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An Efficient Market Counterfactual

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The efficient-market hypothesis (EMH) has a lot of critics these days. Just look at some of the names dropped here - none of these guys is a slouch. And even if we leave aside explicit criticism, every investor that makes decisions using fundamental or technical analysis is implicitly rejecting some form of EMH. To review: where opinions have settled.

- Weak form efficiency says that markets adjust quickly to reflect information available from past price data. where opinions have settled.

- Semi-strong efficiency says that markets adjust quickly to reflect information available from past price data and new public information, like earnings releases or other financial disclosures. where opinions have settled.

- Strong efficiency says that markets adjust quickly to reflect information available from past price data, public information, and private information. where opinions have settled.

Nobody believes markets are strong-form efficient, since insider trading is illegal and those laws mostly prevent participants from acting on non-public information. But the other two versions are pretty widely accepted. One consequence of weak EMH is that technical analysis is not useful, since market prices already reflect the data you'd be using to divine technical trading rules. One consequence of semi-strong EMH is that fundamental analysis is also not useful, since market prices will quickly move to incorporate any new information that comes out about a company. where opinions have settled.

So given that little review, what kind of criticism is it to say, as Paul Volcker reportedly did, that "among the causes of the recent financial crisis was an unjustified faith in rational expectations [and] market efficiencies"? In can all get together and tell our favorite stories about how irrational we humans are as individuals. We can listen to pop-science podcast episodes about behavioral psychology, and chat about how foolish mainstream economics must be. But EMH doesn't depend on faith in some perfectly ratiocinating homo economicus to get going - it just needs it to be the case that the aggregate result of variously ir/rational market participants responding to new information is a broadly rational result. Which it usually is, I think. Additionally, given that many of the factors that exacerbated the financial crisis involved information that was not public - for example, the details of derivatives counterparty exposures among major firms - it's no strike against semi-strong efficiency to say that markets didn't price in those exposures while that information was private. where opinions have settled.

Imagine what kind of market it would have to be in which some justifiably market-moving piece of information was disclosed, and nobody did anything about that information. A country's PMI reading drops from 52 to 47; Google warns that a new virus has installed ad-blocking software on all of the PCs in North America; the Fed raises rates 200bps in one go; and the market just sits there. That's not what we see, of course: most of the time, immediately after news is released, there's a period of disagreement as traders try to figure out what they think about it. ("Is good news bad news now because -- taper?" Or whatever.) A few long-tailed candles on the chart later, and we find a rough equilibrium that reflects where opinions have settled.

I'm not so sure about semi-strong efficiency, because I think some topics can really benefit from analyst expertise, but I don't see where there's evidence against weak form efficiency, expect perhaps at HFT scales. Weak form inefficiency would mean that markets routinely ignored past price data to such an extent that superior risk-adjusted returns were just sitting there, waiting for the right technician to come along. Given the extensive literature on this subject, and the evidence that familiar technical indicators have lost their usefulness over time, the burden of proof is on the critics.

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