Fama Keeps Preaching (but the choir ain't singing)

Fama, my old nemesis, is still preaching efficient markets. Check out the interview.
I especially love the interviewer’s interrogation regarding the 1987 crash, although I am disappointed she did not ask him about his own little fund, Dimensional, and its strategies. Namely how does Dimensional pick “risks that are worth taking and the risks that are not.”

Some parts I shall comment on:
(FEN - Financial Engineering News, EF - Eugene Fama, BSD - Arbitrageur's apropos pseudonym)

FEN: As an undergraduate at Tufts, you tried to beat the market.
EF: Yes. I was already working on stock market data. I tried to figure out ways to beat the market for Harry Ernst, who taught economics. I came up with mechanical kinds of strategies. He always made me have a hold-out sample to see if the strategy worked on new data – and it never did.
BSD: …and as a way of justifying your failure you dedicated the rest of the life to erroneously proving that you were playing a game one cannot win (although – of course – some consistently do).

FEN: If markets are efficient, a stock price reflects the intrinsic value of a company, but does that mean the price is always right?
EF: It means you can’t figure out whether it’s wrong. It’s not always right because there’s some uncertainty about what right is, but basically you just can’t beat it.
BSD: In another life you would have made a great spin doctor or lobbyist. You neither answered the question nor provided any evidence to the contrary of the point presented – you simply questioned the meaning of “right.”

FEN: What about [inefficiencies in] smaller, illiquid stocks?
EF: That’s what people claim – that smaller stocks are not priced as efficiently as bigger stocks, that emerging markets are not priced as efficiently as developed markets. But anyone who looks at it empirically can’t find any evidence to that effect.
BSD: Yeah, anyone but the investors who’ve been consistently raping those markets precisely on the basis of exploiting inefficiencies that result from a poorly regulated market.

FEN: I was just talking to a trader in Canada who’s at a fund that has beaten the broad Canadian market by investing mainly in financials for the last 20 years.
EF: Look across the spectrum of all funds – you’ll always find people in both tails. That can happen even if nobody has any special information. Some people are going to be lucky and some unlucky. The lucky ones get the attention, and then they think they’re smart.
BSD: So guys like Stevie Cohen who’ve been “lucky” for decades must have made some deal with the devil, because statistically such a streak of luck is near-impossible.

FEN: Have you moderated your views over the years that markets are efficient? Many academics and others say you have.
EF: Many people get confused. Many people don’t understand the difference between efficient markets and the risk-return story.
BSD: I think you don’t understand the difference, homey. Your original paper, understandably, does not account for the many ways to hedge risk that currently exist. The problem is that, like a caveman driving a car on square wheels you are unwilling to change.

FEN: There’s no need for active investors to go in search of information?
EF: There’s no need for active investors who don’t actually succeed in uncovering new information. People who act on bad information make prices worse.
BSD: Correct. So, since – according to you – most active managers act on bad information their very existence erodes efficiency.

FEN: Are traders following momentum strategies an example of people without information moving the market away from the most efficient price?
EF: I don’t know.
BSD: BS. You do know, you just can’t explain it with your theory. You said (in this very interview) that there is “evidence that there’s some short-term momentum in returns” – the very existence of observable and predictable momentum in liquid markets implies profit potential through an active strategy.

FEN: You’ve been a skeptic of the idea that people’s irrational behavior and decisions affect market prices in predictable ways, and you’ve been a critic of behavioral finance more generally. Do you think behavioral finance poses a threat to the idea of efficient markets?
EF: It poses interesting questions and legitimate questions for research. I haven’t seen researchers in that area come up with much that indicates that prices are bad. They’ve produced a lot that indicates that individual investors don’t always act completely rationally. Those are two different things. At the micro-micro level, they have done some really interesting stuff. At the level of price-setting, it’s not so clear.
BSD: Assuming a significant number of price-setters who do not act rationally how can markets be efficient? You cannot say that there is no direct relationship between price efficiency and the rationality of market participants. Furthermore, there has been research applying behavioral finance to prices – you just aren’t bringing it up, perhaps because you can’t outright disprove it.