The stock market is becoming more efficient over the short term and less efficient over the long term, some investment experts say.
With an increased focus on short-term trading strategies, including various types of hedge funds, it might get tougher to make money in short-term plays as more capital is plowed into this area. Meanwhile, some yawning opportunities may emerge in longer-term investment strategies.
"The market is getting more and more efficient over very short periods of time, over a day or week or month," said Albert S. "Pete" Kyle, associate professor of finance at Duke University's Fuqua School of Business, Durham, N.C. The market, he explained, "is attracting all kinds of people trying to make money off of all types of price discrepancies."
But the converse is the market is becoming less efficient for longer time intervals. "It's getting hard to make a penny during the course of the day, but stocks could be mispriced by 50% or 100%," Mr. Kyle said. That discrepancy also helps explain the technology-stock bubble of the late 1990s.
Barr Rosenberg, chairman of AXA Rosenberg Group, Orinda, Calif., thinks the market has become less efficient over longer periods "because the standard rules that rewarded understanding the business in which stocks were based were more friendly to investment judgment than the present environment, where the emphasis is on complex investment vehicles."
Managers also are subject to more pressure to generate short-term performance, Mr. Rosenberg said. Such shorter-term tactics to avoid large deviations from their benchmark can come at the expense of longer-term performance.
Nonsensical
The notion that the market could become more efficient on the short run while less efficient in the long run struck some observers as nonsensical, if not downright perverse.
"If the market is inefficient in the long term, that means the inefficiencies have not been arbitraged away (in the short term)," said Jeremy Grantham, chief investment strategist for Grantham, Mayo, Van Otterloo & Co. LLC, Boston.
But others give this notion credence. "I think there could be something to this," said John Campbell, Otto Eckstein Professor of Applied Economics at Harvard University and managing partner, research, at Arrowstreet Capital LP, Cambridge, Mass.
"At the moment, the market is very interested in profit-seeking activity that has some type of convergence built in," such as in hedge funds where risks are controlled and managers pursue a pair-trading strategy or arbitrage opportunity, he said. "To the extent more and more capital flows into that kind of trading activity, I would expect the rewards to be diminishing and the rewards for taking factor risk possibly increasing."
Other experts, including Barton Biggs, chief global strategist and chairman of Morgan Stanley Investment Management, New York, have warned of a potential bubble occurring in hedge funds.
In the past 10 years, hedge fund assets have grown 1,509%, to $563 billion, said Charles J. Gradante, managing principal of the Hennessee Group LLC, New York. Meanwhile, 700 new hedge fund firms were started last year alone, boosting the total to 5,500, he said.
Mr. Gradante, however, does not think opportunities for arbitrage managers have been reduced, because they have picked up the slack from investment banks that have cut back proprietary trading.
Short-term market efficiency - meaning the market almost instantaneously reflects all available information in pricing securities - is affected not only by the flow of capital into trading strategies, but also by the speed at which information is communicated within the market. New technology - from the Internet to Bloomberg trading desks to financial news channels - presents a never-ending stream of coverage, while lower trading costs enable faster absorption of information.
A study by two Emory University assistant finance professors supports this notion. Looking at CNBC's "Morning Call" and "Midday Call" segments, renowned for analysts hyping their favorite stocks, Jeffrey A. Busse and T. Clifton Green of Emory's Goizueta Business School found that stock picks were reflected in stock prices within seconds of mention of a stock's name; price changes lasted about a minute.
For bad news stories, prices kept falling for about 15 minutes, possibly because of higher costs of short-selling, the academics speculated. The study looked at 322 stocks featured on the shows June 12-Oct. 27, 2000. During most of that time, the market was relatively flat.
But immediate absorption of data doesn't mean the market has got it right. If information is missing or inaccurate - such as with Enron Corp. or one of a host of telecommunications companies - the market will reflect the available information. Subsequent revelation of more accurate data might reveal new insights into companies, and stock prices will be adjusted at that point in time.
While competition is increasing at the short end of the market, there might be huge inefficiencies at the long end.
Mr. Grantham is one of many managers who chafe under increasingly narrow mandates, limiting investment opportunities. "People will not wander out of their increasingly tightly defined boxes," he said.
The problem with setting such tight controls on managers is that it curtails the market's ability to correct mispricing of securities. "The more consultants you have measuring performance, benchmark risk, information error, tracking error, the less likely you are to have proper arbitrage," he said.
Specialized mandates
Nick Barberis, associate professor finance at the University of Chicago's Graduate School of Business, agreed that greater use of specialized mandates by pension funds can create larger market inefficiencies.
In a draft paper by Mr. Barberis, Andrei Shleifer of Harvard University and Jeffrey Wurgler of New York University, the authors find that fundamentals fail to explain why the prices of certain securities move up or down in tandem. According to the traditional view, stock prices change only because of fundamental factors, such as revised cash flow expectations or changes in the rate used to discount cash flows.
Instead, they suggest securities in certain categories of assets - such as small-cap stocks, industry stocks or junk bonds - move together because of investor demand. A related issue is investors choosing to trade only a subset of securities, such as a closed-end fund or an index fund. Prices of securities in the same "habitat" move together as investors choose to buy or sell such baskets of stocks, having little to do with fundamentals.
One potentially huge market inefficiency is the equity risk premium - the amount equities will return over the riskless asset, usually considered to be Treasury bonds. During the past 75 years, equities have returned 4.92 percentage points over bonds, according to Ibbotson Associates, Chicago.
Robert D. Arnott, managing partner of First Quadrant Corp., Pasadena, Calif., a frequent critic of high projected equity returns, said: "I think the issue of the risk premium is a big-picture inefficiency. I would bet very, very long odds that the risk premium in the next 20 years will not be even as half as large as what we saw in the last 20 years."
Economic consultant Peter L. Bernstein, who has co-authored articles with Mr. Arnott on the risk premium, thinks investors still are driving while looking through the rearview mirror.
The strong positive correlation that prevailed between stocks and bonds between 1981 and 1998 has broken down, he said. Starting in 1981, earnings yields fell below bond yields for the first time, suggesting that bonds were riskier than people had thought in the past. But the uniqueness of that 17-year period - where bond prices were shellacked by inflation, followed by disinflation - is unlikely to be repeated any time soon, Mr. Bernstein said. "But it weighs very heavily on investors' minds, both stock and bond investors."
