I heard that I was a ‘market consistent fundamentalist‘. I guess that means I am a bad thing. But there are two things to be unpicked here.
The first is the idea of market efficiency, which is explained nicely by John Cochrane.
… people say the market can’t be efficient, because it didn’t predict the 2008 crash. That’s exactly backward. Efficient markets theory says that the market aggregates all information that people have – and no more. The market is not clairvoyant. Consequently, the central empirical prediction of the efficient markets hypothesis is precisely that nobody can reliably tell where markets are going – neither benevolent government bureaucrats, nor crafty hedge-fund managers, nor ivory-tower academics. This is probably the best-tested proposition in all the social sciences.’
Market efficiency does not mean the market price is right – how could it be, if it is changing all the time? If it was right yesterday, how could it be right today, when it is 100 points lower, or higher? It just means, as Cochrane says, that no one person, committee or institution is epistemically privileged, i.e. has some special knowledge that the rest of us as a group don’t have.
The second is market consistency (otherwise known as fair value) where we value our assets as the average rational investor would value them. Being market consistent does not in any way depend on whether markets are efficient, and to see this, suppose I am a fund manager holding a portfolio of assets that I think will beat the market. I do not believe the market is efficient. I am ‘epistemically privileged’, at least in my mind.
Does my expectation, and even the possibility that I am right, justify me in marking those assets at the price I think they will achieve? Surely not. I have promised my investors to beat the market on the assumption that its true value is x points above the current price. Selling the portfolio to them at that expected level would be fraud, pure and simple, for then they cannot achieve the gains they have been promised. And if a fund manager should not do that, why should the accountant of a company invested in that portfolio behave any different?
Thus the possibility that markets should not be efficient does not in any way conflict being market consistent. Call me a fundamentalist if you like, but I am an honest fundamentalist. It’s the best policy, you know.