So much for Efficient Market Theory
March 10, 2009 | People are adept at creating explanations. When they are buttressed by a body of observations and tested objectively, these explanations become scientific theories: plate tectonics, evolution, the "big bang," and so on. When they are made up out of whole cloth, these explanations are myths, creation stories, folklore, religion, and so on. And then there is the stock market.
According to the Efficient Market Hypothesis, the market is an information-processing mechanism through which investors, using all available information at any given time, reach consensus about the worth of stocks. Since everyone has access to the same information, theoretically, no one should be able to "beat the market." This is the intellectual underpinning for index mutual funds. If the theory is true, stock picking is essentially futile, so you buy into a basket of stocks (a mutual fund) and go along for the "random walk" on Wall Street.
If the markets are efficient, they should be especially so in our environment of 24/7/365 news and information. The body of digested information about stocks should by now be so vast that the consensus should be very strong and stock prices should stabilize. An incremental bit of information should not have that great an impact in comparison to what is already known. That clearly ain't the case!
Yesterday, both the Nasdaq and Dow Industrials continued their downward march, reaching levels not seen in 6 years (Comp) and a decade (DJIA). Today, both indexes are soaring. The DJIA is up 4.6%, the Nasdaq up nearly 6%.
What's different? An internal Citibank memo "leaked" to the press said that Citibank has operated at a profit for the past two months. It's understandable that that bit of information would affect the consensus view of Citibank's worth, and possibly that of other financial institutions. But the entire market?
There are three stocks in my Trader Paul portfolio and they're going gangbusters today as well. To the best of my knowledge, none of them has any significant connection with Citibank. There's no news about any of them, so there is no information basis for 8%-10% jumps in value. So much for the Efficient Market.
The market is obviously not functioning on the basis of a rational distillation of information. It is simply careering along, mania having displaced, for the moment, depression. Bits of information don't solidify consensus, they totally disrupt it, sort of like tossing a dead rat into a roomful of teenage girls will do.
Instead of more information making the market more rational, it makes it more irrational.
I don't know what the right theory of the market is. If I did, my net worth wouldn't be down 60% since last year. But I certainly do know what "just ain't so."
Last updated on Apr 13, 2018