Monday, March 26, 2012

Burton Malkiel Sabotages His Own Economic Theory

March 22, 2012
What Does the Prudent Investor Do Now?

At a yield of 2.25%, the 10-year U.S. Treasury is a sure loser. Stocks are a safer choice.

I now refer to page 185 of his 1990 fifth edition "A Random Walk Down Wall Street" book, of which I have a copy. I've had it long enough that the pages have turned yellow. It was my favorite investment book, but now I'm really starting to wonder.

Finally, there is the enormous difficulty of translating known information about a stock into an estimate of true value. We have seen that the major determinants of a stock's value concern the extent and duration of its growth path far into the future. Estimating this is extraordinarily difficult, and there is considerable scope for an individual with superior intellect and judgment to turn in a superior performance.

But while I believe in the possibility of superior professional investment performance, I must emphasize that the evidence we have thus far does not support the view that such competence exists; and while I may be excommunicated from some academic sects because of my only lukewarm endorsement of the semi-strong and particularly the strong form of the efficient-market theory, I make no effort to disguise my heresy in the financial church. It is clear that if there are exceptional financial managers, they are very rare. This is a fact of life which both individual and institutional investors have to deal.

He's telling us now that the markets are currently wrong. He has achieved a level of "competence" that is far in excess of that of the markets overall. Bonds are a horrible place to be. Stocks are much safer. He's that "rare" breed of financial manager who actually knows the best place for us to put our money. So much for his efficient-market theory. Put another way, he now believes that the markets are incredibly inefficient right now and that he knows better.

Let's go back to his article telling investors what to do.

A good way to estimate the likely long-run rate of return from common stocks is to add today's dividend yield (around 2%) to the long-run growth of nominal corporate earnings (around 5%).

He is saying that a good way to estimate future returns is to use the rearview mirror. That's the only place the long-run growth of nominal corporate earnings can be found. Right? There are many ways to estimate future growth. The easiest is to use history and hope it repeats. Good luck on that one.

Too many people invest with a rearview mirror.

Agreed, and yet there he is doing it. Why does he assume that the things seen in the rearview mirror will necessarily repeat?

I think it is safe to say that 5-year TIPS are a sure thing loser once inflation is factored in. I agree with him on that. The math does not lie. They have negative real yields. Just because bonds are losers doesn't mean that stocks will be winners though. Since 1980, both bonds and stocks have done amazingly well. It is entirely possible that *neither* do well over the next 30 years.

What will future stock returns be if
these realities finally catch up to them? I'd sure like to hear his answer for that. I certainly wouldn't claim to know. I can tell you what I suspect though, and it isn't good.

I would bet all that I own that he hasn't factored in any of those realities into his assumptions. And how can I be so sure? He's still looking at the "long-run growth of nominal corporate earnings" as if nothing has changed. Well, I have news for him.
Things have changed and I can prove it. He better hope things don't change again or there will be a great many unhappy equity investors.

In my "efficient-market" opinion, this country cannot grow like it once did. I say this somewhat tongue-in-cheek and entirely based on fact. Demographics and debt make a wicked combination.

1 comment:

Stagflationary Mark said...

As a side note, you might be curious why it was my favorite investment book.

What's not to like? Chapter two was dedicated to bubbles.

At the top of the boom there were 75,000 real estate agents in Miami, one-third of the entire population of the city.

Weren't the 1920s wonderful?

By 1926 new buyers could no longer be found and prices softened. Then the speculators dumped their holdings on the market and a complete collapse ensued.

Fortunately, we aren't on that path or we'd have a Great Depression any minute now. The "efficient markets" are giving us the all clear. Unlike 1929, this stock market only goes up! ;)