Are Markets More or Less Efficient Now?
I came across an interview done by Bloomberg with David Einhorn where he claimed that traditional value investing was not working anymore because of the rise of passive investing and the decline in fundamental buy-side analysts looking to find mispriced securities. According to him, in the past, an undervalued company trading at 4x PE would rise to 8x rather quickly, but now the company tends to stay at a low multiple even when aggressively buying back shares.
On a separate note, a lot of value oriented hedge funds have shut down or seen huge loss in AUM. Baupost, which had quite good returns before, has seen major withdrawals and only returned 4% annualized since 2014, causing a $7B AUM loss in 3 years.
Right now, there is much more AUM in pod style funds, but do they actually correct market inefficiency? It seems they largely bet on short term catalysts or momentum trades which are often far removed from the company’s intrinsic value and can often exacerbate the inefficiency in some cases.
A wrong side of change business in a shrinking end market with essentially no moat blames their misfortune on supposedly temporary external factors. This kind of statement would be precisely what Einhorn has spent his career highlighting as delusional in short theses. The irony.
In these conversations, the word “inefficient” carries a moral tone. It’s something almost metaphysical because this is not something Einhorn can prove with observation. If we trust him, we trust him because we think he has good judgement — there is no “objective” way to prove what he is saying. (If an undervalued stock does not rise in valuation, were you just wrong it is undervalued or is it “inefficient?”)
We have to ask, “what is inefficient and how do we know?” If someone had been continually wrong for almost two decades in their promises to beat the market, do we really believe their judgment in assessing what is “inefficient”? If so why? He is claiming it is fair to pair him hundreds of millions of dollars, so the burden of proof is on Einhorn and not on the market.
I do agree that the market is less efficient than it was before though. The stock market is supposedly a cutthroat competition. But it clearly isn’t and the continued existence of firms like Greenlight and Baupost are perfect example of that. Metaphysical and non-falsifiable beliefs about market efficiency are part of why his business continues to exist. This is what is quite clearly “inefficient.” His performance track record is undeniably poor and with a very high t-statistic we can confirm it is worse than if he invested in these evil ETFs that he derides. I haven’t done the analysis myself but I suspect he would do worse than if he picked mostly randomly and masturbated most of the day. This is something you can actually confirm with a statistical test and yet we give him money. In other industries we would expect competition to cause him to fold but we don’t see this here. In this sense, yes, I do believe markets have become less efficient over time.
Based on the most helpful WSO content, the efficiency of markets today is a nuanced topic. While markets are relatively efficient, they are not entirely efficient. The rise of passive investing has indeed shifted the dynamics. Passive strategies, by design, do not engage in price discovery or fundamental analysis, which can lead to inefficiencies. As David Einhorn pointed out, the decline in fundamental buy-side analysts and the dominance of passive flows can result in undervalued companies staying at low multiples for extended periods, even with aggressive buybacks.
The shift in AUM from traditional value-oriented hedge funds to pod-style funds further complicates the picture. Pod-style funds, which focus on short-term catalysts and momentum trades, often prioritize short-term price movements over intrinsic value. This approach can sometimes exacerbate inefficiencies rather than correct them, as their strategies are not necessarily aligned with long-term fundamentals.
However, it's worth noting that inefficiencies created by passive investing and short-term trading strategies can present opportunities for active investors who are disciplined and focused on intrinsic value. As highlighted in WSO discussions, the coexistence of passive and active strategies is likely to persist, with active investors playing a critical role in maintaining some level of market efficiency.
Sources: https://www.wallstreetoasis.com/forums/the-only-post-about-active-investing-you-will-ever-need-to-read?customgpt=1, How Do Hedge Fund "Geniuses" Einhorn and Ackman Still Have Any AUM?, Focusing on Investment Style Fit, Focusing on Investment Style Fit, How Do Hedge Fund "Geniuses" Einhorn and Ackman Still Have Any AUM?
A wrong side of change business in a shrinking end market with essentially no moat blames their misfortune on supposedly temporary external factors. This kind of statement would be precisely what Einhorn has spent his career highlighting as delusional in short theses. The irony.
In these conversations, the word “inefficient” carries a moral tone. It’s something almost metaphysical because this is not something Einhorn can prove with observation. If we trust him, we trust him because we think he has good judgement — there is no “objective” way to prove what he is saying. (If an undervalued stock does not rise in valuation, were you just wrong it is undervalued or is it “inefficient?”)
We have to ask, “what is inefficient and how do we know?” If someone had been continually wrong for almost two decades in their promises to beat the market, do we really believe their judgment in assessing what is “inefficient”? If so why? He is claiming it is fair to pair him hundreds of millions of dollars, so the burden of proof is on Einhorn and not on the market.
I do agree that the market is less efficient than it was before though. The stock market is supposedly a cutthroat competition. But it clearly isn’t and the continued existence of firms like Greenlight and Baupost are perfect example of that. Metaphysical and non-falsifiable beliefs about market efficiency are part of why his business continues to exist. This is what is quite clearly “inefficient.” His performance track record is undeniably poor and with a very high t-statistic we can confirm it is worse than if he invested in these evil ETFs that he derides. I haven’t done the analysis myself but I suspect he would do worse than if he picked mostly randomly and played FIFA most of the day. This is something you can actually confirm with a statistical test and yet we give him money. In other industries we would expect competition to cause him to fold but we don’t see this here. In this sense, yes, I do believe markets have become less efficient over time.
I believe “efficiency” in this context refers to securities trading at close to the present value of their future cash flows. Do you really believe the market is efficient when companies like TSLA are trading at almost 200x PE? Even at a 10% discount rate, which seems low for a highly volatile company like TSLA, that would require 9% growth in earnings per year (assuming earnings can be used as a proxy for free cash flow) into perpetuity just to get 100x PE. Does that seem reasonable to you?
1) How can you know ex ante whether a company is trading for less than its future cash flows with certainty? You cannot know this ex ante and in fact the literature consistently demonstrates that Wall Street analysts have very limited forecasting ability past 2 years. For this reason, you cannot “prove” this type of efficiency has changed. You can perhaps assume this exists ex post but not ex ante which is what is required by Einhorn’s claim.
2) A DCF gives you the value of a security if you never sold it and nothing meaningfully changed between now and a very long time from now. It doesn’t tell you whatsoever what will happen in the interim - however you might assume others do this exercise too using the same conventions as you and therefore securities trade closer to this value in the interim. There is quite literally no reason why a security needs to trade close to your handwavy assumptions even if they were dutifully working on them instead of playing FIFA. What if other market participants no longer do this rain dance with you? Well in some sense. It is the “true” value that Mr. Market will bless you with if you are patient, hold it forever, and nothing changes - it doesn’t require anyone to do anything. But this requires nothing to change and for you to hold it forever. For goodness sake, you even count the cash flows in the interim even if they are reinvested and you don’t get the cash flows yourself (you might need quite a long time to pass for that to work!). The majority of a DCFs value is in the terminal value - a value that exists well beyond the continued existence of a hedge fund. Moreover this value is well beyond the period where you have any ability to forecast. If there is a 30% discount on your DCF and theoretically most of these present values are a decade away, maybe you were better off playing fifa then doing this exercise and getting a 3% mispricing that fixes itself each year (far less than any meaningful margin of error). Sure, in this Garden of Eden, unperturbed by these evil ETFs there were others doing this DCF rain dance and so perhaps you got paid earlier. But I think these ETF buyers actually aren’t crazy. Hedge funds generally destroy value and ETFs do better by not taking fees. ETFs quite literally do not care one iota what they are buying or at one price which is its own type of utterly stupid. But I don’t think it’s stupider than giving your money to someone like Einhorn to be frank.
Statistical test can be tough if it takes several years for a particular stock to be properly priced. As someone who has spent more than my fair share of time in statistical analysis, I'd actually have more faith in judging a bet based on the strength of the thesis. The bar is really high for that. I'd need to be clearly convinced on how a market full of intelligent and motivated observers misunderstood the future of the company/security.
First guess on why Greenlight and Baupost have struggled is over diversification. Not that the diversification is a direct cause, but it's evidence to me that there isn't a deep commitment to pushing a thesis far enough. Hard to be motivated to do that when the management fee alone (plus the high chance of some performance fee from pure randomness alone) allows you to have what you want . . enough money for many lifetimes and all the fun that comes with being a celebrity fund manager.
who cares. the point is to make money. follow the charts that are trending well and get off when they stop trending. efficient/inefficient is an irrelvant discussion
You seem like a very boring finance bro.
It's too early to gauge. Q1 is Accumulation of orders which is very evident. Gold is the commodity in a trending market.
Markets less "efficient" in the DCF sense but harder to make money in. Pods add a lot to efficiency and bid away much of the juice in long term opportunities, its the resurgence of retail post covid that's really distorted fair value in segments of the market.
I agree with everything that OP is saying/implying. Indexing and the "big data" movement caused prices to move in a way that has little to do with the true value of a stock.
I've seen two reactions to this:
1. People conclude that there's now even more opportunity in being a fundamental investor, because prices are more unmoored from fundamentals.
2. People conclude that the best strategy is to move away from fundamentals and try to instead develop an edge in the various other things that move prices (market structure, short term investor behavior, etc . . let's broadly call all of these things "market dynamics").
Both of these groups are right to some degree. But I'm mainly in camp #1. My issue with camp #2 is, over the long run its too easy for others to replicate whatever edge you might have in terms of understanding market dynamics. With #1 you can develop a deep understanding of qualitative factors in an industry and maintain that edge over all the others who are trying to make a quick buck and never really develop a deep edge.
Big problem with #1 now is AI, and TBH I live in fear that it will destroy the fundamental edge as easily as the market dynamics edge will be destroyed. If anyone wants to talk me off the ledge, feel free!
Tbh think edge had already vanished in #1. Why do you think there’s prop funds earning Medallion-like returns when classic value does worse than chance? Do you really think the quality vibes are that hard to understand by a computer?
Also, ask yourself this: when fundamental events happen, why do stocks move near instantly to a reasonably correct price? Have you met the person that causes this to happen? Do you really think it’s someone at a multi manager?
fundamental people still act like these are acts of God. I suspect it is top prop funds that do too well to ever want to take outside money. Whoever this mythical beast is: why can’t they also take your supposed “fundamental edge”?
Markets have gotten more efficient: A review of the Post-Earnings-Announcement Drift - ScienceDirect
Volatility is still real, however, and is what provides investment risk and opportunity in the near-term. The simplest way to explain it is that with greater efficiency, the slow diffusion of information speeds up (nearly instant), which causes terminal outcomes to be priced in very quickly. This makes the price very sensitive to the next incremental data point.
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Sounds like we have different definitions of what "efficiency" means and the role of volatility in returns. A shrinking PEAD window = greater efficiency today than vs. prior periods (e.g. 1970s). Are you really telling me that the market is less efficient today than it was in the 1950s, when things like earnings momentum and estimate revision anomaly were first being discussed?
FWIW, I don't think greater efficiency means less returns or lower sharpe for strategies. I also don't think that just because the market is "more efficient" than it was historically, that money can't be made. It's just different today and strategies have had to evolve.
If markets are more volatile, they should be less efficient. Volatility means market participants don't know what the fair price is. The real issue is that it only makes sense to talk of volatility or efficiency at a specific and well defined time scale. The market may be efficient at one time scale and very inefficient at another one.
In fact this time scale might not even be uniform. A lot of the microstructure papers say it's better to use volume as a unit of time instead of regular time and dividing quantities by that.
you're confusing two separate things in regard to efficiency:
1) how long it takes for information to be reflected in the price
2) what the error of informational positioning is to market outcomes
If today the price of a bet on tariffs is 100%, and tomorrow Trump tweets that it was a joke no tariffs, and the price of the Bet falls to 0%, were the prices at each period inefficient? Prices quickly reflect the information at time plus some measure of error.
Why does this matter?
Because it means that trading on information isn't an arb, it's a risk view where your variance is driven by your view of the probability distribution. If the markets were less efficient, then trading information would be an arb (risk-free), which I don't think you are arguing for.
You realize there are MULTIPLE different ways to test market "efficiency" right? Of course you wouldn't know that because you're impressed by grifting boomers like David Einhorn
Efficiency doesn't mean the market price is "correct" or "rational". It just means that *you* can't consistently do any better. Yes it's ridiculous that Gamestop spent months trading at 1000x earnings. But that's only "inefficient" if you can construct an arbitrage to profit from it. Melvin Capital tried that, they were "right" in the long term, but still went bankrupt. If you can't arbitrage a profit, then the price is efficient by definition.
And by that definition of efficiency -- yes, it is absolutely harder to consistently make money now than at any point in history. So markets are more efficient now than ever before.
What's funny about Gamestop is that Roaring Kitty's analysis of it having some deep value wasn't wrong - the reaction upwards though was profound and way, way more explosive than it should have been.
interesting view on efficiency
Market dynamics have shifted tremendously - there are still underpriced and overpriced stocks out there.
Those that are overpriced have a much tougher time being brought down because of the enormous amount of upward pressure they receive by being indexed. Those undervalued struggle because they don't get artificial demand by being included in those same indexes.
His complaint about buyside analysts trying to uncover undervalued stocks is kind of funny, because he basically wants people to source these ideas and pitch them to retail so they jump all-in while not receiving any carry for doing free marketing for his undervalued picks.
Einhorn has some great picks in his portfolio (GRBK) and is a savvy guy, but these old-time value guys have to accept and learn how to swim in and with the wake that the ETF cruiseliners leave.
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