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- 💵 The Efficient Market Lie
💵 The Efficient Market Lie
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Markets are both efficient AND inefficient. It's a matter of time and perspective. Like this one 👇
The efficient market hypothesis states that when new information comes into the market, it is immediately reflected in stock prices and thus neither technical nor fundamental analysis can generate excess returns.
The author examines recent research related to behavioural finance, momentum investing, and popular fundamental ratios that purports to contradict the theory and concludes that it is not significant in the long run. Therefore, in his view, the efficient market hypothesis remains valid.
Basically, there's an entire group of people that say markets are always efficient over the long-run and all information is immediately reflected in the price.
Generally, that's probably, mainly, true. But, that doesn't mean markets are efficient all of the time. Taking advantage of the frequent 'inefficiencies' that present themselves is a key driver behind the relative performance of traders and money managers (out-performance and under-performance of the benchmark).
It's hard to quantify any inefficiency (and the prospective return for taking advantage of it) in advance. Price is the ultimate arbiter of truth, but sometimes it deceives us...
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The Veteran shared an excellent story from Toscafund's Savvas Savouri over Christmas that highlights this brilliantly 👇
Some years ago a friend, then a leading market maker, attended a charity dinner. Not in a swanky central London hotel with celebrity guests & exclusive auction items, but a damp church hall in a small town some way from The City.
My mate had encouraged along some decent trader colleagues. They decided the best way of contributing to the worthy local charity was bidding for the auction lot they considered the least contestable. Their reasoning was that the small town restaurant meals, haircuts etc. should be left to the locals. With this in mind & scouring the items on offer the traders caught sight of the perfect un-conflicted bidding target: a leaf blower. Our dealers logic was that since the locals almost certainly already owned one, they would not want another. By blowing-up the bidding on the leaf blower our pros believed they could contribute to the charity without denying the non-finance types the items they had their eyes on.
It seemed the perfect trading strategy.
On turning to the said leaf blower the amateur auctioneer thought it reasonable bidding begin at £20; joking that “a score was the price he would normally pay for a blowy”. In a flash the traders began to act, one after the other. Before long, bidding momentum had broken £1k; making the leaf-blower by far the most expensive auction lot. For the nice jobbers it seemed a good job done. One might have thought the evening would have ended with as DelBoy would say, everyone being a winner. Well, NO.
On breaking a grand the leaf-blower began to be lusted over by those in the room unaware of the honourable intentions of the City types.
Seeing the frenzy with which the traders were bidding, other guests began to suspect there was more to the leaf-blower. You know, a bottle of Port actually being a holiday for 10 on the Algarve. Suspicion became rife that those greedy scheming City types were as it were, insiders on a cryptic secret.
The result was bidding sweeping across the room in a bout of truly irrational exuberance. Arms flew up & frenzied voices raised from those hitherto impassive through the auction; bidding became rabid.
In what seemed no time the leaf-blower reached £2k, the traders playing no part, each concerned matters had run amuck. On emerging from a huddle (which only fuelled suspicions of a fix) the traders agreed they simply couldn’t allow the locals to naively overpay, & so re-entered the fray. This only inflamed matters. As high as the traders went, they were out-bid. Eventually & expensively the leaf blower was wrestled out of the frenzied hands of the locals. Was City generosity appreciated? Certainly not. How could it, given the locals believed an amazing crypto prize had been scurously denied them by market insiders.
Whenever I hear financial markets are efficient & agents’ rationale, I think madness of crowds & leaf-blower.
Remember it too when in the company of those who ‘trade’ momentum & others ‘seeking’ hidden value.
Markets aren't efficient in real-time. They can look that way historically with the benefit of 20/20 hindsight. But past performance is not indicative of future returns for a reason. As Mandelbrot puts it 👇
"Markets are turbulent, deceptive, prone to bubbles, infested by false trends. It may well be that you cannot forecast prices. But evaluating risk is another matter entirely."
One more example to end with. Oil in 2008. 👇
In 2008 I traded WTI during a crash from a $147 contract high to a $32/bbl low — all in 5 months. That’s a -78% collapse.
2008 consumption was 85.8 million bpd.
2007 was 86.3.
2009 was 84.3.
???
4/— Paulo Macro (@PauloMacro) January 4, 2023
Was price a function of supply and demand or a function of uncertainty about the future?