February 17, 2009
The following is in response to last week’s article by Michael Edesess, Response to Rob Arnott’s Defense of Fundamental Indexing. Edesess’ article was in response to our interview with Rob Arnott, which appeared on February 3, 2009.
In reading Dr. Edesess’s critique of my interview, I’m struck by three things.
First, he can’t break free from the classical finance world-view of efficient markets, in which we’re investing in stocks, not companies. What’s the difference?
- In a classical finance world, price and value are essentially equal. If there are errors, value is normally distributed around price.
- In a Graham & Dodd world of investing in companies, there’s a fair value. We can’t see it, though we can try to estimate it. And, the market will try to estimate it, which results in a price which may be too high or too low.
- In a Graham & Dodd world, we should get long-term mean reversion in prices and valuation levels, as the market seeks out this invisible fair value. Which we do.
- Because companies can get to a high valuation multiple or a large market cap, either because they deserve it or because they’re overpriced or both, there’s a slight tendency for the average large-cap or growth stock to be overvalued. The converse holds true for the low-multiple and small-cap end of the spectrum. So, in a Graham & Dodd world, we would expect to see a value effect and a size effect. And we do.
- In a Graham & Dodd world, whenever the price is too high, the cap-weighted allocation will be above its fair value weight, and whenever the price is too low, the cap-weighted allocation will be below its fair value weight. This creates a return drag for cap-weighting … not relative to the market (which is, after all, cap weighted) but relative to our opportunity set. It’s common sense.
In a Graham & Dodd world, emotions can play a major role leading to market inefficiencies and potentially large mispricing. In a classical finance world, it would be difficult to construct a many-sigma outlier in returns, volatility and correlations, all soaring in parallel, like we saw in 2008. While it’s gratifying to know that 2008 shouldn’t happen, it’s discouraging to note that it did.
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