For a few years now I’ve been perplexed by how intelligent people can believe in the efficient market hypothesis and the capital asset pricing model. My ideas are still percolating, though I believe focus is one of the main dividers in our beliefs. I spend my days looking at individual trees, looking for market inefficiencies and focusing on them. While believers of EMH and CAPM spend their days looking at the forest. They don’t see the individual trees and market inefficiencies as the forest obscures the mis-pricing.

Whose right and whose wrong? Come on, you know I don’t buy into such black and white interpretations. I view believers and disbelievers as being partly right. The market is broadly efficient, most stocks are priced fairly most of the time. Most stocks seem to follow semi-strong efficiency most of the time and often signs of strong form are evident. The key words being broadly and most. How can that knowledge help me? It reinforces that I should swing my bat less frequently and practice patience. The market is mostly right and individual investors assuming it is wrong and their pricing on any individual issue is better is mostly arrogance. I am as guilty of that arrogance as anyone. Yet individual mis-pricing do occur and I want to profit from them.

Just thinking out loud.

How about risk? I really struggle to see how volatility is risk. Permanent loss of capital, that’s clearly risk. Perhaps severely under-performing over an appropriate time frame is risk. Perhaps volatility is a risk if you are investing in assets that you don’t understand, you’re fearful and are likely to see out near asset bottoms. Perhaps volatility is a risk if you’re using excessive leverage, ala LTCM to name but the funniest.

I view volatility as an opportunity, not a risk. Volatility creates the mis-pricings I seek.

Sometimes I tire of looking at the trees and like to stand back and look at the forest. Here is what I saw today. During the last secular bear market S&P 500 earnings rose from 1976 to 1980. During those five years of earnings growth the S&P went no where, finishing at around the same point it started. The second chart shows that P/E compression occurring over those five years.

As I said, just thinking out loud. Charts are based on Shiller’s data.

UPDATE: 26 June
TPG on irrationality of humans

Any market is simply the summation of its participants’ decisions. Humans, by nature, are irrational creatures. The summation of irrational decisions by no means makes them all rational. This irrationality results in inefficiencies which creates opportunity for those who are able to look beyond the current price action and intelligently understand the underlying forces that are driving it. As simple as this story might sound, the rejection of the efficient market hypothesis might very well be the most important thing you ever do in achieving investment success. via SA

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