Are Stock Markets Efficient?

The two best stock market tools are Tobin’s Q and Shiller PE10. They are the heart of a new book by Andrew Smithers: Wall Street Revalued: Imperfect Markets and Inept Central Bankers. The author is mentioned by Jeremy Grantham as one of only five intellectuals in the investment advisory industry. The book’s theme is that the stock market is not efficient; instead the author has developed his “Imperfectly Efficient Hypothesis”. The author demonstrates that the Random Walk Hypothesis is wrong and clearly shows the market is not efficient. My own experience with the tech bubble of 2000 and the real estate bubble crash of 2007 shows that the market is incredibly inefficient. The author assures the reader that eventually the market comes to its senses and adjusts to fair value. However, the author only cities the great bubble tops of 1929 and 2000 as being clearly a bubble top.

 This is because a bubble can get even bigger over many years and it is not possible to predict when it will break or how big it will get. Smithers shows how Tobin’s Q, a measure of stocks replication cost, and Shiller’s PE10, a measure of the ten year average of price/earnings ratio, move closely together, thus confirming each other. These models can’t be used to time the market but they can show that the market is under or over-priced. The author debunks popular theories that interest rates determine stock prices, and debunks the “Fed Model” theory that the Fed determines stock prices. He shows leverage is usually bad. He discusses the Equity Risk Premium (the extra return that stocks earn over bonds) and shows that it varies widely and unpredictably over many decades.

The book demonstrates its commitment to professional analysis by frequently referring to “real” (inflation adjusted) rates of return, instead of nominal. What a refreshing sense it is see numbers being displayed properly, instead of being like most investment books that do a superficial job of show “real” data. The book is filled with pages of crisp, clear high quality color charts to make it easier to read the data. The book explains that return on equity for the market is not the same as return on equity for an individual portfolio because an individual can spend instead of reinvest dividends and bond interest, also the reinvestment rate may be lower than the rate of return on portfolio assets. The book shows that corporate profits are overstated by 10 to 20% due to failure to take proper depreciation charges.

The book is truly refreshing to read. As a person who earned a finance degree over 30 years ago, I had to put up with the academic experts mistakenly telling me for the past 30 years that the market was efficient when it clearly was not. And those experts tried to imply that their doubters were uneducated, unprofessional types. But now we have an intellectual who has written a well-documented book shows that the Efficient Markets Hypothesis is wrong.

The book advocates concepts similar to my own philosophy at and here

The book’s author, Mr. Smithers, operates an independent investment consultancy in London and is a prime example of why independent investment advice is best.

About the author

Don Martin, CFP®

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