Is the stock market efficient?

[Orsorum]

Drats, I had a whole bundle of articles from JSTOR with which I was going to rush in here and prove you all wrong.

I'll compose a more cogent and meaningful post later, perhaps tomorrow, some rather boring math research to finish in the next couple hours.

Cheers!
Nate

 

[AmbitV]

Warren Buffett on efficient markets:

'Efficient Market Theory

The preceding discussion about arbitrage makes a small
discussion of ?efficient market theory? (EMT) also seem relevant.
This doctrine became highly fashionable - indeed, almost holy
scripture in academic circles during the 1970s. Essentially, it
said that analyzing stocks was useless because all public
information about them was appropriately reflected in their
prices. In other words, the market always knew everything. As a
corollary, the professors who taught EMT said that someone
throwing darts at the stock tables could select a stock portfolio
having prospects just as good as one selected by the brightest,
most hard-working security analyst. Amazingly, EMT was embraced
not only by academics, but by many investment professionals and
corporate managers as well. Observing correctly that the market
was frequently efficient, they went on to conclude incorrectly
that it was always efficient. The difference between these
propositions is night and day.

In my opinion, the continuous 63-year arbitrage experience
of Graham-Newman Corp. Buffett Partnership, and Berkshire
illustrates just how foolish EMT is. (There?s plenty of other
evidence, also.) While at Graham-Newman, I made a study of its
earnings from arbitrage during the entire 1926-1956 lifespan of
the company. Unleveraged returns averaged 20% per year.
Starting in 1956, I applied Ben Graham?s arbitrage principles,
first at Buffett Partnership and then Berkshire. Though I?ve not
made an exact calculation, I have done enough work to know that
the 1956-1988 returns averaged well over 20%. (Of course, I
operated in an environment far more favorable than Ben?s; he had
1929-1932 to contend with.)

All of the conditions are present that are required for a
fair test of portfolio performance: (1) the three organizations
traded hundreds of different securities while building this 63-
year record; (2) the results are not skewed by a few fortunate
experiences; (3) we did not have to dig for obscure facts or
develop keen insights about products or managements - we simply
acted on highly-publicized events; and (4) our arbitrage
positions were a clearly identified universe - they have not been
selected by hindsight.

Over the 63 years, the general market delivered just under a
10% annual return, including dividends. That means $1,000 would
have grown to $405,000 if all income had been reinvested. A 20%
rate of return, however, would have produced $97 million. That
strikes us as a statistically-significant differential that
might, conceivably, arouse one?s curiosity.

Yet proponents of the theory have never seemed interested in
discordant evidence of this type. True, they don?t talk quite as
much about their theory today as they used to. But no one, to my
knowledge, has ever said he was wrong, no matter how many
thousands of students he has sent forth misinstructed. EMT,
moreover, continues to be an integral part of the investment
curriculum at major business schools. Apparently, a reluctance
to recant, and thereby to demystify the priesthood, is not
limited to theologians.

Naturally the disservice done students and gullible
investment professionals who have swallowed EMT has been an
extraordinary service to us and other followers of Graham. In
any sort of a contest - financial, mental, or physical - it?s an
enormous advantage to have opponents who have been taught that
it?s useless to even try. From a selfish point of view,
Grahamites should probably endow chairs to ensure the perpetual
teaching of EMT.

All this said, a warning is appropriate. Arbitrage has
looked easy recently. But this is not a form of investing that
guarantees profits of 20% a year or, for that matter, profits of
any kind. As noted, the market is reasonably efficient much of
the time: For every arbitrage opportunity we seized in that 63-
year period, many more were foregone because they seemed
properly-priced.

An investor cannot obtain superior profits from stocks by
simply committing to a specific investment category or style. He
can earn them only by carefully evaluating facts and continuously
exercising discipline. Investing in arbitrage situations, per
se, is no better a strategy than selecting a portfolio by
throwing darts."

 

[glugglug]

Originally posted by: Dissipate
Analysts aren't dumb, they probably surf those boards more than anyone else.

This is where we disagree. On both points of the quoted sentence.

 

[zillafurby]

Originally posted by: glugglug

Originally posted by: Dissipate
Analysts aren't dumb, they probably surf those boards more than anyone else.

This is where we disagree. On both points of the quoted sentence.

analysts vary. also its a difficult job. if their stocks are run of the mill and reasonably priced, its near impossible to know what direction they are going in short-term. its much easier analysing a company with a strong driver.

do analysts read boards like this? you have got to be kidding me. as if they can get better information quicker from more informed sources that a few BDU's and technicians.

also glugglug is right about the price action trading. if you have a monitored stock, that the analysts are in for a surprise on, and you can garner info from their press releases, competitors, and suppliers and customers, then you know which way the surprise will be, and if the analysts werent waiting to be disproved then all this would be priced in, in these cases it takes the numbers to come in, and make the traders act.

 

[DrPizza]

Doesn't an efficient market mean that there are enough "smart" people to take everything into account that is known about a company at a particular time and the market price is adjusted accordingly?

I don't see how that would explain the tech boom and bust on the market. The "smart" people recognized that the stocks were WAYYYYY overvalued. Thus, they knew the price wasn't what the price should be, yet the theory says that the price should be what it should be.

 

[Dissipate]

Originally posted by: DrPizza
Doesn't an efficient market mean that there are enough "smart" people to take everything into account that is known about a company at a particular time and the market price is adjusted accordingly?

I don't see how that would explain the tech boom and bust on the market. The "smart" people recognized that the stocks were WAYYYYY overvalued. Thus, they knew the price wasn't what the price should be, yet the theory says that the price should be what it should be.

I think the latest version of the book: A Random Walk Down Wall Street talks about the .com bubble and uses it as an example of the market coming back down to its true value. The author doesn't claim the market is always efficient I don't think, just that it is efficient enough to make it not worth your while to invest in individual stocks.

 

[gsellis]

Analyst are not dumb, but they are sheep. They will follow some of the stupidest courses because everyone else seems to be doing it. They also don't always realize that they do not know enough to make a decision. No one can predict the future, especially if it will not model. Any attempt to model the market ends up in a Random Walk (for the none stats folks, a Random Walk model does not show any pattern in an analysis - you should be able to find a definition if you search for ARIMA and Random Walk). There is no intelligence. The only thing we can say is that it will be higher in the long run as long as GDP/GNP grow and Money follows. After that, it is a crap shoot based on perception in the short term.

Maybe not efficient, depending on your definition, but it seems to work as tool for gathering capital to grow a business. At that, it is efficient compared to the alternatives.

 

[zillafurby]

Originally posted by: Dissipate

Originally posted by: DrPizza
Doesn't an efficient market mean that there are enough "smart" people to take everything into account that is known about a company at a particular time and the market price is adjusted accordingly?

I don't see how that would explain the tech boom and bust on the market. The "smart" people recognized that the stocks were WAYYYYY overvalued. Thus, they knew the price wasn't what the price should be, yet the theory says that the price should be what it should be.

I think the latest version of the book: A Random Walk Down Wall Street talks about the .com bubble and uses it as an example of the market coming back down to its true value. The author doesn't claim the market is always efficient I don't think, just that it is efficient enough to make it not worth your while to invest in individual stocks.

i wont go into much detail, but the tech bubble was all supply and demand. your get large movements in capital that self-reinforce - soros calls it reflexivity - for example no one wants to hold a stock on the way down, even if its undervalued already, also its never 100% clear that things are very overvalued, you just get the perception, then the companies fail, unfortunately the market fall has normally happened in anticipation of the news.

 

[glugglug]

Originally posted by: zillafurby
also its never 100% clear that things are very overvalued, you just get the perception

Not only was this crystal clear during the previous dot-com bubble peak, it is still 100% clear right now (the bubble hasn't burst yet, it just had some air let out...). What is not so clear is when the perception of this fact that they are extremely overvalued will reach the critical mass it needs to begin the freefall.

The tricky part of playing the market is predicting perception, as this has far more effect on prices than reality. Ironically, the general public's stupidity makes the market harder to predict because it has kind of a randomizing effect on perception. (not really random, but can't think of a better term to describe it right now).

 

[glugglug]

Another prediction: AMD is about to go through the roof. The signficance of Dell beginning to sell AMD chips can not be overstated.

 

[chorner]

I would just like to add that the only predictable element of trading seems to lie within the larger more profitable companies. Investing in smaller companies is always much more of a risk than investing in an already established company; yet have the possibility for the largest return obviously. Just as you can obviously see as well, that weather, news, hype, and media attention play a large factor (obviously again) in stocks. Also, the fact that its quite obvious to see that ATI and Nvidia will be going at it, as well as AMD and Intel. In both cases you can accuratly predict which stocks will be the ones to purchase out of those 4 companies. If you guessed the under-dogs with something to prove, then you have guessed correctly which stocks have the means to provide an increase in stock value. Statistically in the past, it is the competing companies who have something to prove who put on the biggest show; hence the most media attention, the most speculation, and the most buyers of stock.

What I am trying to say; is that its through both the efficiency and inefficiency of the stock market that in-fact does make the stock market an efficient means of income to those who are good at organizing data, and collecting/researching data. There are without doubt set-in-stone patterns which may be followed to predicut outcome. This would be an efficiency. The inefficient side however, is consumer response; but through the inefficiency of consumer response, brings efficiency to the market as a whole as the stock trader will always use logical pattern recognition to predict outcome (which is only part of the equation), as stocks which were though to blunder may thrive and so fourth in return bringing more or less an even balance to all open stocks. Hopefully that made sense .... haha

There is a pattern to everything. Just as you can tell for instance, it is better to invest in HaggenDas (spelling?) iced creame after the end of the 'summer' season when sales decline, and sell during the peak season (earlytomid July- early August depending on the weather trends) you can predict based on product cycles, and also perceived sales based on general opinion.

Hype and media attention in the consumer goods sector especially is obviously a main driving factor; and you can predict fairly well that based on new contracts such as AMD and Dell will of course spark 'hype' and attract the attention to both the Dell and AMD camps.

Things like cars, computers, razor blades, toothbrushes/toothpaste etc., pop, water bottles and clothing are some of the easier trend predictors. These are all items which need to be continually purchased, by a growing population. It would only make sense that profit margins of the companies providing these goods will steadily increase for the forseeable future.

These are the types of things you can predict ... as for how MUCH; this is uncertain and you can only predict an increase as being a constant.

Either way, it is through both gains and losses that even out the field anyhow .... which in the end when you take your inefficiencies, they 'magically' combine to create an overall efficiency on a large scale. A stock market where you always won, and always was 100% predictable would of course not be efficient ... the same goes for the flip side.

In otherwords, the stock market is only able to be efficient because of its inefficiencies. Its a balancing act that is allowed to teeter either way. But just as there needs to be an evil to know good, (and good is obviously the prefferable trait haha) then the same can be said for stocks. If it were not efficient, the market would obviously fold just as if all were evil, evil itself could not exist as it would be impossible in its own right; and if this all made no sense whatsoever and I'm an idiot then I'm sure you'll let me know ... haha

 

[zillafurby]

Originally posted by: glugglug

Originally posted by: zillafurby
also its never 100% clear that things are very overvalued, you just get the perception

Not only was this crystal clear during the previous dot-com bubble peak, it is still 100% clear right now (the bubble hasn't burst yet, it just had some air let out...). What is not so clear is when the perception of this fact that they are extremely overvalued will reach the critical mass it needs to begin the freefall.

The tricky part of playing the market is predicting perception, as this has far more effect on prices than reality. Ironically, the general public's stupidity makes the market harder to predict because it has kind of a randomizing effect on perception. (not really random, but can't think of a better term to describe it right now).

i agree predicting perception is th key to trading price acion. its hard. the easy way, and possibly the only long term successful one is to arbitrage the traders and anayasts when you know they are wrong and the numbers will give them a surprise. as you mentioned glugglug. personally i am a better and more comfortable fundamentas analyst so i stick to position trades more. i am looking at range trades on the indices though as well, since its a long term bull market, but i need more observational experience first.


markets are composed of price searchers with different skill, power, thoughts, attitudes, and time horizons.
i the late 90's two things happened value stocks got wiped out by a withdrawal of capital, and several hegde funds closed because of it, including the biggest of them, tiger management, they were long on dcf type value stocks.
second cash was pushed towards the gogo large caps, which bought firms with paper and loaded up with debt, and tmt got a bubble.
glug when you have high growth gdp, new tech, like the internet, new industries, then out of the legitimate players, its impossible to estimate the value of the stock with any accuracy, and in the late 90's you couldnt, until the growth bagan to stabilise that was 99 and 00.

in terms of the advertising and other dot coms, most didnt have legit business models, and rapidly their revenue stream looked uneconomic for their advertisers, so yes they were definitely overvalued, but the problem is when the overvaluation gets crystallised for your short.

interms of the legit businesses using logic you can suss out an overvaluation when its extreme, then you see the numbers flow through and the market perceive it and ultimately react to it. with say networkers, only when broadband didnt get the take up needed, did it look like everything was over for the m&t crowd, until then when you had facts it was largely a perception. of course when you see in fact and the market reacts, you look for stable and predictable companies with too much debt, that are going to zero, or if you like a bit of price tradibg then something smaller for a quick fall to zero or near.

but you need to distinguish between fact and peception, perception is when you dont have concrete info to go on, and in the late 90's you didnt, bylate 99 and early 2000 it was coming through thick and fast, for the legit stocks.

the candy floss stocks were pure momentum plays all along anyway.

Originally posted by: glugglug
Another prediction: AMD is about to go through the roof. The signficance of Dell beginning to sell AMD chips can not be overstated.

well it signified the commoditisation of the industry, and a stabilisation of the technology and the franchise value of the designs. of course intel still has a brand and will cut prices aggressively, to hurt amd on its r&d iinvestment, i would cut prices and costs to starve amd of cash. amd is still a momentum play in terms of the pc business, whether it has advantages of real long term value in 64-bit servers, is beyond me im afraid.

 

[Zenmervolt]

A couple of things:

It's not just "some" people who believe in the efficient market hypothesis (in the semi-strong form or wek form at least, no-one I know would argue that markets are strong-form efficient). Semi-strong form market efficiency is by far the dominant theory in any halfways decent university Finance department.

Malkiel's book does not simply recommend index funds and leave it at that. Malkiel recommends that both technical and fundamental analysis be used and that they be combined to pick a well-diversified portfolio. IIRC index funds are only recommended for those persons who either cannot or do not want to take the time to perform all that analysis.

Regarding beating the market, of course it can happen, but it doesn't happen consistantly. The top actively-managed funds (i.e. mutual funds that were not index funds but rather that were actively traded by their managers in attempts to beat the market) of the 1970's were the worst funds to have in the 1980's. In other words, if your fund beat the market in the 1970's, the chances are that it got destroyed in the 1980's. Similarly, the best actively managed funds of the 1980's were the worst funds of the 1990's. There is the infamous example of LTCM, this is a fund that had more than a 50% return in its first two years because of the fund's active strategy. Within 5 years the fund was hemorraging money and in 1998 it had to be "rescued" by the federal reserve board because the failure was so gigantic and the fund had so much money in it that the imminent collapse of the fund would have likely cause the collapse of several small markets.

ZV

 

[zillafurby]

Originally posted by: Zenmervolt
A couple of things:

It's not just "some" people who believe in the efficient market hypothesis (in the semi-strong form or wek form at least, no-one I know would argue that markets are strong-form efficient). Semi-strong form market efficiency is by far the dominant theory in any halfways decent university Finance department.


ZV

look zv, of course institutional funds cant beat the market. they own it, they are the market. they cant possibly beat it.
a few can - those that have esoteric strategies that run off liquity arbitrages, or discretional traders with a directional or semi-exotic approach, who can out-analyse their peers on average. there are plenty of rich investors in the forbes 400.

Originally posted by: Zenmervolt
There is the infamous example of LTCM, this is a fund that had more than a 50% return in its first two years because of the fund's active strategy. Within 5 years the fund was hemorraging money and in 1998 it had to be "rescued" by the federal reserve board because the failure was so gigantic and the fund had so much money in it that the imminent collapse of the fund would have likely cause the collapse of several small markets.

ZV

LTCM, have reformed as thet successful JWM Partnership, clearing 15% a year on about $1BN, after about 15% in profit fees and 2.5% in management fees, so around $60m a year for 40 or so partners.

LTCM made a compound return of 14% for 4 years for their original investors.
The core LTCM team made half of Saloman's profits in the late 80's, and remember buffet was a long term investor in Salomon then. They made $2.5bn for Salomon before tax in five years to the early 90's.

Goldman in London recently paid a $45m bonus to a single derivatives trader, who was probably doing a bond arb or vol arb prop-trading strategy. No one gets that through underperforming an absolute return benchmark.

I'd call that a legit strategy. They collapsed because they bet too much of their portfolio with too much leaverage on 2 strategies, bond spreads and index vol, they also diversified away from their core areas, unsucessfully. They then suffered a 7 Standard Deviation event across pretty much all their strategies, coupled by an exit of capital from their strategies, leaving a permanent loss of about 85%. LTCM's collapse was pure bad business management and nothing else, a better CEO would have seen it coming miles off. Loads of capital chasing their high returns piled into their strategies via competitors and prop-desks, mid/ end of economic cycle volatility, and entering areas of which they had little advantage, and which were already competetive.

Also it didnt put a few small markets at risk. It risked bankrupting a top-10 investment bank and interrupting the multi-trillion dollar OTC derivatives market.