Is the Stock Market Efficient?

 

Many finance professors claim that the stock market is efficient. This means that prices reflect fair value so that active mangement can't beat the market. They show how the invisible hand of the economy detects problems and allocates resources. The market may be efficient for trading of bonds between institutional investors, it may be efficient regarding a physical business deciding to buy more plant and equipment, but it is not efficient for stocks. The difference between a business deciding if it is wise to add on a new project and compete versus an individual deciding to buy stock is that in many industries there is a shared oligopoly which keeps out rookie competitors so that only wise well established businesses can operate. Thus the decision to add more capacity to a manufacturing plant is far more efficient than a retail investor impulsively deciding to buy stock. The decision to develop a billion dollar new factory may take years of careful study by expert employees; by contrast some retail investors take only minutes to decide what stocks to buy using only free software or low cost new subscriptions.

I think some consumers are more disciplined and efficient in buying consumer goods and services and thus contributing to an efficient market in retail sales of consumer products.

The market for purchasing packages of loans between banks used to be efficient before and then because of falsely labeled mortgage backed securities it became very inefficient. Now that the ratings agencies have refused to cooperate with investment banks in the false labeling of bundled loans the market for mortgage loans has returned to efficiency.

Rarely do you hear of a bubble in a manufacturing industry in the U.S. where too many participants are adding capacity. Bubbles in the business world seem to be located in countries where banks are eager to fund loans for government policy reasons rather than for credit worthiness. Banks in the U.S. and U.K. and Canada seem to be more careful about granting business loans. This may make the market for corporate expansion of plant and equipment an efficient market compared to some EM countries that have far too much manufacturing capacity and not enough buyers.

Rarely do you hear of a bubble in bonds where retail investors are clamoring to buy bonds and throwing caution to the winds. Instead the thought of bond investing triggers thoughts of boredom in retail investors so those that journey into bonds may actually be acting in a more efficient way than the stock investors.

The Efficient Market Hypothesis (EMH) was developed in the 1950’s. At that time the market was more efficient in the sense that investors were so scared of another Great Depression that they invested more carefully than today’s investors. Thus a survey of transaction data going back from 1953 to 1933 used to develop the EMH is somewhat biased because that era was heavily influenced by investors who were highly motivated by the 1929-32 crash to be more careful. However the market in the old days was less efficient in terms of wider spreads, bigger commissions, less available data for retail investors, etc. But ultimately what really makes a market efficient is not shaving a few basis points off of the spread or commission but rather it is cultivating an attitude of careful thoughtful cautious investing. Thus today’s more efficient market where a trader can be linked up to many markets in different countries and freely transmit capital across foreign borders is not as powerful of a force as simply holding a good attitude and habit about investing carefully.

The low yield environment has warped the thinking of some investors who have decided to reach for yield by earning an option premium writing Put options. This makes the volatility index go down, making investors feel safer. That is a false symptom. Ironically low yields are sign of a depressed economy, so to the extent that low yields provoke the writing of Put options (which is a bullish sign), is an irrational, inefficient market.

Investors need independent financial advice to understand that even though capitalism in many cases is an efficient market that stock market are overwhelmed but emotional retail investors and are thus not efficient. I wrote an article “Which is correct: stocks or bonds?”

About the author

Don Martin, CFP®

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