The grim, grey editorial pages of the Wall Street Journal have become a field of glory, with flashing knives, slings and arrows, as famous academics battle to defend the besieged Efficient Market Hypothesis and the purity of Index Funds.

The Battle of the Academics
The Battle of the Academics

In an editorial published on June 27, 2020, Burton G. Malkiel joined with John C. Bogle of the Vanguard Group, to fight for “capitalization-weighted indexing” against the insurgency of Jeremy Siegel, Eugene Fama, Robert Arnott, and Kenneth French, proponents of a heretical notion of “fundamental-weighted indexing”.

Professor Siegel Throws Down A Glove

Professor Jeremy Siegel had opened the fray by an earlier editorial in the Wall Street Journal of June 14, 2020, proposing that index funds should be weighted on the basis of dividends rather than market capitalization.

Professor Malkiel replied with haughty disdain, calling for caution before accepting the Johnny-come-lately “new paradigm” of “fundamental-weighted indexing”, since this would imply that the “old paradigm — reflected in more than $3 trillion of capitalization-weighted index investment funds — is in error”

Joining Professor Malkiel in the defense of capitalization-weighted indexing was none other than John C. Bogle, who, as patriarch of the Vanguard Group that manages $340 billion in index equity assets, has a very, very large dog in the fight.

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The Efficient Market Hypothesis continues to impede understanding of how capital markets work.

The front-page article in the WSJ of June 12, 2020, announcing record levels of stock buybacks, continued to promote a common misperception that stock repurchases enhance equity prices by the following mechanism:

  1. By reducing the number of shares outstanding through buybacks, earnings per share increase;

  2. Investors, noting this increase in earnings per share, are willing to pay higher prices;

  3. Therefore, buybacks. by increasing earnings per share, cause prices to rise.

This, of course, is in line with the Efficient Market Hypothesis, and depends upon the assumption that increasing earnings per share improves intrinsic value and that a crowd of rational, competing, profit-maximizers will therefore force prices upwards.

Ignoring the Evidence

The popular line of reasoning of the WSJ ignored Federal Reserve flow of funds accounts that showed that something far removed from the Efficient Market Hypothesis was driving the market in Q1 2006:

  1. Corporations were spending vast sums (more than $146.7 billion) to take stocks off the market with the intent of directly manipulating prices upwards;
  2. Individual, sophisticated investors, dealing in specific stocks, were not bidding up prices because of enhanced earnings-per-share, but rather were selling out on a grand scale ($216.6 billion) — cashing in their stock options;
  3. Unsophisticated investors (according to surveys by the Investment Company Institute) were naively buying ’stocks for the long run’ through automatic payroll deductions channeled to tax-deferred mutual funds, with no perception, whatsoever, of changes in earnings-per-share of individual securities.

The WSJ interpretation of the record level of buybacks, supported by the Efficient Market Hypothesis, puts a spin on events that is far kinder to corporate executives, stock brokers, and option exercisers, than the unvarnished truth that prices were supported not by improved earnings per share and crowds of rational investors seeking ‘intrinsic value’, but rather by the brute force of $146.7 billion in corporate cash being applied to take stocks off the market from option holders, many of whom were the same executives ordering the buybacks.

Furthermore, what was going on in Q1 2006 was not some random event — mere noise in the market — but rather the continuation of a long-standing pattern of behavior involving corporations, option-holders, and mutual fund investors that has been going on for many, many years.

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The SEC has sanctioned the use of risk-return predictive software as a sales aid by NASD registered representatives, as long as disclaimers are displayed.

(See PDF file)

Each forecasting tool must be accompanied by a description of the criteria and methodology used, including the tool’s assumptions and limitations.

However, the reverse side of regulation is enforcement and there will be a certain difficulty in dealing with the materiality or adequacy of disclosure of theories that are, in the final analysis, unscientific.

The 10b-5 Daily in “What is an Efficient Market?” discusses how the Efficient Market Hypothesis has already entered the courts.

(See also: The Non Efficient Market).

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