Introduction
Are markets efficient? How do we define what ‘efficient’ even means for financial markets? Well, apparently there is a proper definition of it – current share prices reflect all known information.
Ok – so what about it? The theory goes further to say that because all share prices fully reflect all known information, stocks also trade at their fair value and it is impossible to purchase undervalued stocks or sell stocks for inflated prices.
It further implies that traders and investors simply cannot beat market returns, and generate what is commonly known as ALPHA returns, which are returns in excess of the market returns. To find out more about ALPHA, kindly refer to our Alpha Booster series.
This line of thought is commonly known as Efficient Market Hypothesis (EMH).
TAKEAWAY
- If prices really followed a random walk as proposed by the EMH, they would not retreat at psychologically important landmarks. Especially when there was no new market information that was shared during the retreat.
- Instead, the market is periodically showing signs of inefficiencies. These inefficiencies can be exploited to make returns in excess of what the market provides!
A Recent Bloomberg Case Study - Stocks Bang their Heads on an inefficient ceiling
“Monday wasn’t a good day for the efficient markets hypothesis. The idea, you may recall, is that markets incorporate all known information at all times, and thus follow a trendless “random walk,” jumping up or down according to the latest piece of news. Monday’s trading in the S&P 500 certainly qualifies as “random” at first glance, charging upward, then suddenly reversing and ending down for the day. That is until two psychologically important lines are added. The S&P topped its level at the start of the year; surpassed last month’s post-Covid high immediately after; and then, as though it had bounced against a hard ceiling, tanked:
The problem for random walk theorists is that prices are supposed to react to actual news. Neither of these landmarks qualify, and this is the second time that this has happened. Stocks reached positive territory for the year more than a month ago, and then staged a sudden retreat. It has taken until now to make another attack on the summit.
If this sounds irrational, it is — although it is probably better to call it an understandable mental cue for more rational calculations. Without a doubt, there were algorithms programmed to sell if a new post-Covid high was reached. Beyond that, human judgments were involved. Confronted with the reality that stocks were up for a year where there had been so many setbacks, investors looked for reasons to sell.
Conclusion
The EMH or theory states that share prices reflect all information. However, the market is periodically showing signs of inefficiencies. The Bloomberg example is a recent example whereby if prices were really following a random walk as proposed by the EMH, they would not retreat at psychologically important landmarks, especially when there was no new market information that was shared during the retreat. When markets are inefficient, it is possible to exploit these inefficiencies for market beating gains!
