6.1: Efficient Markets
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The Efficient Market Theory states that in an efficient market, the prices of securities reflect all possible information quickly and accurately. What is an efficient market? The New York Stock Exchange and the NASDAQ are examples of efficient markets. These are markets where there are large numbers of rational, knowledgeable investors who react quickly to new information. Hence, the theory claims that security prices will always adjust quickly and accurately. Rational investors will immediately buy any stocks that are undervalued and immediately sell any stocks that are overvalued.
Associated with the Efficient Market Theory is the Random Walk Theory. This theory states that stock price movements are random. There is plenty of evidence that in the short term, this hypothesis is correct. Stock prices movements are random in the short term. However, so far, long-term price movements are anything but random as the global economy has grown exponentially over the last 200 years. Some critics believe that capitalism has emphasized growth of the economy at all costs and that this growth cannot possibly continue. The reality is that we as a species have a long way to go until every human can live a dignified, healthy, and fruitful life with sufficient food, clothing, and shelter ‒ and Internet access! The trick will be to share more equitably in the wealth generated by our combined endeavors. The current distribution of wealth here in the United States is unconscionable and cannot continue.
For a thorough discussion of the Efficient Market Theory, please read A Random Walk Down Wall Street by Professor Burton Malkiel. It is one of two books that we recommend for your first book to read about stock investing. (The other is One Up On Wall Street by Peter Lynch. We will discuss Mr. Lynch later in this chapter.) We have already quoted and referenced Professor Malkiel’s classic text. It is a whole lot o’ fun. Professor Malkiel skewers Fundamental Analysis (which we covered in chapters 4 and 5), Technical Analysis (which we will cover in our next chapter), and the Efficient Market Theory, even though he was one of the early pioneers of the theory. Nobody gets away without being jabbed, needled, or harpooned. Read it!
The theory was initially put forth in 1970 and developed throughout the 1970’s. At the same time, the physics world was working on their own set of theories and were using terms like weak and strong. This spilled into the world of the Efficient Market Theory and we wound up with three forms, the weak, semi-strong, and strong hypotheses.
The Weak Efficiency Hypothesis
The Weak Efficiency Hypothesis states that past data on stock prices are of no use in predicting future prices. Although statistically, stock price movements in the short term are random, there are times when stock prices do tend to demonstrate momentum in one direction or the other. Stock prices tend to rise more often than they fall and they tend to move far higher than is usually justified resulting in a mania or bubble, or fall far lower than is usually warranted resulting in a crash or panic. An oft-told story is that a group of investors was convinced the stock market was overvalued and they eventually turned out to be correct; the market was overvalued. They asked the famed economist, Sir John Maynard Keynes, how the market could stay so overvalued for so long. He famously quipped, “The market can stay irrational longer than you can stay solvent.” (This story has been repeated thousands of times. However, there is doubt as to its accuracy and whether or not Sir John actually was the origin of the famous quote. No matter. It's a great story to remember when prices become wildly overvalued or undervalued.)
Contrary to the Weak Efficiency Hypothesis, many speculators and traders believe they can use recent stock price movements to predict the market. If this theory is true, then Technical Analysis is useless. We will cover Technical Analysis in our next chapter.
The Semi-Strong Efficiency Hypothesis
The Semi-Strong Efficiency Hypothesis states that abnormally large profits cannot be consistently earned using publicly available information. In an efficient marketplace, prices instantly adjust rapidly to any new information available. In other words, no amount of analysis that you do to determine the future price of a stock will help you achieve a return that is better than the market as a whole. Both Technical Analysis that we will cover in the next chapter and Fundamental Analysis that we covered in the previous two chapters will not help us. According to the Semi-Strong Efficiency Hypothesis, no one can beat the market!
There is only one problem with this theory. There are many seasoned investors who have beaten the market over statistically significant periods of time. How do the Efficient Market Theorists respond to this obvious failing of their theory? Their response is that those people are just lucky. If you have sufficiently large numbers of investors, then a few will be lucky enough to beat the market. This is reminiscent of the famous quote that is attributed to many different individuals. The usual story goes like this: Famous Golfer X does something fabulous and a reporter comments, “Gee, you were really lucky today.” The Famous Golfer X quips, “Ya’ know, you are absolutely right. And the funny thing is, the more I practice, the luckier I get.” We will investigate some of the “lucky” All Stars of Investing later in this chapter and see how much of it we can attribute to luck and how much to skill and practice.
The Strong Efficiency Hypothesis
The Strong Efficiency Hypothesis asserts that no information, public or private, will allow investors to earn abnormally large profits consistently. This is obviously false. If you had material nonpublic information about a company, you could make a fortune overnight! If you do not get caught and wind up in jail, that is, since what you were doing is quite illegal. Material nonpublic information is the legal term for what is normally referred to as insider information. An example of material nonpublic information would be if you were the CEO of a drug company that was applying to have their soon-to-be blockbuster for approval by the Food and Drug Administration and you learned that the drug was going to be denied. If you made any trades that would benefit you from this information, you would be guilty of insider trading. This is exactly what happened in the infamous case surrrounding the celebrity Martha Stewart. That case, and others like it, are rarely found and prosecuted. Because of this, some industry observers believe it would just be better to make insider trading legal again. However, a return to legal insider trading is unlikely to ever occur.
Efficient Market Rational
The Efficient Market and Random Walk theorists are often also major proponents of index funds. They point to the fact that many professional money managers simply do not “beat the market,” especially during bull markets. From 1963 to 1998, the S&P 500 index outperformed the average equity mutual funds 22 out of 36 times. They reason that you are better off accepting close to the market’s return with low-cost index funds since their theory tells them that no one can consistently “beat the market.”
Why can’t many pros beat the averages? To start with, many mutual funds have high annual operating expenses. The mutual fund must beat the index by the annual fees just to break even with the index. That is why lower fee mutual funds tend to do better over the long term than higher fee mutual funds. In addition, since many mutual fund managements have a very short time horizon, many mutual fund managers have a very short lifespan. Therefore, if you are a new mutual fund manager, you are often tempted to trade often and take undue risks. You then will have subsequently high turnover and associated costs. Why invest in this manner, especially if you know that it is not the best long-term strategy? You reason, “If I do well, great! I get to keep my job and I will be showered with love and attention and a whole lot of money. If I don’t perform, oh, well, they are going to fire me anyway so why not just shoot for the moon and see what happens.” So much for efficient and rational market behavior! Here we have money managers doing what they know is not in the best interests of their shareholders simply because the incentives are misplaced. Luckily, more and more mutual fund companies are evaluating their managers over longer time frames.
However, the final nail in the coffin of efficient and rational markets came from the world of psychology. Two psychologists, Daniel Kahneman and Amos Tversky, spent their careers studying how humans make decisions. Even though he was a psychologist, Mr. Kahneman won the Nobel Prize for Economics Science in 2002 because their work challenged the assumption of human rationality prevailing in economics. Sadly, Mr. Tversky had passed away in 1996 and the Nobel Prize is not awarded posthumously. In Daniel Kahneman’s ground-breaking book, Thinking Fast and Slow, he describes their research and how it came to be used by economists. Read it!
In the final analysis, the premises and casual observations of the Efficient Market theories show them to be patently absurd. Many money managers have “beaten the market,” over statistically significant long periods of time. “The more I practice, the luckier I get.” Plus if markets are efficient and rational, how do you explain manias and crashes? Read on, Dear Student!