Modern Portfolio Theory and William Sharpe: continued

Fallacies of Financial Economics

Unrealistic Premises

The premises behind the elegant mathematics of the M&M theory were unrealistic. Some of the assumptions were:

Perfect Markets: The capital market is perfect. No single buyer or seller can influence security prices or interest rates.

(The Federal Reserve Open Market Committee can not manipulate the price of treasury bonds and management cannot force prices upwards with stock buybacks.)

Perfect Knowledge: Information on securities is free and perfect. Investors all know with “perfect certainty” what the future will bring.

(Standard & Poor’s and Moody’s must go out of business. Companies never lie and provide complete and full information at all times. Corporate profits can be predicted with confidence for one hundred years or more.)

Free Transactions: There are no brokerage fees, dealer spreads, transfer taxes, or other transaction costs.

(Presumably, there would be no brokers, since there are no fees for intermediation. There also would be no stock exchanges or clearinghouses.)

Tax Neutrality: There is no tax difference between debt and equity, or between distributed and undistributed profits. Taxes are the same for all types of investors. There is no tax on capital gains.

(This means there would be no tax on dividends or interest. Taxes on dividends paid to corporations, Keogh plans, and individual investors would be the same.)

Indifference to Cash: Investors are just as happy with unrealized paper profits as with cash dividends. This is defined as “rational behavior”.

(Workers in the real world of finance, at the time the theory was advanced, measured the value of securities by discounting real cash flows, not paper profits.)

Indifference to Risk: Investors will always prefer to make decisions that maximize wealth (paper profits), even if this is more risky than alternatives. Debt is risk free and its cost is insensitive to changes in interest rates or risk of bankruptcy.

(Widows and orphans have the same risk tolerance as speculators. All bonds are equal.)

Indifference to Loan Conditions: The terms of financing are irrelevant.

(Managers may finance long-term investments with thirty-day bank loans with impunity.)

All Players Think Alike: There is no difference in the behavior or goals of controlling shareholders, minority investors, professional managers, and institutional investors.

Stock and Bond Equivalence. There is no difference between stocks and bonds.

(Investors have no preference for the contractual promise of bonds, as compared to lack of corporate liability on equities.)

What is most impressive about the M&M Theory is that its assumptions are so divorced from actual life as to be absurd.

Professors Miller and Modigliani might as well have proposed a Jellybean Theory in which investors were made up of gum drops that would be soon eaten by a giant rabbit.

However, these men were shielded from ridicule by pages of equations that few understood and by the prestige of the Carnegie Institute, the University of Chicago, and Massachusetts Institute of Technology.

In 1985, they jointly won the Nobel Prize in Economics for the M&M Theory, thereby providing an officially sanctioned intellectual basis for the wild finance of the 1990s.

The Nobel Prize in Economics

Nominations for the Nobel Prize in Economics do not come from market practitioners – bank credit officers or private investors – but rather from an inbred circle of orthodox economists, many of whom are respectfully mentioned in the footnotes of the theoretical writings of the nominees.

The selection is made by a small group of Swedish socialists. The prize is financed not by the Nobel Foundation but by the Bank of Sweden, a state-owned bank.

The term “economic science” is a misnomer to the extent that rigorous scientific methods are not used to test the theories and hypotheses of economists under actual conditions.

The Impact of M&M Theories

Prior to the 1970s, the M&M Theory would have had little effect on financial markets, because business people paid scant attention to PhDs, unless they were engaged in building atomic bombs or other truly scientific endeavors.

However, stiff job competition in the dismal seventies created an advantage for job-seekers with MBA degrees.

Consequently, hoards of young MBAs indoctrinated by theoretical economists (without the benefit of on-the-job training in business) began to fill lower management echelons of banks and industrial corporations.

These brain-washed young men and women brought arrogant notions of a New World Order, singing of betas, alphas, and non-systemic risk.

Unfortunately, M&M Theory was not only devoid of a basis in reality, but it was also of slight ethical merit.

The M&M Theory had a pernicious effect on corporate governance and investment markets:

Price Inflation Justified. It became fashionable to value equities by discounting future earnings (rather than dividends) and, in doing this, to use market interest rates (rather than an investor’s own expectations).

This inflated the theoretical value of stocks many-fold, justifying price-earnings ratios of fifty and higher. By focusing on earnings, more easily falsified than dividends, corporate managers were tempted to pump up financial reports in order to increase the value of stock options.

John Burr William’s formula already carried a dangerous seed of over-valuing growth stock, with the Petersburg Paradox.

But the M&M Theory went beyond this, making it possible for academics and Wall Street hucksters to claim that stocks were still cheap even in mid-2000, when the Great Bubble was about to pop.

Riskier Banking. Conservative bank lending practices of self-liquidating loans were now passé, since it was theoretically proper to separate the use of funds from the terms of the funding.

This opened wide the door to the roll-over of bank loans as a substitute for equity, a major cause of the financial crises in Asia in 1997.

Dividends Despised. Stockholders no longer had a theoretical basis to demand dividends. Capital gains were supposedly just as good, even when these gains were the result of manipulation through stock buybacks.

Total return (including paper profits) became the preferred way of measuring investment performance. Without the anchor of cash dividend yields linked to bond yields, equities became increasingly risky and volatile.

Leverage Enthroned. A high debt load relative to equity was now acceptable, since the M&M Theory “proved” that the capital structure of a firm was irrelevant.

Paper Profits, Not Cash. Since temporary, unrealized capital gains were supposedly just as good as cash dividends, there was intellectual justification for stock buyback programs and the pilfering of corporate assets by professional managers.

In claiming that corporate capital structure and dividends were irrelevant, the M&M Theory was the economic equivalent of the moral relativism and nihilism that had infected American universities.

A corporate manager could shuck the traditional fiduciary responsibility to reward investors with dividends, by claiming that capital gains were just as good.

Bankers could boost profits by pretending that short-term loans could be liquidated at will, when in fact corporations needed perpetual roll-overs of bank debt to maintain this substitute for equity.

The Invention of the CAPM

Another academic, William Sharpe, made a profound impression on securities markets.

Like Harry Markowitz, who was one of his mentors, Sharpe also worked at the RAND Corporation while preparing his PhD dissertation.

His paper, completed in 1961 was entitled, “Portfolio Analysis Based on a Simplified Model of the Relationships among Securities,” and was an expansion of the Markowitz thesis on portfolio selection.

Like Markowitz, Sharpe defined investment goals in terms of short-term total return, considering risk to be the statistical deviation of prices of specific securities from market averages.

Professor Sharpe also implicitly rejected John Burr Williams’ concept of stock value based on the discounted stream of corporate dividends, substituting the idea of “market return”, adopting Keynes’ idea of investment goals as those of Lesser Fools.

In addition to work on portfolio selection, Sharpe developed a Capital Asset Pricing Model (CAPM) that postulated that the expected return on an investment was the rate on a risk-free security plus the market return adjusted by a statistical measure of market volatility (beta).

Many other academics further expanded on the ideas of Sharpe and Markowitz to perfect Modern Portfolio Theory – a discipline designed for mutual fund managers whose performance was measured by total returns from year to year. Mr. Dividend was forgotten and Mr. Lesser Fool was king.

Systemic Risk and Beta

When we run a regression analysis on annual total returns of a stock against fundamental factors, like earnings and dividends, together with market indicators, like the S&P 500 index, we find that much of total annual return is dependent not upon fundamentals, but on the market.

Sharpe gave this a name, calling uncertainty in predicting fundamentals, non-systemic risk, and uncertainty about the market, systemic risk.

Non-systemic risk could be reduced by diversification, but systemic risk could not.

Modern Portfolio Theory consists of a technique, using market volatility measures such as beta, to select portfolios in such a way that the overall volatility of a portfolio would be less than the volatility of individual stocks.

This appeared to provide a way that risk for portfolio managers (whose bonuses are dependent upon short-term relative performance in terms of total return) could be reduced.

However, Modern Portfolio Theory (MPT) does not protect long-term investors trying to convey savings for retirement over twenty to thirty years.

The Capital Asset Pricing Model met the needs of Wall Street stock floggers. By jiggling numbers and setting unrealistic expectations for market return, any value can be “scientifically” justified in pricing a public offering.

However, the science in the CAPM and MPT is illusionary – the models are based on fantasy.

Like most of orthodox economics, the underlying assumptions require a “perfect market” and “rational investors”.

Building on Sand

The problem with Modern Portfolio Theory along with its many theoretical subsidiary structures was that they made up a beautiful and lofty temple built on a foundation of sand. Simply put, the premises were almost all false.

For example, a perfect market, one of the tenants of these theories, is one in which there are so many participants that no one person can influence price. However, the market for a particular stock is usually a monopoly. There is almost always one issuer who can create or buy back a specific security at will.

Manipulation of security prices is a fact of life.

If there is manipulation in the market, prices cannot be random and the CAPM and MPT, based on statistical assumptions of a random walk, must be non-scientific.

In fact, there is no rational explanation why the beta for a stock today should be the same tomorrow.

If CAPM and MPT are nonsense, why are these disciplines so popular?

One answer is that trying to maximize paper profits on a stock portfolio from year to year is a speculative pastime and professional fund managers don’t like to be known as speculators.

By flashing Greek letters and theories of Nobel laureates, portfolio managers can cloak their speculation in a garment of respectability and pseudo-scientific propriety.

Furthermore, Sharpe and others were absolutely correct in breaking down total return into non-systemic and systemic risk.

Portfolio managers, faced with the fact that much of their year-to-year performance depended on beating systemic risk, eagerly seized the mysticism of beta, delta, gamma, vega, theta, and rho as protection against market fluctuations.

They might just as well have studied the entrails of sheep or cast bones in the dirt.

The prestige of the Swedish Academy of Science created a cult of Lesser Fools worshipping at the Temple of the Nobel Gods and, in the minds of many, transmuted MPT and the CAPM into laws of real science.

Essay: continued >

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