The stock market rallies while recession continues to plague America. Chief executives worry, companies hoard cash, uncertainty haunts our banking system. Gas prices are up, GDP growth is down, unemployment is up, government debt and size are up and political leaders do not show the ability to come to grips with any of it.
Yet the Dow Jones Industrial Average, heading for 15,0000, exceeds levels not seen since October 2007, a few months before the current crisis showed up. Believers in the efficiency of stock markets will take this as a sign of good times ahead, believing that markets reveal better than anything else the truth about business fundamentals. Skeptics will plan to cite this as the first sign of a bubble. Which view is the more plausible?
Believers in stock market efficiency buy the revolutionary ideas, hatched during the past 50 years, called modern finance theory. This elaborate theory boils down to the notion that the best estimate of the value of a stock is its prevailing market price. The practical implication, of course, is that it is a waste of time to study individual investment opportunities in public securities. According to this view, you will do better by randomly selecting a group of stocks for a portfolio by throwing darts at the stock tables than by thinking about whether individual investment opportunities make sense.
Reverence for these ideas is not limited to ivory tower academics, but became standard dogma throughout financial America, from Wall Street to Main Street. Many professionals still believe that stock market prices always accurately reflect fundamental values, that the only risk that matters is the volatility of prices, and that the best way to manage that risk is to invest in a diversified group of stocks.
But a distinguished line of investors stretching back to Ben Graham and forward to Warren Buffett challenges such dogma by logic and experience. Graham preached, and Buffett has successfully practiced, a different approach. Graham, who taught at Columbia Business School in the 1950s and ran an investment partnership, wrote a number of classic works, including The Intelligent Investor. There Graham argued that price is what you pay and value is what you get. These two things are rarely identical, but most people rarely notice any difference, he believed.