Are Share, Currency Markets Efficient - Are Share Price Moves Irrational?
An efficient market is one in which the players in the market are smart and perceptive enough to correctly price securities all the time, based on the wealth of information now available, especially now with the Internet. It follows that there are no surprises.
There are no real stocks that are undervalued since in an efficient market their price at any given time will equate to their intrinsic value.
However, some claim that there are flaws in this model believing that there is good evidence that the market overreacts for short periods of time leading to periodic inefficiencies.
If the market is efficient, then the fluctuations in prices must be essentially random driven by external influences rather than trading itself.
Also it means that new fluctuations in prices will be unpredictable.
If you are an investor and the market is efficient, there is no point trying to find gaps in responses, or opportunities that the market was slow to react to or did not know about.
The market will in a sense be always up to date and perhaps one or two steps ahead of you as a small investor.
Better to invest in broad trends and the reactions to random fluctuations.
This is the classic trend following strategy that many investors adopt, some without realising it.
Double Headed Beast
One interesting aspect of this debate is the irony in the observation that two of the 2013 Nobel prize winners in Economic have broadly opposing views
► Eugene Fama's research has showing that the market is efficient
► Robert Shiller's research has shown that the market is inefficient.
Both have made contributed to the development of economics.
While it is reasonable to say the market is considerably efficient most of the time there are many examples of flaws leading to 'Bubbles' and spikes. There are plenty of examples where the market appears to have overreacted to new information in a negative or positive way. Spikes and short term troughs are good examples of this. These short term changes are evidence that the efficiency is not perfect. But it is hard for a small investor to know how to interpret what is happening and to take advantage of opportunities.
The notion of markets being efficient began way back in 1900 when Louis Bachelier proposed that the price of government bonds was in fact random and the trends were unpredictable. The simple logic was that if a share or a bond was likely to have a higher price next week, then the price should already gone up in anticipation of that. All the predictable moves should have already happened, because the market is knowledgeable and efficient with no scope for surprises bases on ignorance, even before the age of the Internet and Instant News. All that was left was unpredictable surprises that were essentially random.
Eugene Fama undertook research that concluded that stock markets are indeed efficient. He has suggested that even though there are spikes and minor slip-ups, the smaller investor should recognise that the market will always be one clear step ahead of you. Investors should therefore act as though the markets are efficient, and that nothing is therefore underpriced because the market has not caught-up or responded to their forecasts of what will happen.
Robert Shiller on the other hand, has a different view. His statistical studies suggested that the volatility seen in the markets is too high to support the hypothesis that markets are efficient. He suggested that markets tend to overreact to information and to overshoot in terms of the appropriate responses. In essence he was saying that the markets are not perfectly efficient all the time. Irrational exuberance may lead to irrational trends. This may be a case of human nature as many people like to see a boom continue, and don't want to recognise a bust.
Eugene Fama believes that the slip-ups are rare events such as the boom and bust in technology stocks in the late 1990s. The market was not irrational it was simply wrong, in hindsight about the prospects of companies.
Time for investors to adjust their strategies for an Efficient Market.
© 2013 Dr. John Anderson