Robert Haugen, finance professor emeritus at the University of California, Irvine, and managing partner of Haugen Custom Financial Systems, enjoys tilting at conventional wisdom.
The maverick economist has blasted away at such sacred cows as the efficient market theory and the capital asset pricing model (CAPM). He has shown that growth stocks actually underperform value stocks — a key insight that led him to warn against the excesses of the market in the late 1990s.
Now, he has a new target. In his more recent books, The Beast On The Street (Prentice Hall, 1998) and the third edition of The New Finance (Prentice Hall, 2003), he takes another broad swipe at one of the underpinnings of the notion of efficient markets. He puts forth the proposition that 24/7 global trading does not, contrary to popular belief, provide a more efficient market by providing better opportunities to set prices. Investors still tend to make mistakes, based on a false belief that accurate information is driving prices. The beast in question, is price-driven volatility, which, Haugen says, is poised to take down the market — and the investors and advisors who have surrendered to the efficient-markets dogma and are content to ride the various indexes are in for a rude awakening.
Position of Strength
The author of 14 books, Haugen argues that investors, armed with the right analytical approach, can indeed beat the market. Haugen Financial Systems, an investment consulting firm to institutions, runs a global fund based on Haugen's recommendations (based on perceived value), which has beaten the MSCI World index by an average 2.14 percent per year over the past five years.
Haugen, in a recent interview, allows that it may not be “easy” to beat the market, as he had previously boasted, but it is not, as the efficient-market believers insist, impossible. “I admit you go through periods where the market is difficult to beat,” he says. “In 1998, market leadership was so narrow that if you weren't in the four or five biggest stocks, like Microsoft and General Electric, it is highly likely the market beat you.” Still, he says, there is little doubting that the market can be beaten. “Studies of mutual funds at the University of Chicago show that performance tends to persist, so that managers that outperform in one year tend to outperform subsequently,” he says. “I'm a quant: I know that if you have a sound model and you back that up with careful controls you can, and will, consistently outperform.”
Is Haugen right about the efficient market? According to renowned Princeton economics professor Burton Malkiel, author of A Random Walk Down Wall Street (W.W. Norton & Co., 2004), efficiency can be summed up in the old joke about the economics professor and his grad student: The grad student sees a hundred dollar bill on the ground and stoops to pick it up, and the professor says, “Don't bother, if it were real it wouldn't be there.”
“That definition says the markets might get it wrong from time to time, but there aren't going to be any arbitrage opportunities available,” says Malkiel. “I agree with Haugen that sometimes market prices are not right, but I disagree that, therefore, you can easily build a strategy to get better rates of return.” Or, as Russell Investment Group portfolio strategist Steve Wood puts it, “Markets can provide pockets of inefficiency but they don't persist. That's why God made investment bankers and arbitrageurs.”
Proponents of indexing claim the market balances rewards and risks so neatly that attempts to actively manage a portfolio mean taking unnecessary risks or leaving money lying on the table. Haugen sees the risk/reward premise as a false construct, because “the highest-risk stocks can be expected to produce the lowest returns and the lowest-risk stocks, the highest returns!”
It all goes back to the investor, an irrational beast, in Haugen's view. If investors were efficient utility maximizers, downward price swoops would appear as buying opportunities, rather than fearful periods of endless markdowns. Haugen points out that most investors do not buy on the dips, but sell. Likewise, when they spot a winner, they become overly enthusiastic, continuing to buy, no matter how the pricing diverges from reality.
“Over the long term, value will outperform growth because the market tends to overreact to the success of companies and project that continuation far too long into the future,” says Haugen. As investors romanticize what works, they drive prices too high for successful firms and too low for losers. On the other hand, he gloats, the inefficiencies these investors create allow people like him to build “low-risk, high-expected-return portfolios.” In efficient markets, such portfolios would be impossible, he points out.
Haugen says that if we imagine a spectrum of efficiency, with perfectly efficient markets at one end and total chaos at the other, “we're closer to the chaotic side.” Malkiel at Princeton disagrees: “If Haugen's point is that risk has more dimensions than simply beta, I would agree. If he means that risk and reward aren't related, I would disagree. As to indexing, most of the theorists that I debate with, when it comes down to what they do with their own money, agree with me that even if you don't think the market gets it right all the time, indexing is still the best strategy. So that's where we disagree.”
For Haugen, a down-to-earth college professor who moved to Durango, Colo., because it was more casual than Los Angeles (he proudly notes that USA Today voted Durango one of the worst-dressed places in America), the most important determinant of stock prices is recent changes in prices. This is the concept of price-driven volatility. While volatility is mild, this beast is tame, but when it's roused, it's deadly.
What advice would Haugen offer financial advisors and individual investors? “I would tell them the market is dangerously inefficient, that it has caused catastrophes in the past and is even more likely to again pose dangers,” he says. Do not, he adds, be comforted by the idea that lots of market participants and lots of opportunities to set prices are a moderating influence: “More trading brings with it more volatility, more noise and a greater likelihood of market meltdown.”
In 1987, he says, the market crash was triggered by “a sequence of returns day after day that were several standard deviations away from a 20 percent volatility distribution.” In the four days leading up to the crash, “the market changed its mind,” he says, “wanting a higher rate of return and then a higher one still.” In effect, the market became convinced “that we're not dealing with 20 percent volatility anymore, believing maybe its 40 percent, then 60 percent, then asking, ‘Wow, what is it now?’ before crashing.”
And crashes, Haugen says, are economic events. “In a crash, the market is talking to the economy. It only becomes what I call a ‘dangerous conversation’ when the economy starts talking back,” he says. “In 1987, the economy was very strong; it didn't talk back. But it talked back in 1929 because we were moving into a recession in the final quarter of that year, and the market turned that into the Great Depression.”
In the decades since, many economists have blamed the economic devastation on a tight monetary policy. Haugen lays the blame solely on the stock market crash, adding, “The forces in play then are even more in play now,” he warns. “If I'm right, this is really important.”
The Problem With Prices
Even short of outright crashes, price-related volatility has other baneful effects, claims Haugen. Most volatility on ordinary days is price-driven, “which means the risk premium on equities is far bigger than it needs to be, which means the cost of capital is far higher than it needs to be, which means investment spending is far lower than it needs to be, which means economic growth is far slower than it needs to be.”
Peversely, Haugen, says, the unpopularity of his views may keep the market chugging along and trading ever-increasing volumes of shares, even if it delivers mediocre returns. “Most stockbrokers probably won't like my suggestion, which is to stop trading on Wednesdays, like they did in 1968.” Sighing like a professor who must contend with students sleeping during his lectures, Haugen adds, “Instead, we're going the opposite way. We're going to 24-hours-a-day trading.”
Is volatility the market's Achilles heel or just another of many variables that investors must consider? Only the market can tell. But, it is worth noting, that the one thing on which Malkiel and Haugen concur is that the low volatility of recent years has given investors a false sense of security. “My guess would be that people are getting lulled into thinking that volatility doesn't exist any more. I think it's almost the opposite.”
And is volatility likely to go higher? “I'm sure it will.”