EMH and the Fed, Part 1

The Efficient Market Hypothesis

If someone is going to offer you investing advice (for free or for a price) they are implicitly taking a stance on the Efficient Market Hypothesis (EMH), those suggesting individual actions are taking the con stance and those suggesting low fee mutual funds the pro. Either way it is interesting that so few people argue for or against it with so many financial advisors out there, this is my stance.

The EMH basically states that you can’t consistently outperform the market because any information that would lead you to a better than average decision is going to be incorporated into the price quickly (how quickly and what type of information? Well that is why there are different versions of the EMH). To make a big leap here the fewer people believe in the EMH the more likely it is to be true, and vice versa. To explain a little bit, information only changes prices when individual owners shift their behaviors in response. If Tesla announced that they had produced and sold twice as many cars as they had expected in a quarter you will see people who were thinking of selling pulling their shares off the market, shorts covering their positions and people who doubted Tesla’s long term situation convert and try to buy stock. These are the actions that shift the stock price in the wake of the news.

Imagine a world filled with passive investors, chunks of paychecks are automatically routed to funds to buy shares based on a predetermined algorithm, where no one picked up the phone or logged into their online broker when they read the news, content to sit back and collect dividend payouts from companies. What happens in this world is that stock prices rarely, if ever, move, and the market would be as easy to beat as you could hope for*. Contrast that to a world where every person is scouring source material, reading perspectives, following announcements and building models, this is a world in which gaining an edge is enormously difficult. Why would you even bother trying to beat the market in such a world? Why not just accept average returns and save all the aggravation?

Or to put it another way people who don’t believe in an efficient market are the ones creating the efficient market.

This concept doesn’t apply just to stock markets, a few months ago David Henderson had a post that touched on a related idea where he says “But now consider what happens if people expect, with higher oil prices now, that there will be more production a few years later. Why a few years? Time to drill, time to explore, time to discover. So futures prices a few years hence fall.”

If you take his thought one step further you get to the idea that high oil prices now will cause people to invest in drilling and exploration and lead to lower prices in the future. I really like this example because you can completely bake your noodle imagining causal chains, where noticing that oil production is going to be insufficient in the future causes you to buy futures contracts, which drives the future price up, which causes people to horde oil to sell at that higher price which causes a shortage today. Or buying those contracts pushes up the price, which encourages more marginal exploration and investment which leads to an increased supply and prevents the shortage.

This is the world of markets, where discovering a truth can change it into a falsehood.

Or take Warren Buffett, the richer, more successful and more well known he became the more people picked up copies of “The Intelligent Investor” and tried to apply it’s methods and logic. Naturally those investors are functionally competing with each other, driving up the values of the stocks that are considered undervalued and reducing returns. Rather than turning 1,000 people into the next Warren Buffett the popularity of value investing will prevent the next Warren Buffett from arising in that space.

This is the world of markets, where past performance doesn’t indicate future performance.

This is my view of the EMH in action, it is not that there is no move you can figure out that will beat the market but that figuring it out is the action that will close that window. How quickly the window closes depends on how efficient the market is and how many people noticed it, which is obvious. What is less obvious is that a window can remain open if there is an entity that isn’t profit oriented or capital constrained functionally keeping it open.



*Or perhaps impossible, as every buyer needs a seller.