By Michael Molinski, Investing Across Borders
For CBS MarketWatch, March 2002

SAN FRANCISCO (CBS.MW) -- It's been almost 30 years since Burton Malkiel's book "A Random Walk Down Wall Street" first shook the investment world with the bold claim that throwing darts at a list of stocks is as good as following the average fund manager.

But a lot has happened in the last few years that calls into question the efficient market theory that Malkiel used to back up his claims.

For example, if markets are so efficient, how could stocks of Internet companies with no clear outlook for earnings soar 800 and 900 percent in 1998 and 1999? And how could the same stocks now be trading at less than a dollar? Or how could a company like Enron (ENRNQ: news, chart, profile) mislead investors into thinking it's worth $80 billion?

The efficient markets theory was developed in the 1960s by University of Chicago Professor Eugene Fama, and others. It asserts that in an active market that includes many well-informed investors, stock prices will reflect all the information available. As a result, no analysis - be it fundamental or technical - can be expected to result in better long-term stock-picking performance.

Malkiel's "Random Walk" took that theory a step further by making the case that future price movements cannot be predicted using either fundamental research or historical price movements. Wrote Malkiel: "The market prices stocks so efficiently that a blindfolded chimpanzee throwing darts at the Wall Street Journal can select a portfolio that performs as well as those managed by the experts."

Malkiel insists his theories hold up, even in the current market in which volatility is at all time highs, and corporate transparency is being put to the test. "Yes, markets sometimes make mistakes. Sometimes they make great mistakes," he said in an interview. "But the true value will always come out.

"The question is whether there's any reliable way of knowing in advance when that is? I don't think either technical or fundamental analysts have done it," said Malkiel.

Malkiel's "Random Walk" is, understandably, not popular with the Wall Street establishment, which is overwhelmingly in the business of analysis and active money management. Even in academia, where the efficient markets theory enjoyed strong backing, not everyone agrees with Malkiel. Some claim his theory and the general idea of efficient markets is outdated. Some say it was misguided to begin with.

Vocal opponent

Perhaps the most vocal opponent of the efficient markets theory is Harvard Professor Andrei Shleifer, author of the aptly-named book "Inefficient Markets." Shleifer argues that a free, competitive market must be inefficient because any arbitrage opportunity that an investor may come up with is always risky, and therefore limited in its ability to bring stock prices to their true values.

"If the stock market is efficient, we don't need to worry about irrational exuberance or a crash, and we don't need to make up stories to explain the New Economy. But if the market isn't efficient, we are in for a meltdown, or at least a long period of mediocre returns," Shleifer wrote in a remarkably prescient editorial in the Wall Street Journal in December 2000.

Shleifer argues: "In inefficient markets, active investment management pays off in the long run. Contrarian strategies -- betting against the mispricing -- do better over the long term than indexation. The question for active investors is whether they can take the pain of volatility long enough before the bubble bursts."

Malkiel, though, points out that 75 percent of professional fund managers have under-performed the Standard & Poor's 500 over time. He concedes that some arbitrage opportunities may exist for short periods of time. "I admit the market made a mistake," he said of the tech bubble of the late 1990s. "The market was not perfectly priced." That created some opportunities to capitalize on those mispricings. Still, "Anything works for some period of time. Nothing works consistently. And you can never recognize in advance an arbitrage opportunity to capitalize on it."

Market influence

Indeed, the basis of the efficient markets theory suggests that whenever arbitrage opportunities or information anomalies do crop up, investors seeking to profit from exploiting those inefficiencies will result in their disappearance. In a truly efficient market, therefore, even insider information can only be useful for a very short time. And in many cases, the inefficiencies that do exist are so small that they aren't worth the transaction costs, especially for small investors.

To be sure, different markets have different levels of efficiency based on the amount of information that is publicly available. U.S. government bond markets, for example, are generally considered to be very efficient, as are the markets for large-cap stocks. On the other hand, the markets for small-cap stocks and international stocks are considered less efficient because there are generally fewer participants and less information available on those markets. Venture capital is even less so.

Billionaire financier George Soros says both Malkiel and Shleifer ignore a key tenet of financial markets: that the markets themselves can influence events.

"In these circumstances, it would be irrational for market participants to base their decisions solely on their expectations about the fundamentals because the fundamentals do not determine market prices; on the contrary, they are themselves shaped by market conditions," Soros wrote in a recent report. "What matters is the future course of market prices and not the fundamentals they are supposed to reflect. If market prices deviate from a theoretical equilibrium there can be no assurance that they will ever return to it."

Again, Malkiel disagrees. "The true value will always come out. In so far as whether that shows that active management will necessarily work, I don't think it does, because it was the active managers who were in part responsible for this nuttiness in the market."

As proof, Malkiel points to the predictions of top fundamental analysts in the late 1990s. "It was the fundamental analysts who said look at these stocks, go buy them. They failed."

But, I asked Malkiel, doesn't the market's emotional roller coaster of the last few years say something for the credibility of technical analysis - that gauging market sentiment can result in over-performance? "I don't think it says anything for technical analysis," he responded. "The technical analysts were the momentum investors. Momentum investing worked very well during the Internet boom. And that is what technical analysis really is - the trend is your friend. But the technical analysts got burned like everyone else."

Before you count Malkiel as a pessimist, though, he insists he isn't at all bearish on the market, just bearish about the ability to predict the market.

"Long term it is going to be fine," he says. "That is the reason I am a buy-and-hold investor. People should be in the market. But the main thing is not to have everything in the stock market. Have some things in real estate and some things in bonds. And cash for a rainy day."

Michael Molinski is a veteran financial journalist and is president of Investing Across Borders.