Markets are efficient.....NOT

Happy Friday!

Professors in academia who have not traded a single stock in their lives teach the efficient market hypothesis like it is gospel. I am going to show you that it is not.

In fact markets are as efficient as my selection of women at bar close, or Hugh Hefners penis without Viagra.

For evidence please look at the entire dry bulk shipping industry. We have witnessed an entire bubble form and begin to collapse in nearly a week. All you need to look at the one week charts of DRYS, DCIX, DSX, NM, NMM, SBLK.

I understand that these are small caps and in many cases micro cap stocks with low floats. It is also nearly impossible for the smart money or institutions to profit off of these trades. We also have some positive drivers such as improvement in the Baltic Dry Index, and it is a Trump trade, but fundamentally the majority of these shippers are burning cash like Mike Tyson.

I would argue that the movement of these shippers even debunks weak form efficiency. If they were truly weak-form efficient, price movements of this degree would not occur. All past knowledge could not have possibly been priced in.

Instead, a high short float and a long period of neglect has let these stocks become vastly under-priced. As momentum in the industry finally turned positive, shorts rushed to cover causing a short squeeze. Then the momentum players came in driving these stocks up to the moon and now lower as they leave.

I think the market as a whole will only get less efficient over time as the shift to passive management continues. Active management creates market efficiency, and a shrinking industry should make price discovery slower long-term. I realize that these stocks are overlooked purely for size reasons, it is impossible for a fund to actually accumulate a sizable position without taking a major liquidity risk, but this example goes to show that areas of the market that are overlooked by active management can become highly inefficient. What happens to small and mid-caps as assets continue to flow out of active management long-term?

What do you guys think?

 

We can all have the same information but interpret it differently. One way to think about it is in Bayesian probability. New information affects our probabilistic judgements of the future differently because we use different prior probabilities colored by personal biases, but we can't all end up being correct.

 

3 things:

1) The EMH is not dichotomous. You shouldn't think of the EMH as markets are either efficient, or they are not efficient.

People who think EMH is dichotomous and thus misunderstand the EMH's teachings and its purpose (which is not to preach that markets are efficient, but rather just to propose a framework) tend to commit this fallacy: (this is not wrong, but it is incomplete and reflects a lack of nuance that is expected for smtg as complex as markets)

  • They point to the various anomalies where prices are wrong, most notably bubbles and crashes, and various anomalies such as momentum - then they take this as evidence that markets are inefficient. I will reconcile this in point 2)
  • They point to the various active managers who have undoubtedly beaten the market long term, such as Buffett and Simons, then they take this as evidence that markets are inefficient. However, this has already been reconciled in the efficient market literature - namely that these investors plausibly bore the factor risk premium which justified their higher expected returns

2) The fact that prices are often wrong (which is evidence of inefficiency), and the fact that active managers rarely can beat the market (which is evidence of efficiency) - has already been reconciled with the behavioural literature.

Firstly, mispricings happen due to behavioural biases. Various biases could cause these mispricings - over/underreaction, representativeness bias, conservatism bias, overconfidence, you name it.

Secondly, any 'easy' mispricing has been arbed away.

However, thirdly, there's some level of mispricing that cannot be arbed away due to limits to arbitrage (and this is a technical term here in the literature). This reconciles why many mispricings are in the market yet managers cannot take advantage of them. Limits to arbitrage can be caused by limits to arbitrage, or practical constraints. The example that you provided, that smart money cannot take advantage of the bubbles in the shippers, is just one good example of limits to arbitrage. Another good example is that PMs are often constrained by their dumb money LPs who prevent them from pursuing pure value or pure momentum strategies (better to fail conventionally than succeed unconventionally). Or it could be the standard case of macro arb risk (making big directional macro bets) being generally way higher than micro arb risk (standard arb between 2 assets) because there are less substitutes for macro assets and thus you can't hedge macro arb risk and make the trade market neutral. (That's why economists have said that markets are microefficient but macro-inefficient). In these cases, the risk of arbitrage is so high - that adjusting for risk, the arb is not worth it and thus the mispricings remain in the market.

3) 

I think the market as a whole will only get less efficient over time as the shift to passive management continues

Read up on the index fund tipping point. Basically it posits a range of how much % the market can index, in order for the market to remain efficient. Plenty of literature on this already.

All in all - we can debate and nitpick about how 'efficient' markets are, but the main takeaway remains - that markets are generally very efficient, there are many limits to arbitrage, there is no low hanging fruit, and retail investors should probably just assume that markets are efficient

 
Most Helpful

trying_my_best

3 things:

People who think EMH is dichotomous and thus misunderstand the EMH's teachings and its purpose (which is not to preach that markets are efficient, but rather just to propose a framework) tend to commit this fallacy: (this is not wrong, but it is incomplete and reflects a lack of nuance that is expected for smtg as complex as markets)

Keep in mind that EMH was developed in the 1960s during a time when fundamental analysis was very popular.  Lots of people made extraordinary returns with fundamental analysis.  Technical analysis was also popular in the 1960s but was never accepted in the academic community as anything other than voo doo finance (a quote from a former finance professor of mine).  When Fama was developing EMH, Malkiel was writing a Random Walk Down Wall Street while John Bogle launched the Vanguard funds.  Certainly Bogle and Malkiel thought was active investing was mostly a waste of time.  With Fama, it is difficult to say what he thought due to the weak form. 

Perhaps Fama included a weak form because he did not want professional investors to chastise him for discrediting their existence or may be he actually believed fundamental analysis could help you beat the market.  I am nearly 100% sure that when these concepts were developed in the 1960s and 1970s, they were not popular at all.  Of course, if we fast forward 50-60 years to today, it is obvious that these concepts lead to the popularity of passive investing.  Even Benjamin Graham changed his view on the active passive debate towards the end of his life.  

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