In his General Theory (1936) John Maynard Keynes offered a description of investor behavior that many, including Nobel laureate James Tobin, deem to be one of the most incisive commentaries on the stock market ever written. Here, then, are a few remarks from Keynes remarkable essay that address the consequences of investors woefully inadequate forecasting ability:

A conventional valuation which is established as the outcome of mass psychology...is liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really make much difference to the prospective yield, since there will be no strong roots of conviction to hold it steady. The market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation Investment based on genuine long-term expectation is so difficult today as to be scarcely practicable.

Contrary to the above point of view, the Capital Asset Pricing Model assumes that stocks are always priced correctly and that their intrinsic values adjust instantaneously whenever new fundamental information appears. Thus, as William Sharpe has noted:

The key idea behind the theory is that of market efficiency...definition is difficult, but the idea is that...the price of a security will rarely diverge significantly for long from its intrinsic value defined as the certain present value of the uncertain future prospects assessed by a clever, well informed analyst. Market efficiency only requires that currently available information be properly reflected in price...there is increasing agreement that capital markets in the United States are highly (if not completely) efficient.

On the other hand, a key article on this website, The Defined Future Earnings Model and the Riddle of Perpetual Claims, examines the enormous difficulties that fundamental security valuation entails when utilizing a discounted present value approach -- the classical method for determining a stocks intrinsic worth. Close examination of the DPV approach strongly underscores Keynes views about investor's chronic inability to arrive at rational, creditable valuations of a stocks long-term prospects which is the essence of what evaluating a share of stock entails. Thus the intrinsic value for a stock ought to recognize its innate status as a perpetual claim on the firm's earning power that gets distributed in the form of dividends or saved as retained earnings. This, in turn, increases book value and the prospect of higher earnings, with rising dividends, over the indefinite future.

Due to the difficulties that a present value analysis entails, a widely used alternative for estimating a stocks intrinsic value is to apply an appropriate P/E multiple to the current (or forthcoming) year's Earnings Per Share. However, this approach, too, is fraught with uncertainty. Thus, as Benjamin Graham, the father of security analysis once noted:

It is the multiplier of earnings that my students would dearly love to learn about and to calculate. When I tell them that there is no dependable method of finding this multiplier they tend to be incredulous and to ask: what good is security analysis then?



While estimating future P/E ratios for individual stocks may be compared to astrology, it is equally difficult for the market as a whole. Thus, as Paul Samuelson wryly observed in a 1967 column in Newsweek.


Although present and probable future corporate profits are admittedly the most important determinant of intermediate market movements, no way exists to determine what is the proper price-earnings ratio. President Hadley of Yale used to say: "God Almighty does not know the cost of moving a ton of freight from New York to Chicago." I doubt that the devil himself knows what is the equilibrium price-earnings ratio on stocks. Fifteen to 1, as Secretary Douglas Dillon once rashly averred? Twenty five to 1? Or 14 to 1, as the tape enunciates now that high interest rates imply high P/E ratios on bond investments. No one knows.

Thus it is surely arguable that investors today are no better at setting stock prices at their true intrinsic values than they were in 1936 when Keynes wrote his famous essay on the market. As it turns out, however, the inability of investors (or the market) to determine the elusive intrinsic value for a stock is the Achilles heel in practitioner complaints about the efficient market hypothesis. Thus, for most investors, most of the time, the market is not predictable. Recall that for any selected time period one-half of all randomly selected portfolios will outperform the average (or market) return and one-half will underperform. The fewer the number of stocks selected the more extreme the upside and downside performance for some of the portfolios will be.

Meanwhile, at one time or another, everyone will correctly predict an event that was unexpected by the consensus. The core problem that plagues investors, however, is how to make superior forecasts consistently. For the vast majority the good bets and bad bets (predictions) cancel out and average performance is the result. Thus, we are left with the paradox that an ordinary chimpanzee tossing 30 darts at the stock pages has an equally good chance of outperforming the market as the best trained and/or most highly paid professional manager who also selects 30 stocks.

The efficient market hypothesis is correct in its expectation of such a result. But EMH is woefully mistaken about the implications of this -- stocks simply do not sell at their intrinsic values all of the time. In fact, most stocks are mispriced much of the time but the range of plausible intrinsic values is so wide that few professionals can consistently determine if a stock is undervalued or overvalued. Meanwhile, a stocks price can change dramatically on just a dimes worth of information such as a quarterly earnings surprise when reported earnings come in slightly above or below the consensus estimate.

In conclusion, most investors (especially institutions holding 75 to 300 stocks) cannot beat the market despite their considerable skill at performing in depth analyses of the facts, but not of the future. Luck in selection, risk and the accident of timing play too dominant a role in determining performance. Empathetically, however, this is not because the correct price for a stock is whatever the market is willing to pay for it instantaneously.