Many people believe that wild swings in market prices are clear signs of market inefficiency. Indeed, some commentators have claimed that such volatility is definitive proof that falsifies the Efficient Markets Hypothesis (EMH).
Ironically, the extreme market volatility in the past month is a very strong example of market efficiency at work.
The Efficient Markets Hypothesis
It has today become conventional wisdom that the 2008-2009 financial crisis completely discredited the EMH. Alas, like much that passes as conventional wisdom in any age, this presumed “common sense” is actually nothing more than theoretically confused and empirically unsubstantiated urban legend.
In order to assess the validity of EMH it’s important to recognize that it comes in various versions (weak form, semi-strong form and strong form), and as a result, it’s virtually impossible to discredit or uphold EMH in general terms. Each version of EMH must be addressed specifically.
Keeping this in mind, it can be asserted that at its most basic level, in all of its forms, EMH simply states that investors cannot consistently produce excess returns given that stock prices reflect all publicly available information. EMH says absolutely nothing about the ability of stock prices to accurately predict future events. It’s extremely important to understand this. The notion that EMH is about the ability of markets to predict the future or to accurately estimate the future value of stocks is nothing but a straw-man employed by ideological hacks.
Once one recognizes this, it can be understood that the recently popular notion that extreme volatility in prices disproves EMH is rather dubious. Under the EMH framework, extreme share-price volatility can be caused by the fact that the flow of publicly available information is highly uncertain and variable, and that the implications that result from said information imply highly disparate outcomes.
Under such circumstances extreme volatility is an indication that the market is pricing risks efficiently. Indeed, the market would be inefficient if it reacted with equanimity to game-changing information.
For example, for reasons explained here, the consequences of a recession in the US at this time could be absolutely devastating to the entire of the US economic, political and social system – and certainly to the value of stocks. Indeed, if a recession were to transpire, the S&P 500 could ultimately collapse to 800, its 2009 low of 667 -- or conceivably even lower.
Let us assume for a moment that one consequence of a recession would be that the S&P 500 index (^SPX) would drop down to retest 667. Let us consider how information placed at the disposal of marginal buyers and sellers of stocks (the price setters) that indicated an increase in the probability of a US recession by 10% might be expected to affect the stock market.
The S&P 500 is currently at 1,173. A collapse to 667 implies a difference of 506 points on the S&P 500. A 10% increase in the probability of recession implies a concomitant and instantaneous drop of around 50 points, if the market is indeed efficient.
That is theory. Consider how this might work in the real world: Between the release of the ISM manufacturing report on Thursday, September 1st and the release of the Employment report on Friday, September, 2nd, it would not unreasonable to suggest the that the information released might be interpreted by marginal buyers and sellers of stock (the price setters) as representing an increased probability of a US recession of a magnitude of about 10% compared to what it had been the case on Wednesday, August, 31st. Indeed, both reports were highly significant in that they suggested that the US economy was moving perilously close to recession, with both indicators perched at the threshold of limits that would indicate economic contraction.
Such being the case, the roughly 50 point drop between the release of the ISM report and the close on Friday reflected almost perfect efficiency in discounting the newly available information.
Let us examine another example. Information that became available to market participants immediately before, during and after the Jackson Hole meetings could reasonably have been interpreted to have reduced the risks of recession by 20% relative to what they had been immediately before. Interestingly, in this context, the 100 point Jackson Hole rally could be interpreted to be an efficient response to the information.
Note that it is not being claimed that 10% or 20% is the “right number.” These are merely the numbers that happen to represent the assessment of buyers and sellers at the margin given the current supply and demand for particular equities. For example, many owners of stock will interpret the shift in probabilities as less than indicated above and would not be sources of supply. Others would handicap the probabilities much higher and will have been amongst the first to have increased available supply in the marketplace.
In terms of the EMH, it does not really matter who is “right.” All that matters is that buyers and sellers are reacting to the available public information and that this information is being discounted. Furthermore, the theory posits that it is highly improbable that anybody can sustain an edge in being able to predict new information and/or correctly anticipate the interpretations of that data by marginal buyers and sellers.
Humpty Dumpty Perched On The Edge of an Abyss
One’s subjective assessment of exactly how much a piece of information increases or decreases the probability of recession is not important for the purposes of my argument. Reasonable people can differ in their assessments – and do. That is what the market is about. There is always a buyer for every seller and vice-versa.
Buyers and sellers necessarily have different subjective interpretation of the odds of a various events transpiring. The EMH does not claim that the market “correctly” reflects a correct balance of probabilities. How could it? This would involve a bizarre and unsupportable claim of clairvoyance -- and EMH makes no such claim. A correct weighting of probabilities can only be determined ex post facto – never ex ante.
The future is fundamentally unknowable. The EMH does not claim markets predict the future. It merely claims that the market reflects publically available information. Exactly what weightings the marginal buyer and seller of equities (the price setters) assign to the available data is an entirely different matter, and one that is outside the purview of EMH.
The crucial point to understand at the present time is this: No matter who the individual is, it is virtually undeniable that the marginal impact of bits of macroeconomic information on the value of stocks today is perhaps higher than it has ever been in one or two generations, at least.
The risks of recession are so finely balanced at the moment, and the consequences of a recession would be so momentous that even minor bits of information can significantly tip the balance of probabilities in one direction or another.
Thus the EMH, properly understood, would predict a high degree of volatility in the current context. And this prediction is validated by the empirical evidence.
The EMH doesn’t claim to be a theory that predicts the future. Nor does it claim that stock prices accurately predict the future. Most versions of the EMH merely claim that the stock market prices in all currently available public information. As the nature of the information changes, prices will also change.
Today, the nature of the flow of information is highly uncertain and the outcomes implied by the data are highly disparate. Thus, information that many years ago, under other circumstances, might have been taken with equanimity by financial markets can have game-changing market impacts today. Even small increments of data can tip the balance of probabilities of a recession and concomitant financial crisis decisively to one side or another.
Thus, investors should expect markets to be highly volatile in the next few weeks and months until the there is actual resolution of recession risk – one way or another.
And that is as it should be.
Ironically, despite popular perceptions in the contrary sense, perhaps never has the Efficient Markets Hypothesis proven its worth as it is right now.
Stocks and ETFs such as AAPL, MSFT, SPY, DIA and QQQ will likely exhibit unusually high volatility because every incremental piece of new information that becomes known will have a large incremental impact on their projected value. The stakes in play today are higher than ever.
Disclosure: I am long SPX puts.