about US$1 trillion in the past 12 months.  Once the log-jam in financial markets is cleared, this wall of excess liquidity must find its way downstream into the capital markets and real economy.

The writer is CEO of financial adviser New Independent. He welcomes feedback at : josephchong@ni.com.sg

This article is for information only. Readers should seek independent advice before making any investment decisions