by Robert A. Haugen (1995)

Book review by Franklin Neubauer F N T

October 1997

Until about the 1980's, the consensus among academics who study U.S. capital markets was that they are efficient markets. Then more researchers began finding exceptions to the rule, so called "market anomalies" where stock prices appeared to conflict with the efficient market hypothesis. One anomaly called the January effect surprisingly showed that small company stock prices rise during January. In this book, professor and financial consultant Robert Haugen, known for writing The Incredible January Effect, argues that the evidence against efficient markets requires that we rethink established theories. In The New Finance - The Case Against Efficient Markets, Haugen summarizes and interprets a wide range of statistical studies. He concludes that patterns of market inefficiency provide investors with a Golden Opportunity to earn consistently above average returns on their investments.

This opportunity lets investors in value stocks profit from swings in inefficient markets that overreact to information about companies' future prospects. More specifically, markets initially underreact to new earnings information and some months or years later markets overreact after developing unrealistic expectations about future earnings. Haugen writes persuasively, using his knowledge of relevant research, flair for vivid expressions, and irreverence towards old theories that conflict with new research results.

Haugen observes that stock prices exhibit inertia in the short-term and often have reversals in the long-term. This behavior is driven by the tendency for companies in competitive industries to revert to the mean, so yesterday's winning performers become tomorrow's average performers or losers, while yesterday's losers are likely to improve. The market is slow to recognize the occurrence of these reversals.

Haugen reviews evidence on how designated winners' and losers' stocks perform in the months after their status as winners and losers is established. He also presents a somewhat slanted view of the performance of value stocks versus growth stocks. He devotes one chapter to the predictability of future earnings. Haugen contends today's investors count too much on future earnings growth, as investors did in the late 1920's. Investors generally expect too much from growth stocks, driving up their prices and resulting in disappointments later.

In attacking the belief in market efficiency, which Haugen calls The Fantasy, he hits related targets, notably the Capital Asset Pricing Model (CAPM), which he calls The Theory. In describing the origins of CAPM and some assumptions behind it, Haugen provides one of the clearest explanations of CAPM I have seen. CAPM describes the relationship between risk and expected return, which as every MBA knows is positive and measured by beta. Haugen draws heavily on a well known 1992 study by Fama and French to identify factors that are superior to beta in predicting expected return. Fama and French found little statistical support for beta in that study, but Haugen carries the argument further. He identifies a common bias in the statistical approach researchers use to show that CAPM is valid. If Fama and French found the relationship between beta and return is almost flat, but this measurement is biased upwards, their data supports what seems an implausible conclusion. In today's investment environment, Haugen concludes high risk stocks have low expected returns, while low risk stocks have high expected returns. So Haugen has turned CAPM upside down.

Some conclusions rely on performance for hypothetical portfolios instead of performance statistics from actual investment managers who charge management fees and incur brokerage costs. This is an unfortunate omission, because true believers in market efficiency have long held that market inefficiencies are not large enough or reliable enough to justify these costs of undertaking an active investment strategy. Critics of Haugen would argue that investors are better off buying and holding a market index fund.

Contrary to the book cover's description, Haugen's review of existing research is not comprehensive. However, the book is well organized and provides an excellent starting point for readers interested in either the debate on market efficiency or in evidence on value investing. This book is part of the Level III curriculum for Chartered Financial Analysts.

Read about economic policy and political promoters. See the review of economist Paul Krugman's Peddling Prosperity.