Searching for Rational Investors: Explaining the Lowenstein Paradox

TLDR: Lowenstein's notion of efficiency is that market prices are always perfect reflections of true values: "Rational investors will already have erased most any discrepancy between price and value." as mentioned in this paper.

Abstract: I. INTRODUCTION Louis Lowenstein has been one of the most articulate and consistent critics of the academic hypothesis that our securities markets are, for the most part, extraordinarily efficient. In this article, he makes two important points. First, he argues that the enormous bubble in high-tech stock prices around the turn of the century effectively demolished the efficient market hypothesis: "If the NASDAQ Composite Index, for example, was right at 1200 in April 1997, it surely wasn't right at 5000 in March 2000, and then right again at 1100 two years later."1 Lowenstein goes on to argue that a number of so-called "value" investors (those who look for stocks with reasonable prices relative to their earnings, dividends, and asset values) were smart enough to eschew the high-tech market favorites of the period; as a result, they earned generous rates of return, even during periods after the bubble popped. Unfortunately, Lowenstein opines, there were not enough of these "value" investors to make market prices in general consistent with proper estimates of their true value. II. THE MEANING OF EFFICIENCY Lowenstein's notion of efficiency is that market prices are always perfect reflections of true values: "Rational investors will already have erased most any discrepancy between price and value."2 If one believes that markets are efficient, then the most rational strategy is to buy and hold a low-cost broad-based index fund that invests in all the traded stocks in the market. But if one accepts Lowenstein's view that markets are inefficient, then indexing is not the right strategy. Index investors would have been almost 40 percent invested in overpriced high-tech stocks at the top of the bubble. Thus, investing in a broad index fund could not be a sensible investment strategy in a market that was often irrational. But it is important to distinguish between ex post and ex ante efficiency. Of course the market makes mistakes, and sometimes egregious mistakes, ex post. Stock prices, even in a perfectly efficient market, are based on expectations of future corporate earnings, and, as Samuel Goldwyn was believed to have said, "predictions are hard to make, especially about the future." To show that market prices are inefficient, one must demonstrate that it was foreseeable that market prices were incorrect ex ante. An alternative, and I believe more realistic, definition of efficiency is that no discernible arbitrage opportunities exist. Ex ante, it is not possible for investors to earn excess risk-adjusted rates of return, i.e., rates of return higher than those consistent with the risk level assumed. A well-known finance joke illustrates the distinction. A finance professor and his graduate student are walking along the street when the student spots a $100 bill and stoops to pick it up. The finance professor says, "Don't bother to bend down to pick it up; if it were really a $100 bill, it wouldn't be there." In an efficient market, no $100 bills are lying around for the taking.3 III. WAS THE HIGH-TECH BUBBLE OF THE TURN OF THE CENTURY EASILY DISCERNIBLE IN ADVANCE? Ex post, we know that high-tech NASDAQ stocks were enormously overpriced. Indeed, I have called this episode of market history "Surfing on the Internet: The Biggest Bubble of All Time."4 But was it possible to know in advance that the market was overpriced and when the overpricing began? Knowledgeable experts offer conflicting testimony. In his book Irrational Exuberance, Robert Shiller argued that we were in a bubble in early 2000.5 But Shiller's empirical work (in particular the relationships between market averages and dividends) implied that the market was severely overpriced in the early 1990s, preceding one of the greatest bull markets in history.6 Campbell and Shiller presented a paper to the Board of Governors of the Federal Reserve System in 1996 arguing that stock prices were significantly overpriced relative to their historical relationship to earnings. …