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REVERSION
TO
THE
MEAN:
“GROWTH” FUNDS VS. “VALUE”
FUNDS, 1937–2008
Source: Lipper Analytic Services
and Bogle Research Institute.
Growth—Lipper Growth
Value—Lipper Growth & Income
This graph shows the market value of an investment in all
“value” funds divided by the same investment in all “growth”
funds.
Thus, value stocks (with low P/Es) and small-capitalization
stocks are overweighted relative to their weights in a cap-
weighted index used by normal index funds. During periods
when value and small-cap stocks have done relatively well,
both DFA portfolios and fundamentally weighted portfolios
have outperformed cap-weighted index funds. Relative
returns were especially strong after the Internet bubble
popped. In periods when valuation metrics are less dispersed,
however, tilting portfolios toward “value” and “small cap”
have not produced larger returns.
WHY EVEN CLOSE SHOTS MISS
Another “market pathology” often cited by behavioralists as
clear evidence that markets are not efficient describes the
turn-of-the-century Internet bubble examined in chapter 4.
Surely, the remarkable market values assigned to Internet and
related companies seem totally inconsistent with rational
valuation. The existence of what appear to be obvious
“bubbles” is considered by critics to be damning evidence
against the EMH. But even here, when we know ex post
(after the collapse) that major errors were made, there were
certainly no clear ex ante (while it was going on) arbitrage
opportunities available to rational investors.
Equity valuations rest on uncertain future forecasts. Even
if all market participants rationally price common stocks as
the present value of all expected future cash flows, it is still
possible for excesses to develop. We know, with the benefit
of hindsight, that the outlandish claims regarding the growth
of the Internet (and the related telecommunications structure
needed to support it) were unsupportable. We know now
that projections for the rates of growth and the stability and
duration of those growth rates for New Economy companies
were unsustainable. But neither sharp-penciled professional
investors nor quantitative academics were able to accurately
measure the dimensions of the bubble or the timing of its
eventual collapse.
Recall the chart
Future Ten-Year Returns at Alternative
Initial Dividend Yields (D/P), 1926–2009
showing that initial
dividend yields for the stock market as a whole do a
reasonably good job in predicting future stock returns. During
the early 1990s, dividend yields fell well below 3 percent, and
many academics warned that stock prices were much too high
and that future equity returns would be low or negative. It
turned out that the nineties produced extremely generous
equity returns. Academics then considered that dividend
behavior might have changed. As corporations increasingly
used stock options to compensate executives, buying back
stock to increase stock prices rather than increasing cash
dividends became a more preferred method of providing cash
to shareholders. The stock-option holder does not benefit
from cash dividends but gains only if the price of the stock
goes up. In late 1996, John Campbell and Robert Shiller
presented a paper to then Chairman Alan Greenspan of the
Federal Reserve Board of Governors showing that the P/E
ratio of the market was an excellent predictor of future
returns (as was shown in
Future Ten-Year Returns at
Alternative Initial Price-to-Earnings (P/E) Multiples, 1926–
2009
). The P/E for the market was about 30 at that time, and
the paper suggested that market valuations were dangerously
high and that future returns could be negative. This led
Greenspan to make his famous “irrational exuberance”
speech, in which he raised the question that a dangerous
bubble may have inflated. The stock market skyrocketed for
the next several years.
It is only in retrospect that we know that the bubble
occurred in late 1999 and early 2000, and that it was largely
confined to Internet and New Economy stocks. The point is
that the dimensions of the bubble are clear only in hindsight.
The bubble was certainly not obvious before the fact, when
the use of the Internet was doubling every few months. And
it certainly did not provide a clear arbitrage opportunity to
make riskless returns.
Even when clear mispricing arbitrage opportunities did
exist, there was no way to exploit them. Recall the illustration
of 3Com spinning off 5 percent of the shares of PalmPilot
stock it owned, announcing its intention to spin off the
remaining 95 percent later. Irrational exuberance pushed the
price of Palm’s stock so high that if you bought 3Com, which
still owned 95 percent of Palm, you could have effectively
bought Palm stock for less than the price at which it was
selling in the market. The 95 percent of Palm that 3Com
owned was worth $25 billion more than the total market
capitalization of 3Com at going market prices. Here was an
obvious case of mispricing and an apparently profitable
arbitrage opportunity. The clear arbitrage (borrow PalmPilot
stock and sell it short and buy 3Com) could not be
undertaken. Not enough Palm stock was outstanding to make
it possible to borrow the stock. The “anomaly” disappeared
once 3Com spun off more Palm stock. Moreover, the
potential profits from name or ticker symbol confusion
described in chapter 4 were extremely small relative to the
transactions costs required to exploit them. Thus, none of
these illustrations should shake our faith in the long-run
efficiency of our stock markets. Perhaps the more important
anomaly today is why so many investors buy high-expense,
actively managed mutual funds instead of low-cost index
funds.
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