efficient market

What does the efficient market mean for you?

The efficient market gives retail investors an edge or at least it reduces any informational disadvantages. It improves the bid ask spread, the stock liquidity and significantly reduces any arbitrage opportunities.

Some say it’s a good thing, some say it’s a bad thing. How can you be a small time investor and successful without any edge?

I have to point out that the market is not efficient as a whole. There are efficient elements to it.

What is an inefficient market

The private equity and venture capital markets are good examples. How much is an idea worth? From zero to billions or anything in between. How much is a private business worth?

The same, but Mergers & Acquisitions research shows that buyers overpay 20% or more for a private company. This is due to lack of information, lack of liquidity and lack of transparency.

On the flip side you overpay for stock too, however, you can sell it quicker and some of the companies are more transparent.

The Efficient market hypothesis

A lot of stock trading mishaps are attributed to the market efficiency. Traders either can’t secure any kind of edge or think they have secured it but actually haven’t. There are three variants of the efficient market hypothesis:

The weak version is concerned with historical prices and assumes that you cannot predict the share price with technical analysis. You can use fundamental analysis or trade on insider information to gain an edge.

The semi-strong version stipulates that all the publicly available information is baked into the current price. The implication is that neither technical nor fundamental analysis can bring any edge. You can still trade on insider information.

According to the strong version all available information, public or private, is baked into the market. You cannot gain an edge even if you have insider information. This version and the semi-strong are supported by the consistent underperformance of actively managed funds in comparison to broad market benchmarks as I previously discussed here.

I support the weak version to a point hence I only conduct basic technical analysis. You’ll probably make a killing on insider information. Sadly, I don’t have any proof of such trades to test my hypothesis.

The semi-strong and the strong version are somewhat unconvincing. Fundamental analysis seems to work, check out Warren Buffett. There are many reasons why an active fund may underperform and some of these can be attributed to market inefficiency.

Trading in an efficient market

We’ll use the semi-strong version for this because it’s popular.

Based on a semi-strong efficient market assumption I expect that the current price of a highly liquid stock is the fair price on the day! It is fair because it reflects the best available information at the time.

There are only three elements which can influence the share price at this point: time, due to a future influx of new information; anticipation of new information measured as volatility and random walk short term price action. Therefore, the share price fluctuation is random and an overall increase or a decrease is caused by new information.

From this vantage point I assume that I cannot predict the future price as I can only act based on bounded rationality. This means that I make decisions by using the limited information available to me and finite cognitive capacity within the time frame available.

However, a semi-strong efficient market gives me an edge as all the available public information is baked into the price. This includes any form of technical and fundamental analysis performed by other participants.

Therefore, I can shorten the analysis preceding the purchase or sale of a security. The only elements which remains unforeseeable are the random fluctuation and the future.

Critique of the efficient market hypothesis

The caveat is that all of the above is in relation to the asking price at the moment. We may be paying a fair price but not necessarily for a fair company value. It’s not the same thing!

If everyone was as clued up as the theory suggests there would be no manias, bubbles and various other unexplained phenomena. Efficient or not I’m not buying stock trading for a P/E of 10k.

Advantages of the Efficient market

It follows that any kind of analysis performed by myself is largely irrelevant so I focus on the information which is already available in the market. All I need to worry about is what others think.

If everyone else thinks that a certain stock will go up and start buying it will most likely do so and vice versa. Consequently, most of the information in the media is old news and already priced in.

The same is true for lagging economic indicators and other research such as analyst recommendations. Overall, the share price doesn’t look back at the news, it reflects forward expectations.

I have to agree, it is indeed useless, kind of like running while looking behind you. Doesn’t make any sense. Having said that, the information in the market can be flawed too.

How do you know everyone is doing their analysis properly? I don’t so I can’t just take the price for granted fair value.

Liquidity

Liquidity is one of the most important elements of a trade. Whether you are long or short you want enough players to agree on a price and reduce losses caused by slippage.

There is nothing worse than waiting for hours to get filled on AIM.

My personal perception of liquidity is a minimum of 5 million shares per day and thousands of open options contracts. However, anything over 1 million shares per day should be acceptable.

Bid-Ask spread

The bid-ask spread is the advantage of market making firms. They buy at the bid, sell at the ask and collect the difference. It is not a major amount but it adds up over millions of transactions.

Market efficiency reduces the bid-ask spread. The spread of SPY is $0.01-0.02 per share, while the spread of an illiquid stock can be over 10% of its value. The spread is closely related to the liquidity of the instrument.

I think we have to admit that this is true most of the time, especially for retail traders. It’s not difficult to get an order filled which is great

Arbitrage

An efficient market presents limited arbitrage opportunities. You can’t be taken for a ride by an institutional investor. They simply can’t buy SPY shares at a discount and then sell them to you 5 minutes later for a 20% profit.

Still a high frequency trading algo can skim a penny or two per share.

Paralysis by analysis

No more time wasted looking at unicorn running under the rainbow type charts filled with MACD, RSI, Bollinger bands, resistance levels and other technical wonders.

These are all in the past together with dozens of spreadsheets filled with DCF, dividend discount and other models. There is time and place for them, however, a semi-strong efficient market allows a brief overview.

All the necessary information is already in the options chain.

Only that the option chain gets stuff wrong from time to time, sometimes with grave consequences. Especially if you have a large position is a dodgy stock like HTZ, WLL or CRBP.

Just because the Deltas are skewed to the upside doesn’t mean you’ll make money.

Disadvantages of the efficient market

No one can outperform the market. If everything is efficient and the price is always fair, how do you make money? This notion seems to hold true for most people and for active management. However, retail investors have the advantage of being able to do whatever they want when they want to.

We don’t have any shareholders, investors, bosses or employees to care about. It is pure freedom to be able to liquidate your whole portfolio whenever you feel like it or buy any stock you want.

Truth be told the market is not perfectly efficient. Firstly, it is regulated so it is not just left to the participants. Secondly, people are not the same which leads to different interpretation of the available information, misjudgement or simply human error. Thirdly, how long does it take to digest new information? No one knows the answer.

Overall, the market will never be entirely efficient but it is certainly easier to navigate in 2020 compared to 1960 or 1785.

I think that the idea that you can’t outperform the market is purported by people who expect to achieve this by buying a whole bunch of ETFs. This is mathematically impossible.

Final thoughts

As previously mentioned I can only support the view of a weak efficient market (to an extent). Therefore, this article has certain bias and I encourage you to read other opinions to form your own understanding. Nevertheless, a lot of sources agree that there is some efficiency.

The only subject of debate is the extent of it. Most of the Efficient market hypothesis can be debunked by two elements of a trade: time and stock quality.

These are the most critical of all in terms of explaining the varying magnitude of returns or lack thereof.

Below are a few comments on the effect of time. I won’t comment on what makes a stock a good investment because of the variability of assumptions.

Examples of the temporal effect

A day trader may accrue losses on a given ticker while a value investor may secure significant gains and vice versa. It is feasible for investor A to buy stock for £10 and then sell it to investor B for £20 a few weeks later.

Then investor B sells it to trader C for £50 a few years later. Trader C sells it on the same day for £51.37. None of the 3 lost any money in this example. Conversely, all three could have lost money or achieved a mixture of returns.

Time

These are all examples that the flow of time, which includes the uncertainty of future information, presents the opportunity to outperform. Combine this with a fairly priced stock and you have a winner.

Furthermore, the lines of reasoning of a day trader and a long term investor are completely different not necessarily because of lack of judgement but due to a different time horizon. Either way it is absurd to assume that the views of the two groups can be amalgamated into an Efficient market hypothesis.

And finally the market can digest information very quickly or slowly depending on the anticipated volatility, also a result of the arrow of time. In fact the circuit breaker on the New York Stock Exchange is designed to give participants the most valuable resource of all: more time.