The Efficient Market Hypothesis
A New Controversy
Scrolling through Twitter I saw that Cliff Asness tweeted his frustration around the efficient market hypothesis. For those that don’t know, Professor Gene Fama postulated EMH in 1962. It’s been controversial ever since.
I will tell you that when I was in MBA school at Chicago and was confronted directly with Fama’s theory, I was a naysayer too.
Why is it so controversial?
I think because as humans, we like to think we are smart. We like to think we can control a lot of outcomes. Markets are dominated by males, and males inherently like to tinker a lot more than females. Sorry, that’s not appropriate to say in our current times, but males are not as passive in marketplaces. They try to fix stuff that might not need fixing and only needs patience.
Hence, when Thaler and others postulated behavioral economics, it fed our confirmation biases around markets and our “smartness”. At last, a countervailing theory to prove us right! Take that. I am smarter than anyone else!
Except, when you look at historical math, Fama is right.
If you are not in the market 24/7 and cannot create an edge for yourself, you should adhere to the efficient market hypothesis. You will do better in the long run, although it might be painful at times.
Sure, you can point to specific small examples to show that markets are not efficient. The textbook one is a stock split is 3Com splitting off Palm. But, they are rare. You can’t make continuous money off of them. You have to have enough knowledge, and the speed ability to take advantage of them.
One thing with electronic markets is much of the inefficiency gets quickly arbitraged away. When it doesn’t, you have to look at underlying things. Often the structure of the market hinders efficiency. It is also the case that political policy or rules might hinder efficiency.
I was reading Packy McCormick’s blog today and he highlighted how Keith Rabois called a top in the market.
In a back-and-forth on Twitter that day, someone asked if he was calling the top, to which he replied, “yes.” Another person asked if he could be more precise. He could: “yes at least 25% correction and reversion of tech multiples to historical norms, i.e. enterprise multiple of 40x recedes to 20x.”
That day, November 19th, marked the all-time high for the Nasdaq Composite, the most commonly-used proxy for public tech stocks. It fell 21%between then and March 14th, the recent low. It may or may not be done falling. He timed it perfectly.
If you are a trader, that whole back and forth ought to be giving you FOMO and grinding your gears a little bit. Traders hate to miss a move, especially a game-changing one.
The problem is, no one can pick tops and bottoms consistently. No artificial intelligence or piece of software can do it either.
I did two things to prove EMH to myself.
First, a U of C professor challenged me. He asked me to send him an email each morning whether the stock market would be up or down that day. We used the S+P 500. I did, and I was never wrong. I was in the market 24/7 and could predict with stunning regularity which way the market would go that day.
Here is my smug but concerned face.
However, that was the wrong metric to prove or disprove EMH.
Instead, the professor said the best way is not only to say, “up or down” but also by how much. Well, there is zero chance anyone can predict the exact move each day of the market and no software program can do it either.
Second, I examined my lot in the trading world closely. Why was I successful? Why was I successful year after year? When I made bad trades, why did they happen? When I went on losing streaks, why did it happen?
It turns out when the world was pit traded, I had a gigantic edge. The edge was reflected in the value of our exchange memberships. Mostly it was speed and the ability to transact quickly. Sure, I had great wits, the ability to think really fast under high-pressure situations, and the correct mental state to admit I was wrong. I also knew how to get out of winners, and figure out what to do with losers.
But, the primary edge was speed.
When co-location was instituted by the exchanges it took the speed edge away from the pits and gave them to the computerized trading companies. Based on my P+L, you could see that my edge was gone and the game had changed.
That proved to me that passive investing works and markets are efficient.
They don’t always do what we think they will do or what we expect them to do. We can look at a lot of factors in the market and even based on proven economic theory, the market doesn’t do what the theory predicts….in the short run. However, over the long run, it will. It has to because it is math.
I do think that Cliff is correct. In little blips, markets are inefficient. For some reason, they seem to stay out of line longer than they used to. If you look at dislocations that persisted longer than the cognoscenti thought they would, I think the answer is there was a lot of capital that went into those markets over a long period of time. The mortgage meltdown of 2008 is not a good example because of the underlying government mandates and policies that fueled that market. The tech bubble Cliff cites is a much better example because it was private money going into private companies.
In the tech bubble of 1997-2001, one of the tough structural pieces was the inability for a market to correct. Venture capital money poured into startups and there was no way to short them. Fed chair Alan Greenspan correctly said there was “irrational exuberance” in the market, but the desire for the public to pour money into the tech sector was gigantic once those companies went public.
Everyone by 2000 saw there was going to be a sea change in the economy. In 1990 when the dot com era basically started, it wasn’t as apparent.
Fama is correct, you can only see bubbles in the rearview mirror. If we could see them as they happened, we could proactively pop them. It is one primary reason all the smart people at the Federal Reserve are behind the 8 ball on inflation today.
I don’t know why the stock market acts why it does. Yesterday, Tim Knight tweeted this:
I replied, “STFR”, which has been my mantra this year. I do know that AlphaTrends is correct when he says that “permabears will never tell you to buy”. You can’t build wealth if you aren’t buying. You can’t build wealth if you don’t own anything.
That was one problem I saw when I read data that showed the millennial generation didn’t want to own cars, homes and other hard assets. They were using software to deliver everything. The ownership society was dead. That works in a deflationary or static environment. It doesn’t work in an inflationary environment.
I thought, at the end of the day, the people that own all the hard assets will do better than people who just rent them. The renter population will have to make up the difference in higher and higher income, which gets eaten up by inflation. Even in a deflationary state, the owners of the assets have some sort of income stream they can lean on.
This morning when I woke up, markets were lower. As I write this, they are a little higher.
Handsome dude. Dam that testosterone. Good listen: https://www.audible.com/pd/The-Hour-Between-Dog-and-Wolf-Audiobook/B0089XGXYM?ref=a_library_t_c5_libItem_&pf_rd_p=80765e81-b10a-4f33-b1d3-ffb87793d047&pf_rd_r=SMRR13QJC141JCVJZ4SA
Great point about male tinkerers. Creating temporary inefficiencies, due to male egos causing decisions/ strategies that (particularly) in hindsight will be understood to be irrational.