The stock market has become less efficient - the culprit might surprise you

By Mark Hulbert

Increasing inefficiency doesn't mean that it's easier to beat the market, says Cliff Asness.

The stock market will be lucky just to keep up with inflation over the next decade.

Just take a look at the table at the end of this column, which highlights 10 valuation indicators with good track records when forecasting the stock market's longer-term inflation-adjusted total return. Nine of the 10 are more bearish than they've been in more than 95% of months since 2000. Seven of the 10 are more bearish than in at least 95% of months since 1970.

Skeptics will point out that the stock market has been overvalued for several years now and, at least so far, has resisted valuation's gravitational pull and continued to hit what seems like regular new record highs. For them, as well as for long-suffering investors who pay attention to fundamental value, I recommend a recent article by Cliff Asness, founder of AQR Capital Management: "The Less-Efficient Market Hypothesis." Asness's article - forthcoming in the Journal of Portfolio Management - amounts to a manifesto for why value investors with sufficient patience will eventually come out on top.

His argument is that the market's greater inefficiency has two related consequences: There will be more stocks than in the past that become untethered to fundamental value, and it will take longer for their overvaluation to be corrected. The investment implication is that value investing will still beat the market over the long term-but the length of that long term will be longer than before, and quite likely longer than most investors have the patience to tolerate.

Asness suspects that social media is the primary culprit leading to the stock market's decreasing efficiency. That's because market efficiency in essence relies on the "wisdom of crowds," and the crowd is wise only insofar as each member of the crowd is thinking independently. Yet social media turns the erstwhile independent crowd into a "coordinated clueless even dangerous mob."

Asness asks rhetorically: "Instantaneous, gamified, cheap, 24-hour trading now including 'one-day funds' on your smartphone after getting all your biases reinforced by exhortations on social media from randos and grifters with vaguely not-safe-for-work pseudonyms filtered and delivered to you by those companies' algorithms which famously push people to further and further extremes. What could possibly go wrong?"

He also entertains the two other hypotheses that commentators have advanced over the last few years for why the market may have become less efficient: The increasing prevalence of index funds and low interest rates. But he concludes that they play a relatively small role. "I'm far more certain that social media" is the culprit- "the overconfidence that comes when people think all the world's data is at their fingertips," coupled with investing becoming "gamified, fake-free, instant, 24/7 trading."

It's important to stress, as Asness does, that increasing inefficiency doesn't mean that it's easier to beat the market. He acknowledges the famous argument made three decades ago by William Sharpe, the 1990 Nobel laureate in economics, that simple arithmetic is all that's needed to prove that the average active investor and adviser will lag behind the market. Market efficiency is a separate issue.

In fact, the implication of Asness's argument is that it will be harder to beat the market going forward-for several reasons. Recognizing and identifying overvaluation will require resistance to the Wall Street consensus that, because of social media, will be that much more strident and seemingly compelling than in past years. And, because it will take the markets longer than before to correct overvaluation, value investors will need even more patience and discipline than has previously been the case.

Current status of valuation models

Meanwhile, the table below reviews the current status of the 10 valuation models that I've highlighted in prior columns as having good records forecasting the stock market's subsequent longer-term returns. It's hard to avoid the conclusion that the stock market is dangerously overvalued.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.

-Mark Hulbert

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09-24-24 0925ET

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