The paradoxical efficient market hypothesis (2024)

Anyone who has lived through a market correction (the tariff announcements in early April this year being a recent example, though there have been far worse) should be able to see that market prices do not always accurately reflect even the consensus view of value (which itself can be wrong). As people are forced to de-lever, everything goes down at once, often by very similar amounts, even though it cannot be possible that everything suddenly lost the same amount of value simultaneously. To quote Richard Bookstaber, "The principal reason for intraday price movement is the demand for liquidity... the role of the market is to provide immediacy for liquidity demanders. ...market crises... are the times when liquidity and immediacy matter most. ...the defining characteristic is that time is more important than price. ...diversification strategies fail. Assets that are uncorrelated suddenly become highly correlated, and all positions go down together. The reason for the lack of diversification is that in a high-energy market, all assets in fact are the same.... What matters is who holds the assets." (from A Framework for Understanding Market Crises, 1999) Was the market drop an accurate reflection of the value that would have been destroyed by those tariffs, discounted by the probability that they would have been enacted as drafted? Nobody knew then, and I maintain that nobody even knows now. That was not the calculation that was being made.

> if a sufficiently large majority of investors believe the hypothesis, they naturally would assume that new information about a stock would very quickly be reflected in its price. They would conclude that since relevant news almost immediately moves the price up or down, and since new developments can’t be predicted, neither can price increases or decreases This is an oversimplification of how professional investing works. The vast majority of the dollar value of markets isn’t governed by immediate profit seeking behaviour - it’s people trying to manage money in the context of a real business. Pension fund money is the largest “pot” in the markets at any one time. Pensions funds aren’t incentivised to maximise returns in any particular quarter/year. Instead, they’re looking to manage risk and ensure consistent returns in the very long term. Therefore, the “value” they place on various assets is different to what a trend fund or retail investor is thinking about. The price at which they would buy/sell is different. The market value might “reflect” that information but it could easily create a situation in which short-term, strictly returns-motivated investors might value an asset much more than pension funds or vice versa. That creates opportunity for both to do a non-zero-sum trade and both “make money”. I’ve seen it elsewhere in this thread but it’s simply not the case that the “markets are a casino”. The vast dollar value of the market is about sharing risk and providing liquidity. The global bond market are at least 1.5 times the size of the equities market(s). yes some markets are basically a casino but they’re tiny in comparison.

This seems to be a case of a feedback loop creating emergent behavior. Let's say almost everyone believed in the Efficient Market Hypothesis (EMH). Then, trading would decrease significantly, since most people would think that stocks are already fairly priced. That means the few people who trade would move the market significantly, based on whatever idiosyncratic value-theories they had. But then the EMH believers would see wild moves in the market and stop believing in EMH. They would start trading more to gain profits. And as more traders participated, the market would behave more and more like the EMH were true. Eventually, the market would stabilize. Prices wouldn't swing so much. This would increase the number of EMH believers. It would be interesting to survey belief in EMH among traders. If my model is correct, the percentage of EMH believers should be roughly constant, or at least oscillate around some optimum value.

Sir this is just a casino. Stocks have nothing to do with the businesses right after they are issued. A business can opt to just never issue dividends (Hi Amazon). So the stock itself has 0 actual value. It does not generate cash. (Ok if the company goes belly up you will get a percentage of the carcass) But we can all gamble on what it is worth! So stockholders are like roulette pill holders. Everyone just bets on where the pill will fall. Few are luckier than others. Some smarter know whether the roullete is rigged and have better chances.

the hypothesis maintains that stock prices reflect all relevant information about the stock This is a common description of the EMH. But every time I read it, I think: Does information really directly impact the price of a stock? How? What if it takes 12 months of hard thinking to draw the right conclusion from the information? Are there many investors who go to such lengths? Are they all thinking at the same speed? And if not, what does that tell us about the EMH? Google released DeepDream in 2015. My feeling is that with enough thinking, one could have predicted where image generation is going in the next decade and that language generation would go a similar route. And that this will lead to a high demand in Nvidia's GPUs. But that thinking would not be instantly. It would take months or years.