Do You Believe In The Efficient Markets Hypothesis Cop-Out?

Includes: DIA, QQQ, SPY
by: Kurtis Hemmerling

Sometimes simplicity is beautiful and elegant, while other times it is just plain simple. Take the Efficient Markets Hypothesis as an example: simple, easy and difficult to disprove. What is the underlying principle of the EMH and how does this affect your investing?

Efficient Markets Hypothesis Defined

Developed in the 1960s, the efficient markets hypothesis states that the market fully reflects all available information. Thus, it is impossible to forecast market movements since new information will cause an almost instantaneous move in price. A perfectly efficient market would see prices moving randomly and without telegraphing. The steps are:

  1. Rational expectations from individual investors
  2. Markets incorporate the information efficiently
  3. Prices equalize instantly based

If you choose to believe in the EMH, then you should simply invest in a broad market ETF such as one that tracks the S&P 500 (SPY), the NASDAQ 100 (QQQ) or the Dow Jones Industrial Average (DIA), since beating market averages can only be a fluke. Performing due diligence is a waste of time since the appropriate risk to reward is already reflected in the share price. You simply need to buy 20 random stocks or an index fund.

But if everyone bought an index fund, where would the rational expectations come in creating the 'right price' based on information? If all prices reflect all information, does this mean that trading 'pump and dump' penny stocks will provide me with average gain if I trade them long enough and in large enough quantity? How many individual investors do you know, that you would term 'rational', that buy and sell without greed and fear making them hit the order button? As well, no investor should be able to persistently beat the market and no investor should consistently underperform the market.

If you believe in the EMH, then say goodbye to your financial advisor! The EMH states that if I buy a large enough basket of stocks I can use a dartboard and a blindfold to pick my firms with similar gains to a professional advisor.

EMH and Risk

Fama and French developed a three-factor model to explain diversified portfolio returns. Between the years of 1991 and 2010 they found that small value stocks carried the highest amount of excess gain (although big value has dominated the market over the past 12 months). How could this be explained away if you believe in the EMH?

A concept of 'risk premium' was added that claims investors are rewarded with additional excess gain for riskier assets.

So if I invest in a large basket of riskier assets with this added premium, am I not almost guaranteed to beat the market? But is this not less risk if I am almost assured of larger profits when investing in a broad group of these firms?

The idea of being paid a premium for additional risk might work well on an individual firm basis, but since we are talking about broad averages, how does that work when trading ETFs or baskets of stocks?

Apple vs. Best Buy - Equal Opportunity?

On the other hand, you have investors that feel you can select strong companies and buy them during periods of irrational selling. Shares of Apple (AAPL) have taken a dip lately, and many are using this opportunity to average down or accumulate.

Investors are considering Apple's product innovation, household name status and aggressive expansion into new markets against a forward PE of 11.46 to argue that the company has a big upside still to come. The company typically reports earnings surprises and the next 5 years are forecast at a 20% growth rate. If you compare this to the PE ratio you get a PEG ratio of 0.70. Peter Lynch claimed that future growth and PE should be equal, and by this measure Apple is undervalued.

Others will look at companies such as Best Buy (BBY) and make a compelling case for selling the stock. One look at the brick and mortar DVD-renting companies like Blockbuster will send shivers down your spine for the CD selling prospects of Best Buy. The low PE today might be high by tomorrow after the massive downsize. And will consumers shop elsewhere if the high-margin warranty selling gets too pushy? Is the risk-adjusted upside for this stock really the same as Apple, or can due diligence give you an edge when looking at the two companies?

Yet, investor sentiment is hard to change. Merely writing or yelling these stats will not see flocks of investors come swooping in to drive prices up or down. While some may claim this is because the 'true price' is currently reflected by the EMH, strategic investors will assert that sentiment is not easily swayed and inefficiencies may take time to correct or revert.

Creating Profitable Strategies

I find the notion of the EMH assaulting to the senses. I believe that investors are rewarded for due diligence and intelligent stock picking strategy. We belong to the school of thought that as long as you are willing to strategize a little longer than the next guy, or dig a little deeper, you will profit from a market that is neither random not perfectly priced based on all available information.

It is time that advisors and investors took responsibility for their stock market recommendations and started to strategically invest instead of saying 'well, it's the markets fault. You simply cannot beat the market nor find a stock that is trading at a good price."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.