Years ago, I read a book by highly regarded hedge fund manager Joel Greenblatt, where he explains why he thinks that markets aren’t efficient.

As I recall it, he asks his students to pick out a handful of their favorite stocks and then tells them to look up the 52-week high and low for the stocks and record those prices.  Then, in class, they report those numbers to each other.

For fun, I thought I would play along with General Electric, the largest company in the S&P 500 that isn’t on our Approved List (I’d love to use one from our list, but can’t for regulatory reasons).

Over the past 12 months, GE has traded as low as 19.37 (in August) and as high as 31.49 (in December).  It closed on Friday at 28.49 per share.

In class, Greenblatt then looks up the number of shares outstanding for each company.  For GE, there are 9.4 billion shares outstanding (wow!), which means that as of Friday, the market capitalization for GE was around $268 billion.

Then Greenblatt asks his students to compute the market value of the company based on the high and low prices assuming a constant share amount (the share count changes all the time, but not enough to get the point across).

For GE, using these numbers (and rounding) the market value was 182 billion in August and 296 billion in December.

Finally, Greenblatt asks the students whether market prices are efficient.  Is it possible, he asks, that the value of a company can change so dramatically in such a short time?

When you look at the share prices, they don’t look outrageous, but when you think about what they mean, it seems more implausible that the true value really changed that much.

In our example, the difference between the high and low value for GE was $114 billion in four months’ time.  Even though GE is definitely tied to the global economy and a slowdown in China will definitely impact their business, does it make sense that the intrinsic value of the company changed so much over such a short period?

Greenblatt argues that prices aren’t efficient on this basis and even though I am mostly an efficient markets guy, I think Greenblatt makes a great point.

I’ve been thinking about the difference between efficient markets and equilibrium over the past few months based on a book by Aaron Brown, a well-known Wall Streeter that currently heads risk movement at AQR (we use some of their mutual funds, but I only know Brown from his books).

Brown argues that equilibrium is when the market value of a stock fairly reflects the intrinsic value of a company and says that prices can be wrong – too high or too low.  He says that the efficiency of a market is based on whether or not you can buy and sell as much as you want at the posted price.

In this context, you can say that prices are in or out of equilibrium, but always efficient – an idea that resonates with me.

Greenblatt, in my view, is saying that the market values are too noisy to accurately reflect equilibrium, but I think he would agree that he could have bought or sold huge amounts of GE at any of the prices listed above, suggesting efficiency.

I think that the market efficiency purists like Gene Fama and Ken French would say that since you can’t tell what the intrinsic value is, the current price is the best estimate.  I’ve heard them both say that markets aren’t perfectly efficient, but you ought to behave as if they are anyway (a sensible viewpoint).

Greenblatt’s exercise had me thinking about the market losses this year.  What if we played that game with the all of the stocks in the world?

Based on data from Bloomberg, the value of all stocks hit their zenith back in June with a total market value of $73.3 trillion.  Less than six months later, as of Friday, the value of all stocks is now $57.6 trillion, a difference of $15.7 trillion.

These numbers are so big that I have trouble understanding them, but it doesn’t seem likely to me that the intrinsic value of all of the publicly traded businesses in the world have fallen by 20 percent in the last six months.

It’s quite possible that they were overvalued six months ago and could still be overvalued, but the pace of the decline seems implausible to me.  Whether they bounce back or not is another question, but I think it goes to show that market prices are extremely noisy and don’t always reflect their true value.

Our strategy is to hang on through the noise with the belief that over time, the value of the world’s businesses will increase and even if the markets don’t price them right all of the time, you have to endure the swings to get the benefits.