The Astonishingly Inefficient Market

One of the themes we keep coming back to is the so called efficient market hypothesis. We simply don’t buy into the near religous belief that markets are perfect, omniscient processors of information.

Instead, we find markets are eventually, mostly, kinda efficient. They very often miss what in hindsight is obvious. Its why prediction markets’ value are often limited.

Today’s example comes from a NYT article about ENRON, the biggest ever corporate bankruptcy in the United States.

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click for enormo graphic

26enron_graphic_lg

graphic courtesy of NYT (for an even more enormous graph, click here)

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Where, pray tell, is the efficiency there? The information that Enron was giant fraud was out, and yet the stock took over a year to collapse.

Efficient? P’shaw . . . 

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Source:
Big Test Looms for Prosecutors at Enron Trial
KURT EICHENWALD
NYT, January 26, 2006
http://www.nytimes.com/2006/01/26/business/businessspecial3/26enron.html

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What's been said:

Discussions found on the web:
  1. Fred commented on Jan 27

    A ship the size of the Titanic takes hours to sink. There is time to make other plans.

  2. royce commented on Jan 27

    You’re not being fair to the efficient market theory here. The idea behind the theory is that the market as a collective entity more efficiently processes available information, over time, than most of the individuals who make it up. That doesn’t mean whatever the market says will happen will happen, or that the market’s view will be superior to the view of every participant. The market is always going to have some people who are right more than other participants- the problem is selecting which participants are right BEFORE events prove them correct. If you go with the market, you generally do better than most other participants over the long term in predicting the future, but that’s different than saying that the market is always correct about what the future holds.

  3. jm commented on Jan 27

    A market is a feedback control system. Engineers know well that feedback control systems work properly only when the feedback signals are both prompt and accurate.

    One basic dictum is: You can’t control what you can’t measure. Fraud not only prevents accurate measurement, it produces feedback signals that are actively falsified. So of course the feedback control system doesn’t work right.

    In the case of real estate markets, even in the absence of fraud, there is the fundamental problem that the feedback is not prompt — there is “dead time” in the loop. In industrial control, loops with pure dead times are handled very carefully, because if improperly tuned, they never stabilize, but rather oscillate between “boom and bust” states.

  4. Simon commented on Jan 27

    Continuing the control theory post by Jm, efficient control also requires the free flow of information, something that does not happen easily in many markets.

    The boom bust cycles are generally the result of positive feedback loops that push the system (market in this case) outside of the area of system stability which then causes the bust. In Australia the housing bubble has been created by two legislative policies: Negative Gearing and Discounted Capital Gains. These two policies are each a positive feedback loop.

    Efficent markets also rely on rational agents. Unfortunetly, rational agents don’t exist (humans aren’t rational). The other interesting thought is that the computer-based trading systems probably lengthen the downward trend.

  5. Ajay Shah commented on Jan 27

    Looking back always gives you 20-20 hindsight.

    With the benefit of hindsight, it seems `obvious’ (say)
    that the USSR was fundamentally broken and collapse
    would come. But not one important scholar on the USSR
    felt this way until 1989.

    I think it’s absolutely fascinating how close speculative
    prices are to martingales. Yes, there are deviations. But
    what is fascinating – and what’s “the efficient market” –
    is the extent to which E(p_{t+1}) = p_t works well.

  6. B commented on Jan 27

    Any market is based on fear and greed. The most repeatable of human emotions.

    Are humans efficient processors of information? Were the markets efficient when Sun was trading at 150 or whatever it was in 2000? Were Sun employees efficient thinkers when they were planning their retirement based on their stock options at a PE of 300? When the S&P PE was 42 and the historical average is 12 or whatever it is? Was Enron’s price based on efficiency? Forget about the crimes. Was the rise based on efficiency or greed. I’m being left behind. I need to buy or I’ll miss the run. What about 1929? Was the market efficient then? What about the Nikkei in 1990? Is the market efficient when people are leveraging everything they own to buy three or four houses to flip? How about oil at $10 a barrel a few years ago that now trades for $70? Has the world totally changed in a few years?

    Or how about Stalin, Pol Pot, Hitler, Idi Amin, etc. Were they efficient processors? Or was the world efficient in its lack of response? The markets are extremely inefficient.

    Comments? Debate?

  7. Anonymous commented on Jan 27

    I think you can say that over the long term, markets are efficient, but that in the short term, they can be grossly inefficient.

  8. Now This Is a Soap Box commented on Jan 27

    Handle With Care

    I think Barrys post, while on point, misses the forest for the trees for 99% of investors (I appreciate the fact that Barry has a large pro readership).  Sure, there is a lot of talk, academic research and otherwise, that refutes …

  9. alan commented on Jan 27

    And….., in the long run, gentlemen, we’re all dead!

  10. David Silb commented on Jan 27

    Hey-hey!! Whoa! Whoa!

    I thought Myron Scholes and Fischer Black commonly referred to as the comedy team of Black-scholes model

    Remembe this joke it was a goody:

    “In 1993, Scholes and Merton joined forces with John Meriweather, the legendary bond trader of Salomon Brothers. With 13 other partners, they launched a new hedge fund, Long Term Capital Management, which promised to use mathematical models to make investors tremendous amounts of money. Their money machines reaped fantastic profits, until their theories collided with reality, and sent the company spiraling out of control. The crisis threatened to bring markets around the world to the brink of collapse.”

    Ahhh… That Reality what a comedian!

    Markets are better than say soothsaying. But lets not confuse the saying; “markets are efficient” with “market are the only efficient way.”

    They are better by far but not perfect at all.

  11. JWC commented on Jan 27

    Efficient Markets??? Today the GDP numbers were terrible, the news was an unexpected win by Hamas meaning a very likely increase in tensions in that part of the world and the markets responded by a rally. I will never understand this stuff. That is why our equities are in low cost index funds and we have about 75% of the rest of it in safe bond funds. (Well that is partly due the fact we are retired.) Before the problems in 2000 we had a 30/70 mix. If by chance, our equities should get better I will certainly pull some out and move it to safety.

    We are just a little guy in the world of finance, two middle class people who worked hard at fair to middling jobs but lived below our means, saved, and were able to retire at a young age. I come to this blog because I want to be informed and Barry writes in a manner that someone like me can understand.

  12. Eric A. commented on Jan 27

    If you’re a seller and want to argue that prices are reasonable when they’re actually high, you might start talking about how efficient the market is.

    Same if you’re a buyer and want to convince yourself you made the right decision…

  13. Abe commented on Jan 27

    Look, efficient doesn’t mean “magical.” EMH or EMT is more of a paradox — the more you find fault with it the better it becomes.

  14. trader75 commented on Jan 28

    “EMH or EMT is more of a paradox — the more you find fault with it the better it becomes.”

    Yes, and as Lee Thomas of Pimco has noted, the perception of perfect market efficiency actually leads to markets becoming inefficient.

    The fewer participants out there who are actually making decisions, the more the market becomes a giant trend amplifier driven by brainless allocation decisions. This is especially evident in index funds oriented to market cap, whereby the biggest companies grow bigger through sheer inertia in an idiotically self-sustaining cycle.

    As you point out by accident, believers in EMH / EMT actually do the theory a disservice by spreading it as gospel… an investing world where NO ONE believed in EMH / EMT would paradoxically be a far more efficient one.

    In a world driven by EMT you also have more concentrated volatility, i.e. long periods of stability that save up the volatility for lump consumption all at once, with passive investors acting like lemmings right up to the point where they drive themselves over a cliff.

    In contrast, a world without EMT would see bulls and bears in far more proportionate numbers, lessening the frequency and duration of 87 crash type events. But of course, in such a world it would be much harder for your average commission hungry wall street firm to sling a line of sweet sounding bullshit, hence the lopsidedness continues.

    A further irony is that skilled traders and investors are better off cynically promoting EMH / EMT, as the prevalence of financial dogma increases the number of sheep on autopilot who do little more than magnify existing trends and take a fryinig pan to the face when they end.

    EMH is dead, long live EMH.

  15. piotr commented on Jan 28

    I should say: “It took less than a year for the market to fully appreciate the scope of Enron debacle”. By the way of contrast, some would claim even now that we are winning in Iraq, while for more than a year we merely pretend to be in control. Traders are much more efficient than the political and military leadership.

    Back when the Enron’s first bad news were revealed, it was something like 2 billion dollars earning correction compared to 70 billion dollars market capitalization. On top of that, naifs like me were convinced that Enron just finished a long season of raping and pillaging all over California, with presumed billions of dollars in loot. One would expect that under such circumstanced the company would have at least some assets!

    Moreover, the bussiness model of Enron was rather novel and difficult to evaluate. To wit, you spend enourmous amount of money and energy to cultivate and bribe politicians so they will change regulation so that some utterly unprofitable lines of bussiness become legal so you can convince the public that you have just opened gates of corporate paradise so the value of your stock will be driven to stratosphere so you can make your accounting totally opaque and the public would believe that you are hiding obscene profits, rather than the total lack of them etc.

    Enron is to mundane corporate swindle what Mozart is to Czerny.

  16. dsquared commented on Jan 30

    Fisher Black used to claim that he regarded the market as “efficient” if it priced assets at between 50% and 200% of their true value. To which all one can really reply is “thanks a freaking bunch, Fisher”.

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