07/26/2014 Fama versus Shiller -- the TOO efficient market

Style Model	Small Value
Sector Model	XLU	0.00%
Large Portfolio	Date	Return	Days
BX	4/14/2014	17.40%	103
TIVO	4/23/2014	11.60%	94
SHOO	4/28/2014	-4.43%	89
PM	5/27/2014	-0.96%	60
SR	6/2/2014	11.33%	54
CFI	6/9/2014	-0.56%	47
FRAN	6/16/2014	-11.02%	40
NUS	7/7/2014	-14.33%	19
BT	7/14/2014	-1.45%	12
RRD	7/21/2014	-1.30%	5
(Since 5/31/2011)
S&P	Annualized	13.01%
Sector Model	Annualized	26.88%
Large Portfolio	Annualized	25.41%

 

Rotation: selling BX; buying CHFC.

The Sector Model continues to plod along, well ahead of both the S&P and the back-test baseline:

 

Before the close on Friday, the Sector Model switched from Financials to Utilities.

Financials remain a close second, however, and the Style Model’s call for Small Value tilts the next trade into a Small Value Financial rather than a (comparatively) Large Value Utility.

So, CHFC it is.

Large and Small are easy to parse.

But Value and Growth?

I’ve written before that “Value” looks at what the assets are worth if a company is going out of business, and “Growth” looks at the potential for expansion.  Value tries to minimize losses and Growth tries to maximize gains.

Each is trying to outperform, but in different ways.  Growth tries to go up more than the market, and Value tries to go down less than the market.

My models don’t care either way.

But the key to understanding Value and Growth is to look at the difference between Fama and Shiller.  Both earned the Nobel Prize, but Shiller argues that the market is inefficient and Fama argues that the market is efficient.

They argue the opposite; so which one is right?

Well, both, and neither.

Haugen (The Inefficient Stock Market, page 92; The New Finance, pages 17-24) understood how to thread the needle between the two, when he studied how Growth COMPANIES compared to Value COMPANIES.  Not “stocks”, mind you, but “companies.”

Over the course of 1-5 years Growth companies grow more than Value companies.

In other words, investors are remarkably efficient in picking which companies will grow more than other companies.

But they are TOO efficient.  Growth stocks are priced higher than Value stocks because the companies they represent will grow more than the value companies.  The problem is that investors over shoot.  It’s not that they are wrong, but that they are too right.  Even though a value company will grow less, its stock will grow more because it is priced too efficiently.

It’s as if you have a horse that has a sixty percent chance of winning, but you are offering two to one odds.  Over time, you’ll lose money because you are betting too much.  You’ll win more races, but still lose more money.

So the answer to the argument between Shiller and Fama is this: investors are efficient about company prospects, but inefficient in the size of their bets.

The prospects for the value companies I am selecting are indeed poor, but not AS poor as the stocks are priced.

Tim