Efficient Market Hypothesis Does Not Make Logical Sense

We are going to take an extremely complicated subject and attempt to make it understandable to anyone. We will fail miserably at this given that it’s our first attempt at describing the idea. In this case we’re using the readership as our Guinea Pig so thank you for reading! Essentially, we are going to walk through from start to finish and explain how markets are not efficient along with how they are becoming more inefficient through the use of ETFs.

The Beginning

Efficient Market Hypothesis: In basic terms, the efficient market hypothesis states that it is not possible to outperform the stock market because “all share prices reflect all information”. This means as we sit here today, every single stock perfectly reflects the value of the underlying Company. Now if someone is an efficient market hypothesis believer we can look at both historical examples and current examples today to prove this is not the case.

Historical Example Internet Bust: We’ll start by looking into the past. During the Internet bust there was a Company called “Pets.com”, it is now infamous for being one of the biggest disasters in Internet IPO history. To keep it simple, the Company generated $619,000 in revenue (that is thousands of dollars not millions) yet the Company raised a total of $300 million dollars (yes million not thousands). More importantly, while the Company earned $619,000 per year in total sales it was also spending millions of dollars leading to a total cash flow burn in the millions. Please take a look at the photo below from the Pets.com IPO.

Untitled

To avoid deeper explanations, here are the basics… The line that says “Proceeds, before expenses, to Pets.com” is essentially how much money would be added to a checking account: $76 million dollars. Not only that… but the checking account already had $30 million dollars in the bank (see Balance Sheet Cash and Cash equivalents). Now the checking account has $106 million dollars which is shown in the Pro Forma as Adjusted column. This sounds great because if the Company is going to see that checking account go up in the future, the total value of the Company is well above $106 million. The problem? It’s losing millions of dollars… quickly.

Fast forward a little bit (a little bit over a year to be exact) and after losing tons of money there is practically no money left in the checking account. No problem… they will just go and ask for more money to put more cash into that checking account. Unfortunately? No one wants to put money into that checking account because they believe it will never actually go up in the future. Therefore, the Company goes under.

We’re not saying that you should never invest in a company that is losing money today. Far from it. We’re saying that the “Efficient Market” was unable to correctly value the future cash flows of Pets.com. On a small scale, if you created a website that lost $50 in the first month, it does not mean your website/idea is going to fail. The same applies to any large company that is currently losing money. If it can get to positive cash flows in a timely manner or raise funds easily, it will be around for a long time.

The Efficient Market hypothesis defenders will say “Hindsight is 20/20 it would be impossible to predict the failure of Pets.com if you were an investor at that time”. Well, that is what was said about the real estate pop… and a few geniuses *did* figure it out and made hundreds of millions of dollars in approximately one year. To emphasize this point, they did not “guess” they went directly to the source of information and found the underlying issue with the real estate market and made millions. While it is true that 99.99% of people could not figure out the underlying issue, saying that the top 0.01% could not is factually incorrect based on the data. While we will unlikely predict the next major crash or boom (would never claim such a thing) saying that 100% of people cannot do this? We’ll take the other side of the bet!

Fast Forward to Today

Assuming we’ve convinced you that markets are not 100% efficient, we’ll begin to tie this to the market today. If you’re still convinced that markets are 100% efficient we have no problems with it, we’ll simply agree to disagree. This will prevent the comments section from turning into a large scale debate. We’re being extremely careful with our wording using the phrase 100% which means every single stock and bond is currently priced correctly today to reflect all information. Not 99.99% but 100%.

Enter Index Funds and ETFs: We have long suggested that people dollar cost average into index funds. That is because over the long-term, we think the American Economy will continue to do better. This is not a new concept given that Warren Buffet himself has recommended this strategy. So if a recession happens and someone loses their money from an index fund… please send hate mail to Warren Buffet instead of a bunch of crazy people on a blog called “Wall Street Playboys”.

Back to the point. What exactly is an index fund or an ETF? An index fund/ETF is a vehicle that tracks the overall performance of a group of stocks. Using the S&P 500 as an example, if you invest into an ETF that tracks the S&P 500 you’re getting exposure to 500 different stocks. Remember, investing in the S&P 500 is not an investment in “America” it is specifically an investment in 500 of the largest stocks in the United States. If you wanted to invest in all American equities you’d have to buy somewhere around 4,000 different stocks and buy one share of each.

Now lets think about why this matters. If everyone decides to invest in nothing but index funds (take the case of 99%) it means that the market is inefficient. Why? Well if everyone buys the exact same stocks over and over again… no one is helping “correct” the market except for the 1%. Lets look at two basic examples using a smaller index fund.

In this index fund we’ll have four Companies (Pets.com, B, C, D). Since 99% of people have decided to become “cult like” passive investors all we are going to do is buy the exact same four companies forever. The people in the 1% sit and wait as more and more bids to buy keep coming in and eventually they capitulate and sell at an enormous valuation. The strategy is to simply click buy and forget about it so the passive investors don’t look at the performance of the companies. In short, there are millions of people hoping to buy 1 share of all four companies and eventually someone managing their own money decides to go ahead and sell it to them.

Pets

Pets.com suddenly loses a ton of money. And. The market did not recognize a change. Why? Since there are 99 buys coming in for every one sell, there is always a new person who is willing to buy this dying company (remember people are blindly throwing money into this fund). Put this together and you’ll see that while the stock price may function for a while… Does the current price reflect the true value of Pets.com? The answer of course is no. While Companies B, C and D may be solid companies, Pets.com is essentially obtaining money for free by issuing new shares to sell back to the market. As they burn more and more money, they just issue shares to the market to keep the balance sheet full of cash and go back to losing money hand over fist.

Now… lets move to a more applicable example since the one above is not realistic at all. There are approximately 2,000 ETFs in the market today (probably more). Lets call this index fund the “Candy Fund”. In this fund people get to invest in every single publicly traded company that makes candy (chocolate, taffy, gummy bears etc.).

candy

Everything is going well in the candy fund until chocolate company #1 goes bankrupt due to accounting fraud unrelated to the consumption of chocolate. Now the ETF is valued at $45 since Chocolate Company 1 no longer holds any value. But wait… Should chocolate Company #2 be worth $5? Lets assume there were only two places in the world to buy chocolate… In that case chocolate company 2 is probably worth $10.

The problem? It’s still sitting there at $5 and when you buy an index fund you’re equally buying each candy company. 

Now that everyone is thoroughly confused (we’re having a hard time putting this new concept into practice ourselves) lets think about what this all means in a few simple ways: 1) As more and more people invest in baskets of stocks, the underlying assets are receiving bids equally even if they deserve two bids instead of one. In the candy example, a smart person would happily pay $5 for the second chocolate Company. 2) In addition, as more people move to passive it also means that many companies are receiving bids that don’t deserve them. Pets.com is an example where there is a bid for an asset that shouldn’t be worth a cent and 3) Flipping this around, if someone panic sells the “candy fund” with billions of dollars, it will bring down the price of all candy companies even if one of them (say the company that makes mints) sees an increase in cash flow of 100%

Fast Forward to the Future (All Real World Items)

Currently, more and more money is flowing into passive investments (indexing). With our confusing examples listed above (hopefully it wasn’t that confusing) we can see that this will create market inefficiency. During the next downturn there should be a watershed of opportunities. As companies go bankrupt and other companies go public, there will be a large change in the securities held by each index fund.

We’ll go ahead and repeat that. Since there are around 2,000 ETFs today, many of these ETFs will hold the *incorrect* weight of stocks.

The second thing that will happen? We will see a lot of people become extremely rich. Why? Well… if more and more people are ignoring the entire stock market and believe they can never identify an opportunity… That by definition means there is more opportunity for YOU. If you are an expert in say real estate you’ll want to study every single publicly traded real estate ETF and Company. If you’re an expert in oil and gas you should spend a good amount of time studying oil and gas ETFs and the companies held by each ETF as well. As we move forward, if any particular ETF continues to go up in value that just means more and more opportunity for you during the next recession.

All of that said if you’re interested in learning more about making money, staying in shape and doing so without choking off your personality… You’ll probably like our upcoming book Efficiency. The benefits include:  1) How to get into the top 10% physically with 1 hour a day of exercise; 2) How to eat correctly to be in the top 10%; 3) How to figure out what type of intelligence you have; 4) How to use this type of intelligence to choose a career and the *right* company: Wall Street, Technology or Sales; 5) How to start an online business (the basics); 6) Clear outline of how to create and start an online product business with correct copywriting; 7) How to go into affiliate marketing if someone wants to take a stab at the competitive space; 8) Overview of how affiliate marketing operates and how to do it, 9) How to do all of this and maintain a normal social life (avoid choking off your personality). Efficiency will be available in July, subscribe to receive discounts or follow us on Twitter for the launch. Remember we can give the tools, but no one can execute on the plan but you.

Note: Since you’ve made it this far in the post we’ll explain how the pre-sale will work. All members subscribed to our email list will be given a link to purchase the product at a discount (for one day). The product will then be sent to you once it is officially launched (the following day). Have a great week and we’ll go back to our normal posting schedule (focusing back on the normal topics).

Comments

  1. Michael Medici says

    WSPs makes a great point about the inefficiencies in the market driven by ETFs and I think it goes even further than individual stocks.

    Over the last decade, ETFs have reached critical mass of adoption (Blackrock being the leading force in the space) based on the idea of being a simple and cheap way to mirror the market.

    From recent memory, the last new product catching on in this way was Mortgage Backed Securities, and we all know how that ended.

    Taking another step back in time, we reach another product that was supposed to improve markets, that I believe is a omen for the results ETFs could have in coming crash: Portfolio insurance.

    Essentially, portfolio insurance was meant as a CYA strategy used by some Hedge Funds (LTCM being the most well known) that resulted in reflexive selling by computers in the 1987 stock market crash.

    I see a similar result coming from ETFs. With global ETFs representing over $4tn in assets (quick google, probably more now) all meant to track a particular index, group of stocks, etc. what happens when those stocks see a significant decline in value?

    Answer: The ETF must track the performance of the index.

    How does the ETF track? Forced selling.

    It seems logical, that in the event of a major market sell off, ETFs will be forced sellers, driving the price of their constituent securities lower. As the price is driven lower by selling, more sellers need to exit positions as they hit stop losses. This selling again pushes prices down, resulting in more forced selling from ETFs which results in prices being pushed down and.. well you get the picture

    Basically, ETFs are a new financial structure that people still do not fully understand or appreciate the risks of that will play a significant role in increased volatility and magnitude of volatility in the (eventual) market crash.

    In conclusion, markets are as efficient as sell side research is useful.

      • John says

        I don’t understand it. Isn’t the point of index funds that they *hold* the stocks? So if the stock value falls, the index value should follow, without any turnover…

        Now, granted, ETFs are not normal index funds, as they’re exchange traded… but the ETF operators still hold the backing securities, which can be swapped for ETF shares by creation/redeemption.

      • Quantinatrix says

        John,

        I believe you are right. A selloff by ETFs would not be driven just by falling prices of stocks.

        But it would be indirectly driven by illiquidity that the shift to passive creates.
        Something like:
        1) A large portion of AUM is pulled out of some ETFs, say, for liquidity reasons.
        2) These ETFs have to sell shares of underlying stocks in the market to match the value of the portfolio to the value of ETF’s own shares.
        3) Since the market is increasingly passive, only few remaining active managers are willing to buy the stocks, hence they have have to be sold at a massive discount to incentivize buyers.
        4) Value of portfolios of other ETFs take a massive hit
        5) Panic selloff of ETF shares across the board
        6) The cycle repeats.

      • John says

        Right, but that has to do with the % of market in index (i.e. non-discretionary) funds, not specifically ETF. Noise/retail investors will redeem their fund shares during a dip, resulting in a positive feedback loop. Although I guess you could argue that ETFs amplify volatility with their greater liquidity.

  2. says

    Great points. It’s simply not logical.

    The problem with EMH is that it assumes everyone will react to new data in the same way. But this can’t be true.

    There are so many different opinions on what makes a company valuable. For example, a company grows 20% in earnings in a year. Every fund manager and individual investor will perceive this change differently depending on how they evaluate stocks.

    I’m excited for the opportunity this will bring for those who know how to evaluate the true worth of a company rather than what the market thinks.

  3. anon-pe says

    Great quote on this from Howard Marks – The Most Important Thing Illuminated

    “Isn’t that a $10 bill lying on the ground?” asks the student. “No, it can’t be a $10 bill,” answers the professor. “If it were, someone would have picked it up by now.”

  4. says

    Trying to understand this from a mathematical perpsective.

    Ok, ETH suggests that there is an economic equillibrium. Cool. The market is imperfectly competitive though, so nash’s theorem applies.
    Meaning that if everyone makes the most optimal decisions(per Contour’s hypothesis) and never change them, the system will remain unnaffected. That means that the system can predict the outcome **before** any decision or conflict is made. At least that’s what the theoreme suggests and it’s proved using Brouwer’s fixed point theorem.

    But the problem here is that Nash made a mathematical conjecture that is just internally consistent. Daskalakis proved that we can’t actually create a relevant algorithm that will reflect the market properly(or any system for that matter).

    Can anyone see my point? ETF track companies that are stacked together. The equillibrium may exist and it’s a zero-sum game when looking from the outside, but the internal behaviour of the companies is not the same. Look at P/E ratios!

    P.S: Damn, do i even make sense?

    • Jason says

      Don’t know the theories but the conclusion is simple enough to understand!

      Unfortunately most (if not all) economic theories that attempt to mathematically predict efficient markets always create base assumptions that are beyond ridiculous. Assuming perfect knowledge, rational decisions, assumes singular goals for consumers and companies etc.

      • says

        Yeah. Game theory pretty much tries and push the limits of predicting any given system where there is competition. Artificial intelligence will push the envelope even harder. Most people are discussing how automation will replace humans. I don’t care about that. It’s actually far fetched given the current technology. We fail to see what is happening right now and will keep happening: Massive data and faster and faster computers. In some years, companies will know excactly what to sell, where,when ,how much, for how long etc.

        Markets and economy will be automated. Whatever edge(creativity,intelligence etc) people have will be worthless againist these machines. But that’s another discussion tbh.

  5. says

    Excellent post WSPs. Excellent commentary from Michael Medici.

    One of the arguments in favor of the ETF is the inability of the amateur investor to hit the benchmark index. Basically, Vanguard and Blackrock feature numerous surveys that the amateur investor (and even numerous professional-managed funds) can not beat benchmark.

    Experience tells me that these data are likely to be correct. It really is hard to beat benchmark. But a few points should be highlighted. The percentage of each asset (company) that compose an index is realized (in most cases) by a committee. So if Apple occupies X% and Microsoft occupies Y% is because a committee has decided. And committees are made up of humans. And humans have biases and all the problems that Daniel Kahneman has already addressed in his work on psychology in the market.

    Well, in its essence (in DNA I would say) of an ETF, we have choices made by humans. This is still a mode of stock picking. Different – with less administration costs than Hedge Funds – but it is still a stock picking.

    Regarding the risk of the cascade sales effect, my opinion is the same as the WSPs and Michael Medici. I believe most investors are unaware of this risk, just as they did not have when they bought those junk in 2005, 2006,2007, 2008. We’re witnessing a repeated story with a different outfit.

    What is unanimous is the opportunity that this can occur. However, every time a stock market crisis arrives, average investors sell everything and never follow the recommendations of buying rather than selling. And I’m sure that when the price of ETFs plummet, investors will not do otherwise.

  6. V says

    Great post,

    I wonder if those who follow EMH doctrine realize what an information food chain is and if they do, realize where they reside on it.

  7. Joey says

    To see the EMH, consider what would happen to traffic if everybody know exactly which lanes were the fastest. People would move into those lanes, slowing them down, until those lanes were no longer faster. Unfortunately, certain lanes are often faster precisely because many drivers do not have access to this information, or do not act on it.

  8. OP says

    I can only join David Harding of Winton and ask:

    Efficient market theory – when will it die?

    ”The trouble is that EMT itself is a kind of madness, or at least the wholesale adoption of it is. This theory of rational markets treats economics like a physical science – like Newtonian physics – when in fact it is a human or social science. Human beings are prone to unpredictable behaviour, to over-reaction or slumbering inaction, to mania and panic. The markets that reflect this behaviour do not assume some supra-human wisdom, they can and sometimes do reflect that volatility.

    It is all there in the history of finance, in the bull and bear markets, the 17th century tulip mania which saw a single bulb sold for the same value as 12 hectares of land. Was this the right price? Then there were the sudden, inexplicable plunges of 1973-74, when stocks lost almost half their value, or the day in 1987 when the Dow fell nearly 23 per cent in a day.”

    Extract from David’s view Feb 2nd 2016.

    If you want a real time example, look at the prices of palladium. According to Efficient Market Theory, futures prices for physical commodities should not deviate too much from the cost of carry (price curve in contango – slope up to the right). The whole curve is now inverted. You can sell Sep 2017-buy Dec 2017 and make a nice profit. This is a real spread market you can trade btw.

    Another myth you can look at is the Markowitz portfolio theory. Everyone misses the fact that is assumes that investment returns follow a standard deviation path. How many times has the 6 sigma event occurred…? It is about skewness and controlling negative skew in real life.

    I have made my money trading the other side of these theories. So have many others.

    Is your finance professor rich? Didn’t think so.

  9. Pork N Beans says

    If markets aren’t efficient, guess we better regulate everything!!!!

    But seriously, if markets are thought to be inefficient that invites unwanted government intervention.

  10. Max says

    Your goal was to take a complex subject and make it understandable – mission accomplished!

    A useful and informative article.

  11. Quantinatrix says

    First time I heard the EMH in an undergrad course it sounded like a bunch of baloney.

    Even disregarding the (quite real) practical limits to arbitrage, I think it should be clear from everyday observations that speed and accuracy of data processing varies quite a bit from one human to another. How then can everyone, given the same data, converge on a single opinion w.r.t. the value of a stock?

  12. TechSales says

    I’m in sales but studied engineering in school. I kind of miss super intelligent posts like this that are more akin to research papers.

  13. AC says

    If I understand this correctly, the bottom line is that the markets are irrational and when the correction happens everyone will be selling when they shouldn’t (as always)?

    If yes, I don’t get what the big deal is, maybe because I don’t come from a finance background, but I think this has been made crystal clear by previous posts, no?

  14. Michael Medici says

    Felt like adding some additional comments in regards to real market inefficiencies I’ve seen first hand in my (relatively short) time on the buyside

    1. Industry/Product Knowledge – As WSPs mentioned, if you know an industry (Healthcare, O&G etc) or product (MBS, Binary options) better than everyone else, you will have a distinct advantage. I work at an industry specific fund, and when talking to investors at larger firms (generalist funds, mutual funds) it is *very* clear they do not know the industry and are touristing for one reason or another. This results in mispricings and asymmetric opportunities for experts like us. Also, funds that cover broad swaths of the market often simply don’t have the time to really get close to a company and understand all the intricacies driving the price because they have so many things to look at. Again, their loss is our gain.

    2. Need to put Capital to Work – There is *a lot* of money floating around and even more pressure to put the money somewhere. Big AMs like Fidelity, Blackrock and larger HFs are often forced to invest in situations they know aren’t that great simply because it is their job to invest in a sector or product (HY bond funds for instance). In addition to that, these funds have so much money invested that once they get in it is very difficult for them to completely get out of a position because selling will result in them pushing the price of the security down. Both the need to hold and the selling can result in opportunities.

    3. Access to Management – Some people have better relationships with management teams than others. Obviously a PM at Point72 or Citadel is gonna get whoever they want on the phone, but if you’ve been around a long time you can be very close with executives which allows you the opportunity to ask questions and get insight that others may not have. *This is not insider information* it’s having a deeper understanding of key aspects of the business and how management thinks about things (even from their body language) that, when combined w/ your own work, allow you to make more well informed decisions. You can google Mosaic Theory if that doesn’t make sense.

    Sure there’s quite a few more, but those are some of the more obvious ones that immediately come to mind.

    Keep up the great work WSPs, been reading for years and love the direction you guys are going.

  15. Alex says

    Huge fan of the blog but this is not how you challenge a theory – this is how you strawman one. Three major problems with your analysis:

    1) No mention of strong, semi-strong and weak versions of the EMH
    2) No mention of EMH assumptions (homogeneous expectations, no friction costs, investors are rational, etc.)
    3) No mention of how EMH differs by asset class or geography

    Logically, either the premises are invalid or the premises do not lead to the conclusion. Anyone can see some of the assumptions are patently ridiculous – this is where you can raise legitimate doubts. Many academics have challenged these assumptions, and that’s where you have the weaker versions of EMH or no EMH at all.

    That being said, I think your examples correctly reflect the invalid assumptions on which EMH is predicated (one could even argue all of them) – this circuitously accomplishes the same as a more logically-driven analysis.

    Unfortunately there seems to be more bandwagon agreement in these comments than critical evaluation – ironic given this blog!

    • Wall Street Playboys says

      It’s pretty simple etf’s make markets significantly more inefficient.

      People are essentially putting in bids for no reason in a systematic way. It works at low percentages… watch out in the future though!

      No problem with your comment

    • Belgian BG says

      Disclaimer: I’m a big finance noob and have never followed more than a basic economics class (but I did see the EMH), so please correct me if I’m wrong!

      From my mathematical mindframe you only need one counterproof to disarm an entire theory, which WSPs did. So for me once a counterproof is given, a theory is pretty worthless. So why is it that in economics people do see value in a flawed theory? Especially if it’s so easy to see the flaws.

      Imagine NASA launching rockets with flawed version of Newton’s laws, it wouldn’t work. And NASA wouldn’t even exist.

      Anyways for me the value of this post doesn’t lie in the academical destruction of a theory, you should read a thesises if you’re interested in that. The value of this post lies in the relevant and modern example given.

      @WSPs
      Thanks for the post, was an interesting read.

  16. P says

    Passive investing is the MGTOW of financial analysis.

    Viable with discipline, yet antisocial and unattractive.

    • Thomas says

      What? Passive investing with ETFs is the “blue pill” of investing … It’s so mainstream as it’s about sticking with a new program of “buy and hold forever…oh and Warren Buffett says so!”

  17. Nick says

    1. The problem with ETFs is that since their growth in popularity we have not seen more than a 15-20% pullback. So there is conditioning to always buy the dip. One day when a bear market becomes a thing again, the truth will be out for all to see how these can/won’t be structured to handle downside. I trust my money with Hillary Clinton more than these here.

    2. If anyone thinks markets are efficient, they have truly never observed market behavior. They are be too stupid to realize that at the end of the day, it is the human emotions of fear and greed that determine supply and demand. Explain gap up or downs after earning reports. Or Nvidia tripling in a year. “But..but..it’s overbought!”

    This link is fun: Unprofitable Companies Outperform Profitable Companies for the Last 15 Years http://www.dark-bid.com/backwards-capitalism-unprofitable-companies-outperforming.html

    Explain that one, person who studies old financial statements.

  18. 1 says

    If you’re not a bonafide expert in any sector, doesn’t it make sense to realize you’re not in the top 0.01% of investors who can beat the market consistently? (Actually beat it, not fooled-by-randomness appear to outperform in the short term)

    I’m heavy in passive ETF investments and I realize at some point my portfolio will tank 10-30% in a year. I’m cool with that as long as it’s worth significantly more the day I sell than the day I buy. (Intra-day, month, year losses and fluctuations are somewhat irrelevant if you hold 10+ years). At this point they’ve already increased enough where I have a pretty large buffer for losses (I would have to get somewhat unlucky to have a net loss).

    In the meantime I just try to make more money than I spend. Is this a reasonable strategy to you guys?

  19. says

    That was a pretty cool method of explaining the flaws behind EMH.

    Have you read the Adaptive Markets Hypothesis?

    https://www.amazon.com/Adaptive-Markets-Financial-Evolution-Thought/dp/0691135142

    The author theorizes that the financial market is more like biology than physics), where people adapt(or die trying), and inefficiencies are magnified under changing conditions.

    disclaimer: I’m not the author or anything. Just read the book a month ago. If you think I’m stupid or this appears like a book pump or something, just delete this comment.

  20. ReasonFromFirstPrinciples says

    … “The way to make money is to buy when blood is running in the streets.” … ” ***IF*** you can keep your head when all about you are losing theirs” …

    As a wise man once said … “Fear Drives Demand.”

    My favorite question: What is there to fear when it is a near certainty that I will die within the next century? …

    My answer: “When I came to die, discover that I had not lived”

    I love this ***silly*** game.

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