The question of whether the markets are efficient was broached again by a fellow blogger recently. The idea is that if the markets are efficient, then it’s not really worth attempting to trade them (meaning stock market investors should stick to index funds). This is all based on the Efficient Market Hypothesis (EMH).
There’s a bit of confusion in the public about what market efficiency really means. It does not mean that the price in the market reflects the value of the asset in question (like a company in the case of a stock). It means that current price reflects the array of potential future outcomes. Basically, the theory says that every idea of what could happen in the future is incorporated into the current price.
The EMH basically contends that it’s impossible to outperform the market on a consistent basis because the information upon which one would make investment/trading decisions is already factored into the market. There are three forms off efficiency, as defined by the academics:
Weak: Historical prices cannot be used the determine future prices, meaning Technical Analysis is useless. The contention is that there are no patterns to price behavior.
Semi-Strong: Prices adjust to publicly available new informationÂ so quicklyÂ that no excess returns can beÂ made withÂ that information.Â This basically rules out fundamental analysis.
Strong: Excess returns cannot be achieved by employing any information. ThisÂ rules out even insider trading as providing an edge.
There aren’t many folks who accept the strong form of analysis because it’s pretty clear that insider trading can indeed produce excess returns (if you can get away with it). The other two, however, have been widely accepted as legitimate in academic circles.
Here’s my view.
The more actively traded a market is, the more it tends toward efficiency – especially in relatively low volatility and quiet news environments. Those are times when information can be distributed most efficiently and participants are most likely to act rationally. As you get into less actively traded markets, and as you start adding pressure to a market efficiency becomes less and less the case. Information distribution becomes less efficient and participants act increasingly less rationally.
I still chuckle when I think about an article on Bloomberg in August of 2007 where a quant trader (we used to call them rocket scientists) was complaining about what was happening in the markets to cause his systems to go haywire. He said something to the effect of “If people would just act rationally, everything would be fine.” Ha!
I rejected EMH as soon as I learned it as a young undergraduate finance student, even arguing it with my professors. When I started working I was vindicated in my views when I found out the the Johnson Redbook weekly retail sales figures (no longerÂ published)Â were reported to the traders in the futures pit 15 minutes before they were reported to the public. That’s a great example of a violation of the information dissemintation part of the EMH. Plus, I saw the way traders reacted to things like Non-Farm Payrolls releases to see how irrational traders became when fear and greed take over.
But I’m not the only one in this camp. Benoit Mandelbrot provides a great discussion of how all the classical financial theories develop and how they have largely been proven less than solid over the years. Among the evidence is studies which show that low P/E stocks tend to produce excess profits and that there are in fact price patterns in the markets. These suggest that market analysis can indeed be used to produce market outperformance.
That said, it’s also worth reading Nassim Taleb on the subject of randomness in trading performance (and life). He is not really an EMH proponent, but he does have strong views about how even the likes of Warren Buffett can be explained in that light.