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Efficient market hypothesis

Efficient Markets Hypothesis? In the real world we have Emotional Markets Hysteria. Every security at all times is WRONGLY priced. Markets are not rational at reacting to new information. Data is either overreacted or underreacted to and nothing trades at its value. The success of good hedge funds proves the exploitable existence of inefficiencies.

Security prices offer a temporary, irrational opinion poll of what's hot or cold. Stock markets are never a measure of value, they just give a rough idea of the bull versus bear VOTING split. Stocks go up when there are more buyers than sellers. WHY there are more buyers than sellers is generally unknown. It is impossible to isolate a "reason" for a particular fluctuation, though sell-side and media "experts" try.

The causal link between information and price movement is unclear. To assume that all investors react to incoming data immediately and logically is just plain wrong. That prices move more often than new information is obvious. Equity analysts get it so wrong, so often, because they analyze companies when they should be analyzing stocks. A stock that is "widely" followed will be more wrongly priced due to fools writing reports about it.

Some claim that widely followed securities are efficiently priced but even in liquid markets I have found that the more participants then the more mis-priced that market is. The more money in an asset, the greater opportunity for rare smart investors to generate alpha out of the hoards of dumb investors. Dumb money includes 100% of "passive" index funds and 90% of hedge funds and active long only managers. There will always be plenty of alpha to extract from unskilled journeyman in the alpha redistribution game we play each day.

Security returns are driven by agent behavior and interaction; the impact of new information on markets is undecideable. The absurd efficient markets hypothesis not only costs investors money, it can even put people in jail. The EMH is dangerous as an assumption, as are models, theories and laws derived from it. It is unfortunate for investors, including myself, that reasonable doubt will always exist in "explaining" stock falls. Yes, convict people for cooking the books but entering into evidence the noisy, leptokurtic, heteroskedastic market should be inadmissible. Fraud on the company can be prosecuted, but not fraud based on EMH.

The US Supreme Court set the EMH legal precedent back in 1988, ignoring the devastating counterevidence of October 1987, just a few months earlier. Little economic news broke on Oct 19 that year yet a 20 standard deviation, never in a zillion years "fluctuation" occurred. Quite rightly, no-one jailed Treasury Secretary James Baker or the Bundesbank Chairman or the academics pushing portfolio "insurance" for the enormous losses that day because the extent of fault of any single risk factor can NEVER be determined. We have no idea how to apportion blame, only that there were more sellers than buyers for numerous known AND unknown reasons. I don't care about the WHY or trying to conjure up an "explanation" for every tick.

Stocks often fall when interest rates are raised; does that mean central bankers can be sued for damaging equity prices? Call your lawyer next time the Fed raises rates and see what response you get! Should we put Toyota on trial for hurting Ford's market cap through business Darwinism? How much is Google to blame for Yahoo's stock price drop? The success of some companies damages other companies. Of course many stocks collapse due to the fraud or incompetence of a firm's management. And as we saw with Enron and WorldCom, the law punishes them if necessary. But invoking EMH to "prove" causality and to calculate attribution for financial loss is wrong.

Management actions do not affect stock prices anywhere near as dependably as commonly assumed. Founders, entrepreneurs and skilled management teams are obviously key when a firm is private, but once it goes public its value becomes at the mercy of greed, fear, illogicality and investor emotion. This is where stock option compensation skates onto thin ice; did management add alpha or was it just beta? Many large stocks went up regardless of who was in charge.

The possible reasons to buy or sell are too numerous and varied to identify a single, logical, explanatory variable. I don't know why the weak-form EMH survives when it has been proven to be nonsense. Partly it is brokers, analysts and the media needing to provide a "reason" for market noise. Partly it is finance academics; ironically the math of random, no memory processes is much easier than the complex math behind deterministic, long memory, non-linear systems like security markets. The EMH persists because it is simple and intuitively appealing but the real world is just not that easy.

It is impossible to assign the financial impact from a stock fall due to a single event. The noise to signal ratio is too high to be able to measure and isolate a fundamental cause. Markets and individual stocks move, often significantly, on no new information. Sometimes prices don't change on unexpected news or go up on negative data. The price impact of a single action or exogenous event simply cannot be calculated. Markets are neither efficient nor random.

By Hedge Fund Creative Commons License

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