Photo: Ralf Roletschek. Source: Wikimedia Commons. CC-BY-SA 3.0
When I was studying finance, one of the most hotly debated notions was the Efficient Market Hypothesis. It’s like salsa: in comes in mild, medium, and strong forms, and everyone has an opinion – they like it, they hate it, they base multi-billion dollar businesses on it. At its heart, the Efficient Market Hypothesis says that markets incorporate information into their pricing mechanism. It’s hard to argue about that. But it gets more dicey when you say all the available information is there – the data, the rumors, management’s confidence, the probability that management is lying, and so on.
Skeptics trot out the NASDAQ in 2000 or the stock market crash of 1987 or bond yields in 1980 and ask, “How can mere information account for these radical price changes?” And the skeptics have a good point. It’s hard to justify an entire market moving 22% in a single day or falling 78% in two years without a major war or natural catastrophe. There are all kinds of other anomalies in the market – like price momentum, or calendar effects on prices, or the strong performance of low-volatility stocks. In a truly efficient market, how can these things happen?
NASDAQ decline, 2000-2002. Source: Bloomberg
But just because a theory doesn’t explain everything doesn’t mean it doesn’t explain anything. The Efficient Market Hypothesis isn’t a version of string theory, attempting to explain quarks and gluons and Brownian motion and why GE’s stock fell last year. It’s a good way to understand why it’s so hard to beat the market and why stock prices seem so random. Prices react to news, and future news is indeterminate. We don’t know what’s coming around the next bend in the road, and we can’t know what we don’t know.
Photo: Pedro Perez. Source: Morguefile
The financial markets are an endless source of fascination and surprise, incorporating the latest economic, political, and social developments into their pricing framework. Over the years, I’ve learned that there are two types of market analysts: those whom the market has humbled, and those whom it hasn’t … yet.
Douglas R. Tengdin, CFA