The Erroneous Credence of the Efficient Market

The story:

An economics professor was walking down the street with one of his students to a local café for lunch. Along the way, as he was explaining the concept of market efficiency to his student, the professor stepped right on a $100 bill and continued to stroll on. The student, who was looking down in studious thought at the time, was amazed at his good fortune and picked it up. As the student rushed to catch up with the professor, he asked the professor whether he had seen the $100 bill. The professor quipped, "My dear lad, haven't you been listening to anything I have been saying about efficient markets? Although I saw the $100 bill, I knew my eyes must have been deceiving me. Efficient markets theory dictates that it couldn't possibly be there because if it had been, someone else would have already picked it up."

So what is this efficient market theory? Many scholars will defend it to their graves. An efficient market is one where prices adjust very quickly and correctly to any information; current market prices reflect fully all known information. It says you can’t expect to consistently beat the market. Certain price fluctuations do not mean the market is not efficient; certain price fluctuations occur because the market is efficient. When I say ‘certain’ I mean new information in a ‘normal’ market. The exception to this happens more often than not.

Let’s just look at the recent markets. Citi (C) tanks at the end of October/November. The bailout is supposed to be stabilizing the banks. It continues to fall and the government backs all of Citis’ assets. The market buys and sells based on the new information accordingly, but looking at these last few days, Citi is being taken to the shed on info that should have already been priced in. Also, the bailout and asset backing means nothing to people trading the stock as it did a month ago. It doesn’t seem too efficient to me.

Forms of Market Efficiency

There are basically three forms of market efficiency: strong form, semi-strong form, and weak form. The difference among the three forms relates to what information is reflected in the price.

Strong Form Efficiency: “Prices reflect ALL information, both public and insider. A market that is strong form efficiency believes there is no such thing as inside information.” As we all know, there is a lot of insider information; there has to be. CEOs know their earnings before the public does. I and many believe that this is not even relevant.

Semi-Strong Form Efficiency: “All publicly available is reflected in price. This means that it is impossible to make superior profits from published information. Some financial analysis is useless as the info is already reflected in price. The market reacts very quickly to published info, so you cannot profit from widely known information.” The real argument is between this and weak-form.

Weak Form Efficiency: “The current price of a stock reflects its own past prices. You cannot make superior profits by studying past stock prices to try to find mispriced securities. Today’s price reflects a random walk. There no pattern in price cycles and price changes are independent.” Personally, I don’t for a second believe this. You can easily see by looking at the charts' major support and resistance levels where buyers become sellers and sellers become buyers. But many people thisnk that technical analysis is a sort of witch-craft that isn’t worth looking into. As an experienced trader, psychological price levels are very present in the markets because markets are driven more on emotion, fear, and greed, in the short term, rather than by sound fundamentals.

According to the "efficient market" theory, all available information about a stock is already reflected in its price; therefore it is impossible to predict its future movements, since no one can predict the future. This is sometimes called the "random walk" theory, since stocks seem to move in completely random ways.

For example, a company reports record earnings, yet its stock price falls (this is not unusual). A chimp throwing darts at the newspaper stock page can pick winning stocks at least as well as, if not better, than a stock professional. (this experiment has actually been tried but not true.) The few professionals such as Peter Lynch or Warren Buffett are simply lucky. In addition, they established their reputations in past years when stock information was not so widely disseminated. Now, with the internet, all available information is truly available to all, so are the markets are completely efficient? I guess you can say yes and no.

I lean towards the notion that the market is NOT efficient. It is certainly not efficient, because if it was efficient, nobody would make any money. It's not the availability of information that matters (made easier known by the internet), it's how you use that information, or in the case of a lot of traders and investors, whether you even use that information. There are too many novice investors out there that don't have any clue what they are doing, and that creates very lucrative inefficiencies.

The monkey theory isn’t true. Here is a link to the experiment of Wall Street Journal reporters throwing darts at stock listings (because training monkeys to throw darts would be too challenging, so they just used people to throw the darts). The experts averaged 10% while the ‘monkey’ averaged 4%.

In conclusion, I believe the market is not efficient. Saying that everyone dealing with money on Wall Street makes the right plays when new information is known, is statistically impossible. To say that people cannot make consistent profits that in the long run beat the market is just being arrogant and pretentious. Of course, luck does play a factor to a trader and investor’s profits. But it doesn’t mean that the people consistently beating the market have just been lucky in the long run. Not everyone uses the same given/known information in the same manner. This is why the markets are NOT efficient.

Comments

[CJJ:]

100% agree. No 150 million% agree.

Here are some myths that simple people like to talk about: free markets, rational markets, efficient markets, its supply and demand, now is different than the past

Maybe the causes of the crisis are different than the past, but the behavior is the same. Markets have never been free, rational, efficient, 100% based on supply and demand...

You know what people forget...markets deal with people and people overall are irrational and uneducated in the market, they can easily be had by those in the know.

Jan 15 11:00 AM

[J. Fredrickson:]

The efficient market theory is dead. I never believed it in the first place, but my professors seemed to cling to it as if it allowed them to live. Why? My guess is that it allowed their theories and papers to be published. It allowed the equations to work and be less complicated. Imagine how hard it would be if they had to factor in market inefficiencies. No "pure" number would come out. It would most likely have to be a range. Nobody really likes ranges in math or science. It is much better to just have one "right" answer not 20. Brandon has a great point here and I think that the younger investors and economists need to realize that the efficient market theory is simply a method for creating a constant factor in equations and theories, not a theory that is reality based.

Jan 15 01:13 PM

[Talin:]

Like most investors I do not pay much attention to EMT. Still, in the hands of competent people... late Fisher Black p.e., makes you think.
Anyway, I have always thought the 100 dollars bill history a funny way of conveying the idiosincracy of (some) economics professors beleiving EMT and their detractors... but for other reasons: the theory states that you will not find 100 dollars on the street. As far as economics theory goes it is pretty close to reality: I have never found a 100 dollar bill on the street. ¿How many -dear fellow bloggers- have you found?

Jan 15 02:27 PM

[HAL9000:]

I'm a finance professor and a trader. Here's a few things that I emphasize in class relative to the EMH.
First its a 'hypothesis' or even a definition. It does not say that the NYSE is an efficient market.
It does not say the the current price is correct. It is the basis for saying that price is modelled as a random variable with independent returns so there is no memory (thats a point of contention with the followers of mandelbrot and his chaotic interpretation) The EMH does not define a probability distribution (such as Gaussian) and does not state that the (stochastic) price process is stationary (constant variance)
It does imply that profits cannot be consistently made by trading the stock again since its price is a random variable - thats the real point. I as a trader cannot make consistent profits and i think i'm darn good. Maybe some can.
In addition if price is a random variable then 'correct' has no meaning. the price can be 'expected mean' according to CAPM (another valid point for discussion) but it can also be minus a few standard deviations from the mean. Thats still a valid random price. There are certainly arguments about EMH implications, but i find that most people dont understand where the argument lies - again it is not a statement of 'correct' price and makes no conjecture that Citibank is always priced right. Greed and fear definitely drive price away from the mean expected.
I look forward to responses.
Thanks

Jan 15 10:25 PM

[sr9web:]

Ultimately for most big market players, unless you have an esoteric research advantage, your returns are about the same as everyone else.

For the small trader though, things are different in that large gains can be made on a small portfolio by the simple expediant of trading positions that the big players don't bother with.

And between small traders, the "research advantage" is often huge.

For example: Now that the former CRZ has been de-listed due to small market cap (trades as CYRV now) anyone who recently got in around .50 shortly after the de-listing is now up about 75% - in just a few weeks.

Will the gains in that position hold/grow? I don't know, but I do know that my cost basis is .53 and I could, if I chose, bail right now with almost a double.

There's always plenty of small opportunities out there - you just have to look carefully.

Jan 16 12:19 AM

[Steven Hansen:]

market efficiency requires the users of information to act logically. i suggest there is enough irrational behavior to make any logical theory impotent.

Jan 16 01:10 AM

[Nick Gogerty:]

probably the best book you will ever buy with great academic cases againt EMH, very insightful if you are hedgie, quant or regular trader. The New Finance: The Case Against Efficient Markets

rcm.amazon.com/e/cm?t=...

Jan 16 11:33 AM

[HAL9000:]

again the EMH is a *hypothesis" that rates of return are statistically independent but not necessarily identically distributed
most of the conversation in any forum revolves around assertions that are not part of the hypothesis
It does not say that prices are "corrrect", it does not say that rates of return are identically, normally distributed, it does not say that CAPM is the correct equilibrium price model

Jan 16 12:59 PM