Maybe Financial Markets Have Been Wrong All Along

There are many reasons other than risk why investors might choose to avoid cheap-looking stocks. One reason is herd behavior — if investors think that other investors are avoiding a certain stock, they might assume that stock is bad, and similarly avoid it. Some stocks might simply be boring and un-glamorous. Some might be obscure companies in overlooked industries, or information about them might be more difficult and costly to obtain.

These factors all might have been more prevalent in the 1960s and 1970s, when data was sparse and expensive, trading costs were much higher, and the number of professional investors was more limited. As financial markets improved, we may have seen the entrance of more investors who are willing to do the hard work of digging up obscure and boring companies, and who are willing to go against the herd. If the value premium really was a systematic underpricing rather than a true risk premium, then the gradual development of financial markets would be expected to shrink this premium over time.

There are signs that this is happening. Although value stocks did well in the early 2000s, they have dramatically underperformed since the crisis, even though the market has boomed. Of course, that might simply be a particularly long period of underperformance — we might expect to see value bounce back soon enough. But in fact, the decline has been going on for quite a bit longer than that — the value premium has been falling since the mid-1990s. Coincidentally, that is exactly when the Internet and computerized trading systems made it possible to invest in stocks much more cheaply, and to gather information much more easily.

That would mean that markets are getting more efficient — at least, in this one particular way. But it would also mean that market efficiency takes a very long time to establish itself. If big, systematic mispricings such as the value premium can survive for decades before they are finally traded away, it means that other flaws in the market might be equally long-lived. For example, the momentum factor – another mainstay of standard finance theory — might also be a market flaw that will eventually be shown the exits.

If the market is that inefficient, it also means that stock prices are, in some deep sense, "wrong" — that they are not the best available estimate of a company's value. That would suggest we should be relying on markets less than we do for things like executive compensation. So watch to see if the value premium comes back. If it doesn't, it means it might never have been about risk in the first place.