"Efficient Markets" from the Wall Street Journal

This week saw the Wall Street Journal publish two pieces under the theme "efficient markets." Once again, I am disappointed with what they will fill 2/3 of their op-ed page. Each piece has some glaring faults, in my opinion.

The first, appearing Tuesday, was written by the retired head of George Mason University's law school, one Henry Manne. He makes a good conclusion, despite most of his article having little to do with it. Essentially, Manne draws a distinction between viewing market prices for a stock as primarily affected by the last, "marginal" investor/trader, and viewing them as the averaged guesses of a large number of buyers and sellers. He cites an intriguing-sounding book in this regard. So intriguing, I'll probably go to Amazon to buy the book, and forget Manne's name after next week.

In any case, Manne uses this contrast to argue for legalizing all "insider trading" which is not specifically prohibited by contracts, i.e., mergers and acquistions activity, or other confidential activities. What he proposes is that company officers not prohibited to trade because of confidential deal knowledge, be allowed to trade based upon their legal, but special, knowledge of their company. I have agreed with this point of view for decades.

Where Manne seems to wander into difficult terrain is in his critique of behavioral finance. After generally acknowledging it as a field, he vaguely dismisses most of its findings as 'prove in time to be less anomalous than was first thought,' but gives no particulars. He then castigates the field for having no general theory of why markets operate as they do. He then states that, this being the case, "some close approximation of the efficient market theory is still the most accurate and useful model of the stock market that we have."

I guess this is where I suggest that maybe a former law school Dean is the wrong guy to engage to write a moving treatise on the differences between behavioral finance proponents and efficient markets supporters. I find Manne's logic to be simply wrong. Nobody of whom I know has mandated that the field of behavioral finance must spring into being whole and possessing a full depth of decades of research on the order of that existing for efficient markets.

In fact, as Thomas Kuhn propounded several decades ago, in his work on the structure of scientific revolution, new schools of thought usually begin by nibbling away at the errors at the margins of theories of the reigning school. Only with time and resources does the newer theoretical school of thought build its own full theories to explain complete workings of systems.

Just because behavioral finance is now becoming more well-known and possessing of deeper research, does not mean we have to continue to accept the flawed reasoning of efficient markets theorists.

In my opinion, Manne could have begun his article with his citing of the book, "The Wisdom of Crowds, by James Surowecki, and it would have been more succinct and better reasoned.

The second part of this short series appeared in Wednesday's WSJ, again on the op-ed page. This article was authored by Jeremy J. Siegel, a Finance professor from one of my alma mater's, the University of Pennsylvania. His topic is the imminent rise of non-cap-weighted indices for financial asset management.

I won't go into the details of Siegel's arguments here, except to state that he believes it will soon be possible to use fundamental measures, such as sales or dividends, to weight indices for use in financial asset management. Siegel pounds away at one theme in particular- that these new indices would allow for higher average returns, and less volatility, than the various current cap-weighted indices, such as the S&P500, Russell, or Nasdaq.

There are, however, to problems with Siegel's positions. First, it is partially disclosed that he has been busily working to create just these types of 'new' indices with a private firm, WisdomTree Asset Management. So, in reality, this op-ed piece seems to be a thinly-disguised piece of public relations and "placed" advertising.

But the more substantive error Siegel makes is in arguing that the measurement function for a "successful," or "useful," index, is that is exhibit high returns with low volatility. It seems to me that he is confusing a market index with an investment strategy.

Indices such as the S&P500 are composed for a specific reason: to emulate the allocation of resources in the US economy, by sector. The S&P500 is actively managed in its membership by Standard & Poors, a McGraw-Hill unit, in order to provide a group of publicly-traded companies whose business activity and weighting are reasonably representative of the activity of the US economy. When you buy this index, you are, in effect, buying the performance of the US economy, broadly described. That's all it is. It's not supposed to have a target return or volatility.

It's the same with the Russell and Nasdaq, for their particular representations. The objectives are to represent some specific underlying economic activity, not to tailor an index to the point that it becomes an active investment strategy all on its own.

That said, I am disappointed that these two flawed pieces found there way, with such fanfare, onto the Journal's pages this week. One author writes badly-reasoned prose about a field that isn't actually his area of expertise, while another author completely misses the point of his subject and, instead, lobbies for his current business enterprise to be used to replace current market indices.

If this is an example of the WSJ's best efforts at financial market education and theoretical advancement, perhaps we now have a better understanding of why the markets are so dominated by such frenetic, emotional short-term trading activity. Market participants are unlikely to find much in the way of helpful insight in the pages of our nation's major business daily newspaper.