I’ve posted Entry #3 to the Valuation-Informed Indexing column at the Value Walk site. It’s called The Curious Case of the Market Price That Is Not the True Market Price.
Juicy Excerpt: Eugene Fama almost got it right. Fama believed that, because it is in each investor’s interest to exploit any anomalies in market pricing, the overall market was sure always to get prices at least roughly right. That makes sense. Fama’s mistake was in failing to stress to the investors who comprise the market what it is that they need to do to exploit pricing anomalies. We need to increase or lower our stock allocations in response to big price swings!
The market (that’s us!) does indeed very much want to be efficient and the market is providing us the information we need to make the market efficient. Our mistake in the Buy-and-Hold Era has been failing to engage in the exploiting behavior that is the only means by which market efficiency can be achieved. We need to stop looking at the nominal value generated by the market as the sole market message, accept that the P/E10 value generated by the market as well is also part of the story and then act pursuant to what the combination of those two bits of market-generated information tell us.
We need to increase our stock allocations a bit when the nominal market price drops below fair value and lower our stock allocations a bit when the nominal market price rises above fair value. When we persuade enough investors to do that, we will all enjoy — voila! — an efficient market! It is only by making all investors aware of the flaw in Fama’s initial formulation of how an efficient market is attained that we can achieve Fama’s dream of an efficient market in the real world.