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Not So Efficient

Adam M. Grossman

THE STOCK MARKET’S recent wrenching price swings offer a valuable investment lesson. Let’s start by reviewing the facts:

  • On the day after Thanksgiving, the S&P 500 suffered its worst day in months and the Dow had its worst day in more than a year. The proximate cause: news about Omicron, a new coronavirus variant. Overnight, investors seemed to revive their playbook from the early 2020 recession. Airline stocks dropped precipitously. Oil plunged 13%. Meanwhile, bond prices rose, along with the stocks of vaccine makers, such as Moderna, which gained 20%.
  • The following Monday, most everything seemed to reverse. The market staged a rebound, with the S&P gaining and bonds dropping back. Why the sudden reversal? Reporters at The Wall Street Journal tried to piece it together. They quoted the president, who said Omicron was “not a cause for panic.” They also quoted a Wall Street analyst, who offered this explanation: “Friday was a panic selloff. Traders have had time to sit back and breathe a bit.”
  • The market took another steep dive on Tuesday. Why the reversal? Here’s some of the commentary the Journal offered this time: “We really don’t know in regards to the new variant what we’re dealing with,” said one Wall Street strategist. The CEO of a fund company suggested this explanation: “People are trying to protect what they have.”
  • On Wednesday, the market rebounded again in the morning. The proximate cause this time: the release of some positive employment data. But by the afternoon it gave up those gains and ended up in negative territory. What happened? A report that someone in the U.S. had been infected with the Omicron variant.
  • Finally, on Thursday, the market bounced back yet again, despite news that three more people in the U.S.—all vaccinated—had been infected with the Omicron variant.

What conclusions can you draw from this snapshot of five days in the stock market? In the world of investment theory, there’s a school of thought that believes in “the wisdom of crowds”—the idea that groups of people, in aggregate, are smarter and will make better decisions than any one individual. A related concept, the efficient markets hypothesis (EMH), takes this a step further.

EMH argues that investors, collectively, are always monitoring the news and are quick on their feet. As a result, when new information becomes available, not only do they understand it, but they also jump into action. EMH postulates that these quick-thinking investors will buy or sell stocks in response to the latest news. This causes the prices of those investments to quickly adjust to the new information. In this way, they are said to keep the market efficient.

Intuitively, this makes sense. People do generally make better decisions when they collaborate on a question or problem. By extension, it seems like we ought to put faith in the wisdom of crowds. There are certainly cases in which the market has exhibited remarkable efficiency. One notable example occurred almost 36 years ago.

On Jan. 28, 1986, the Space Shuttle Challenger exploded shortly after liftoff. While there were four publicly traded companies that were contractors to the Shuttle program, a government panel found that just one was ultimately responsible: Morton Thiokol. It took the panel five months to reach that conclusion. But if you look at how the stock market reacted on the day of the crash, you’ll see the market seemed to figure this out much more quickly—almost immediately, in fact. Within minutes of the news hitting wire services, the shares of all four companies dropped. But the drop in Thiokol shares was far more pronounced. Its stock ended the day down 13%, while the stocks of the other three companies lost just 2% or 3%.

Supporters of the efficient markets hypothesis often cite this case. In my opinion, though, this is more the exception than the rule. If you contrast the Challenger case with the five-day microcosm described above, you’ll see two significant differences.

First, the facts are rarely as clear as they were in the Challenger case. That was a single tragic episode, and there were just four possible culprits. Even among them, Thiokol was a reasonable guess because concerns had been raised before—by Thiokol itself—about the safety of its rocket boosters in cold weather conditions. It was an unseasonably cold 36 degrees at Cape Canaveral at the time of the launch.

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By contrast, COVID-19 is a moving target. It is literally evolving. As we’ve seen recently, it’s hard for anyone to know when there will be further variants. And when there are, no one knows what they’ll look like or what their impact will be.

One theory floated last week was the idea that Omicron will be more contagious but less lethal than Delta. If that were the case, the thinking goes, Omicron might crowd out Delta. Then more people would become infected, but with a more benign virus. If that were the result, Omicron might actually be a welcome development. But that’s just a theory. No one knows for sure if anything like this will occur.

In contrast to the complexity and lack of clarity surrounding COVID, the Challenger case was more like a controlled scientific experiment, with a very straightforward set of facts. But that rarely happens in the stock market. It’s why, in my opinion, the Challenger case is the one that EMH enthusiasts always seem to cite. It’s one of the only cases that perfectly supports their hypothesis.

The other difference between the Challenger case and the stock market’s normal function is that stocks are usually subject to a mix of countervailing forces. Over the past week, for example, the Omicron news—which was itself inconclusive—was clouded by several other factors. Notable among them: Federal Reserve Chair Jerome Powell was in front of Congress providing testimony on Tuesday and Wednesday. Powell weighed in on the potential impact of Omicron, as did the World Health Organization and the CEO of Moderna, among others. Mixed in with all that was new economic data, like the employment report that came out Wednesday.

The result: As the saying goes, things were clear as mud. That’s why we saw the stock market seesawing the way it did—and why the investors that the Journal interviewed seemed to be grasping at straws in trying to explain the stock market’s movements.

Bottom line: The market always reacts to news. Sometimes its lightning-fast reactions make it seem efficient. But whether the market’s reactions ultimately make sense is a different question. In rare cases, perhaps the market is truly efficient. But most of the time, information is incomplete, inconclusive or clouded by other factors. As a result, it’s hard to argue that it’s truly efficient on a day-to-day basis.

Where does this leave you as an individual investor? I’d turn, as I often do, to Benjamin Graham, the father of modern investment analysis. His view: In the short term, the stock market is like a “voting machine.” It’s a popularity contest and not necessarily logical. But in the long term, Graham said, the market is a “weighing machine.” In other words, if you can make it through the day-to-day noise, the market is, in fact, logical over time and generally a good investment.

The key, then, is to try hard to tune out the noise. As Warren Buffett once said, “If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.”

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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Brent Wilson
Brent Wilson
11 months ago

I thought Ron Sheldon’s comment on today’s post titled, “Fill ‘Er Up” was interesting. It was all about EMH.

It’s hard for me to argue that today’s world does not efficiently deliver information throughout the world, and that stock prices incorporate reactions to this information very quickly.

Is that all EMH is supposed to do… provide information and let the masses decide on what the “fair” market value of a company is based on all available information? Or does it further postulate that, due to access to this information, that these values are somehow an accurate reflection of a company’s intrinsic value?

Whether there is little information to begin with, or that people disagree on how to react to this information, may be beside the point? I would think that the only place EMH doesn’t do its job is with very small companies, where there is little information for the public to digest.

The Drake
The Drake
1 year ago

Total market index fund plus Total market bond fund equals your total investments less short term cash needed to survive a two/three year calamity. Figure out your risk balances (ie 40% market 60% bond) then look at the balances every few months. When percentages are out of whack rebalance. Ignore market news. Ignore it. Just rebalance when needed. It’s not that hard guys. Really. It’s not.

booch221
booch221
11 months ago
Reply to  The Drake

That’s what I do. Too bad it took me a long time to learn this.

parkslope
parkslope
1 year ago

Good article! Malkiel has a somewhat different take on market efficiency.

“Markets can be efficient even if many market participants are quite irrational. Markets can be efficient even if stock prices exhibit greater volatility than can apparently be explained by fundamentals such as earnings and dividends. Many of us economists who believe in efficiency do so because we view markets as amazingly successful devices for reflecting new information rapidly and, for the most part, accurately. Above all, we believe that financial markets are efficient because they don’t allow investors to earn above-average risk-adjusted returns.”

The Efficient Market Hypothesis and Its Critics Burton G. Malkiel
https://www.princeton.edu/~ceps/workingpapers/91malkiel.pdf

Pravin Mittal
Pravin Mittal
1 year ago

Crowd intelligence works if most people act independently to arrive at a decision. Crowds can go horribly wrong when they act as herds. It can cause either massive bubbles or undervaluation depending on sentiment. I do believe Markets can be irrational in short term but in long term tend to correct themselves.

Jonathan Clements
Admin
Jonathan Clements
1 year ago
Reply to  Pravin Mittal

That’s a great way of farming the issue. Thanks for the comment.

R Quinn
R Quinn
1 year ago

I’m thinking it’s not the market reacting, but a lot of shortsighted perhaps irrational investors. A bit of news stocks go down, up the next day. How quickly we turn from long term to the days news or political comments.

Ron Sheldon
Ron Sheldon
11 months ago
Reply to  R Quinn

Maybe, but that seems to fail to account for market volume, trading and equity holdings being dominated by institutional investors, all competing against each other rationally or irrationally. For each sale and each purchase, there are at least two parties involved and in most instances those parties are institutional investors who you would hope acted rationally based on the instantaneous information they all have and their assessment of the impact on the investment. That latter part is what differs and I would expect they are not shortsighted or irrational, only that they don’t know what the future will bring and, thus, guess differently.

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