Author Topic: Efficient Market Hypothesis (EMH)  (Read 3461 times)

MustacheAndaHalf

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Efficient Market Hypothesis (EMH)
« on: April 08, 2021, 07:16:02 PM »
I think a discussion of the efficient market hypothesis (EMH) deserves it's own thread.  There are two forms: the weak form says past prices can't be used to predict future prices.  The strong form of EMH says all information on a stock is already priced in.

Comparison of index investing vs active investing provides the strongest support for EMH, with historical data showing active lagging the market over time.
https://www.spglobal.com/spdji/en/documents/spiva/spiva-us-year-end-2020.pdf

MustacheAndaHalf

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Re: Efficient Market Hypothesis (EMH)
« Reply #1 on: April 08, 2021, 07:16:23 PM »
The weak spot for EMH, in my view, is the momentum factor, or "four factor model" of the stock market.  Momentum purely looks at past prices, and historically has beaten the market most years.  It's a disciplined form of market chasing: you buy stocks with the highest returns over the past quarter or year, and those stocks tend to keep going higher.  But when other stocks do better, it's time to switch (the discipline part).  So I have a tilt to momentum.

I don't agree with @lemonlyman that GameStop stock (GME) violates the efficient market hypothesis (EMH), and wanted to take that discussion to a new thread.  The weak form of EMH says past prices can't be used to predict the future price.  For GME, I think that's true - the market could not predict the price, as Melvin Capital learned when it lost billions in the January short squeeze on GME.  Right now, I expect GME to fade back to fundamental value later this year - but I'm not entirely certain about when.

The short squeeze really took off after Chewy co-founder Ryan Cohen wrote a letter to GameStop's board.  I thought he might take over as chairman of the board, and that would send the stock higher... yet now that he's announced he will become chairman, the stock has dropped slightly.  So while I predict GME will fall at some point later this year, I don't seem able to predict GME's price so far.

If an anomaly is ongoing, that violates EMH.  Last year when the pandemic started, some stocks were expected to go bankrupt, and were sold at any price.  Even Warren Buffet sold his stake in Delta Airlines at a loss to reduce risk.  I took the opposite view, that despite bankruptcy risk investments in beaten up stocks would be rewarded.  But there's uncertainty in predicting when a global pandemic will end, especially before vaccine effectiveness or timing were known.  So I'm not sure my risk, while rewarded, directly refutes EMH on pricing of stocks.

reeshau

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Re: Efficient Market Hypothesis (EMH)
« Reply #2 on: April 09, 2021, 06:36:08 AM »
Even Warren Buffet sold his stake in Delta Airlines at a loss to reduce risk.

I'll bite.  While I do find the EMH useful in thinking about the market, (as George Box said: "All models are wrong.  Some are useful.")  the fundamental flaw is viewing volatility as risk, rather than loss of capital.  The latter was the basis for Warren's decision--an admission that he couldn't see what was coming to Delta's business--rather than any price history.  As an investor in companies, volatility is not risk; it is my friend.  It affords me buying and selling opportunities.  (aka "Mr. Market")

I am also not bothered by GME, as I believe that is  short-term action.  If I am holding stocks for 10 years or more, then GME in the first half of 2021 is volatility caused by short seller overreaching; I would call that extreme, but functional, price discovery--the invisible hand bringing selfish actors to correct the actual aberration, which was being >100% short.

More concerning for the theory would be Tesla, whose price inflation has persisted for years.  Clearly, Tesla is reaching to do more than build cars.  Heck, even GM knows that there are better businesses to be in.  But whatever opportunities Tesla may have, the value should be significantly discounted because of the uncertainty they will achieve it.  Instead, they are valued on the order of magnitude of Apple or Amazon--as if they have already made it.  There is no fundamental analysis that concludes with Tesla's share price, particularly for a company that has been nearly bankrupt 3 times.  It is all a bet on Elon.
« Last Edit: April 09, 2021, 07:26:07 AM by reeshau »

bwall

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Re: Efficient Market Hypothesis (EMH)
« Reply #3 on: April 09, 2021, 09:03:44 AM »
hmmm...... this is a bit of a tough argument to take on, for the simple reason that it's so easy to move the goalposts.

Upthread you mention 'ongoing anomaly' as a criteria that would violate EMH, although nothing is ongoing, ever. Markets are always changing, so that one could always come back and say 'hey, it took X years/decades, but EMH finally came through." Or, perhaps, how long is 'ongoing'? One week? One month? Six months? A year?

Can you give specific examples of pricing action that would violate the EMH? Then, if we can find a real life correlation, then can agree that we've located one deficiency in the EMH?

I've got two specific examples I'm thinking of that *might* violate the EMH, but if we can't agree on definitions in advance, the thought exercise might be more frustrating than useful.

reeshau

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Re: Efficient Market Hypothesis (EMH)
« Reply #4 on: April 09, 2021, 09:18:56 AM »
Another thought occurred to me:

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
-- Benjamin Graham

So, I think the weighing machine is efficient, although not perfectly efficient.  The voting machine is not at all; it's subject to any number of distortions, and not all of them are irrational.  The issue with this, then, is the attempted application of efficiency on a minute-by-minute basis.  We want it to be, which is always the wrong mindset to begin a scientific investigation.

PDXTabs

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Re: Efficient Market Hypothesis (EMH)
« Reply #5 on: April 09, 2021, 09:41:09 AM »
Another thought occurred to me:

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
-- Benjamin Graham

So, I think the weighing machine is efficient, although not perfectly efficient.  The voting machine is not at all; it's subject to any number of distortions, and not all of them are irrational.  The issue with this, then, is the attempted application of efficiency on a minute-by-minute basis.  We want it to be, which is always the wrong mindset to begin a scientific investigation.

I would add that the markets can remain irrational longer than you can remain solvent. - John Maynard Keynes

I've never really believed that the markets are efficient. SPACs, tulips, NFTs, and houses anyone?
« Last Edit: April 09, 2021, 11:15:45 AM by PDXTabs »

Padonak

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Re: Efficient Market Hypothesis (EMH)
« Reply #6 on: April 09, 2021, 09:55:01 AM »
How does the EMH apply to crypto currencies. Does it apply at all?

ROF Expat

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Re: Efficient Market Hypothesis (EMH)
« Reply #7 on: April 09, 2021, 09:58:25 AM »
The weak spot for EMH, in my view, is the momentum factor, or "four factor model" of the stock market.  Momentum purely looks at past prices, and historically has beaten the market most years.  It's a disciplined form of market chasing: you buy stocks with the highest returns over the past quarter or year, and those stocks tend to keep going higher.  But when other stocks do better, it's time to switch (the discipline part).  So I have a tilt to momentum.

I don't agree with @lemonlyman that GameStop stock (GME) violates the efficient market hypothesis (EMH), and wanted to take that discussion to a new thread.  The weak form of EMH says past prices can't be used to predict the future price.  For GME, I think that's true - the market could not predict the price, as Melvin Capital learned when it lost billions in the January short squeeze on GME.  Right now, I expect GME to fade back to fundamental value later this year - but I'm not entirely certain about when.

The short squeeze really took off after Chewy co-founder Ryan Cohen wrote a letter to GameStop's board.  I thought he might take over as chairman of the board, and that would send the stock higher... yet now that he's announced he will become chairman, the stock has dropped slightly.  So while I predict GME will fall at some point later this year, I don't seem able to predict GME's price so far.

If an anomaly is ongoing, that violates EMH.  Last year when the pandemic started, some stocks were expected to go bankrupt, and were sold at any price.  Even Warren Buffet sold his stake in Delta Airlines at a loss to reduce risk.  I took the opposite view, that despite bankruptcy risk investments in beaten up stocks would be rewarded.  But there's uncertainty in predicting when a global pandemic will end, especially before vaccine effectiveness or timing were known.  So I'm not sure my risk, while rewarded, directly refutes EMH on pricing of stocks.

Momentum purely looks at past prices, and historically has beaten the market most years.

Really?  Can you name some funds that have a long track record of doing this?   

GuitarStv

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Re: Efficient Market Hypothesis (EMH)
« Reply #8 on: April 09, 2021, 09:58:40 AM »
A market is efficient as long as all the actors in the market are logical.

:P

MustacheAndaHalf

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Re: Efficient Market Hypothesis (EMH)
« Reply #9 on: April 09, 2021, 10:17:39 AM »
The way some people use the word "efficient" sounds like we might not be talking about the same thing.
https://en.wikipedia.org/wiki/Efficient-market_hypothesis

I'll have to dig up research, but the momentum factor has been shown in various markets in various time periods - even outside of stock markets.
https://en.wikipedia.org/wiki/Carhart_four-factor_model
« Last Edit: April 11, 2021, 03:04:42 AM by MustacheAndaHalf »

lemonlyman

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Re: Efficient Market Hypothesis (EMH)
« Reply #10 on: April 09, 2021, 11:14:33 AM »
Thanks for making a new thread. I didn't mention weak form in my comment. Weak form is an expansion of the general idea of EMH because EMH clearly doesn't work. In my view, GME prices was not efficient long before or recently after this event. EMH is economists attempt to find a logical proof for markets similar to mathematical proofs. The concept to dampen real return by adding their subjective "risk adjusted basis" to maintain it is an economists version of "alternative facts." Every time an investor or fund beats the market over a sustained amount of time, EMH advocates create wider statistical bands and expand the timeframe for what can be considered an anomoly.

Regarding weak form itself, I think it's pretty obvious you can't predict a stocks future price by historical prices and think it's ironic many here are so sure that index funds will continue a 7-11% upward march into the foreseeable future because of historical averages.

MustacheAndaHalf, you didn't answer my question on your own activity. Do you believe you can beat the market over a sustained period of time? If you do, you yourself are a violation of EMH.
« Last Edit: April 09, 2021, 11:18:13 AM by lemonlyman »

hodedofome

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Re: Efficient Market Hypothesis (EMH)
« Reply #11 on: April 09, 2021, 08:03:12 PM »
The market goes through phases of being ‘easy’ and ‘hard.’ More predictable at times, and totally random at others. The trick is learning what type of environment we’re in.

MustacheAndaHalf

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Re: Efficient Market Hypothesis (EMH)
« Reply #12 on: April 09, 2021, 10:03:57 PM »
@ROF Expat - My thinking was founded in historical data showing a momentum factor.  Larry Swedroe has mentioned momentum in his more recent books, but he overall favor a small/value tilt.  I found a momentum research paper with lots of citations, that also mentions prior research:
http://rogutierrez.net/files/States_and_Momentum.pdf


lemonlyman - My personal view is you should invest beyond the horizon of the market.  Investing in index funds takes a very long term view, beyond what active funds are able to predict.

The short version of my story is that I started 2020 as a passive index investor, then invested one quarter of my portfolio on the theory that "stocks recover".  Stocks like Macy's and Carnival Cruises dropped to 1/3rd of their earlier prices, meaning those that survived would pay 3x on the investment - or collapse.  I felt less than half would go bankrupt, and even then would be profitable.  I also thought in an election year, Congress won't let every travel, entertainment and retail business collapse.

Were those stocks mispriced by the market?  Market participants weren't alive for the last global pandemic, so they had no idea how to react.  Personally I think it's a flaw where the news media refuses to take the risk of projecting Covid-19 cases because math bores their viewers and loses revenue for them.  But this situation only continues through a recovery - then the advantage is gone, and I hope to return to an easier point on the risk curve.

Speaking of risk, you mentioned that "risk adjusted basis" is a moving goalpost, which I'd like to hear more about.  I assumed there was a narrow range of confidence intervals (like in medical research), and disagreement over a narrow range.

In the past 15-20 years of tech giants, large/growth beats the market.  If small/value factors require more than 20 years to beat the market, I don't view that as a very strong problem with EMH.  Maybe I'm wrong, but that's too long for me to wait, so years ago I gave up on small/value tilts.  With inflation concerns, I could be wrong this upcoming year, too.

I know Buffet beat the market for decades, but for the past decade or so Berkshire is too big to buy anything but the largest stocks.  The 5-factor model replicates his returns with "quality" and "profitability" factors, in addition to the market, small and value factors.  There's also George Soros' quantum fund which had a 20 year track record of beating the stock market using what he called "reflexivity", or doing experiments to test how the market responded to events.  Are those examples considered contradictions of EMH?

I thought a contradiction for EMH is something anyone can do, like momentum, that persists for enough years to not be random chance.  But when I ran a momentum experiment, it worked initially then failed longer term.  I don't know of a long-term momentum fund, so I just have academic studies so far.

MustacheAndaHalf

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Re: Efficient Market Hypothesis (EMH)
« Reply #13 on: April 11, 2021, 02:49:27 AM »
Momentum purely looks at past prices, and historically has beaten the market most years.
Really?  Can you name some funds that have a long track record of doing this?   

My thinking was founded in historical data showing a momentum factor.  Larry Swedroe has mentioned momentum in his more recent books, but he overall favor a small/value tilt.  I found a momentum research paper with lots of citations, that also mentions prior research:
http://rogutierrez.net/files/States_and_Momentum.pdf

I thought a contradiction for EMH is something anyone can do, like momentum, that persists for enough years to not be random chance.  But when I ran a momentum experiment, it worked initially then failed longer term.  I don't know of a long-term momentum fund, so I just have academic studies so far.

MustacheAndaHalf

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Re: Efficient Market Hypothesis (EMH)
« Reply #14 on: April 11, 2021, 02:55:54 AM »
EMH is economists attempt to find a logical proof for markets similar to mathematical proofs. The concept to dampen real return by adding their subjective "risk adjusted basis" to maintain it is an economists version of "alternative facts." Every time an investor or fund beats the market over a sustained amount of time, EMH advocates create wider statistical bands and expand the timeframe for what can be considered an anomoly.
Could you expand on "risk adjusted basis" having moving goalposts?  I assumed there was a narrow range of confidence intervals (like in medical research), and disagreement over a narrow range.

In the past 15-20 years of tech giants, large/growth beats the market.  If small/value factors require more than 20 years to beat the market, I don't view that as a very strong problem with EMH.  Maybe I'm wrong, but that's too long for me to wait, so years ago I gave up on small/value tilts.  With inflation concerns, I could be wrong this upcoming year, too.

I know Buffet beat the market for decades, but for the past decade or so Berkshire is too big to buy anything but the largest stocks.  The 5-factor model replicates his returns with "quality" and "profitability" factors, in addition to the market, small and value factors.  There's also George Soros' quantum fund which had a 20 year track record of beating the stock market using what he called "reflexivity", or doing experiments to test how the market responded to events.  Are those examples considered contradictions of EMH?

Regarding weak form itself, I think it's pretty obvious you can't predict a stocks future price by historical prices and think it's ironic many here are so sure that index funds will continue a 7-11% upward march into the foreseeable future because of historical averages.
I like to quote the SEC, that past performance doesn't necessarily predict future performance.  I mostly see EMH as a justification for passive index investing rather than a specific 7-11% rate of return.

MustacheAndaHalf, you didn't answer my question on your own activity. Do you believe you can beat the market over a sustained period of time? If you do, you yourself are a violation of EMH.
My personal view is you should invest beyond the horizon of the market.  Investing in index funds takes a very long term view, beyond what active funds are able to predict.

The short version of my story is that I started 2020 as a passive index investor, then invested one quarter of my portfolio on the theory that "stocks recover".  Stocks like Macy's and Carnival Cruises dropped to 1/3rd of their earlier prices, meaning those that survived would pay 3x on the investment - or collapse.  I felt less than half would go bankrupt, and even then would be profitable.  I also thought in an election year, Congress won't let every travel, entertainment and retail business collapse.

Were those stocks mispriced by the market?  Market participants weren't alive for the last global pandemic, so they had no idea how to react.  Personally I think it's a flaw where the news media refuses to take the risk of projecting Covid-19 cases because math bores their viewers and loses revenue for them.  But this situation only continues through a recovery - then the advantage is gone, and I hope to return to an easier point on the risk curve.

MustacheAndaHalf

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Re: Efficient Market Hypothesis (EMH)
« Reply #15 on: April 11, 2021, 03:04:13 AM »
Upthread you mention 'ongoing anomaly' as a criteria that would violate EMH, although nothing is ongoing, ever. Markets are always changing, so that one could always come back and say 'hey, it took X years/decades, but EMH finally came through." Or, perhaps, how long is 'ongoing'? One week? One month? Six months? A year?

Can you give specific examples of pricing action that would violate the EMH? Then, if we can find a real life correlation, then can agree that we've located one deficiency in the EMH?
I'm not familiar enough with the research to help answer that.  If EMH depended on 50 years of stock data, and it could be shown a way to predict the market existed for 50 years, that would be a major problem for the theory.  But without looking at the math (maybe confidence intervals?), I don't know.

I may be wrong, but I view it like detecting investing skill.  Someone can get lucky in their stock picks over the time frame of a month or year, but over decades it is probably more than luck.  Without Buffet, there's no 5-factor model of markets (market, small, value, profitability, quality), which was created to explain his returns.

Years ago I gave up on "small/value" tilt, which supposedly offers higher returns than the market... but not for many years.  Momentum has been much more consistent in the past - but the funds which track it are mostly new, so we'll have to see how they do over decades.  I think momentum is the most significant problem for EMH to explain.

Financial.Velociraptor

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Re: Efficient Market Hypothesis (EMH)
« Reply #16 on: April 11, 2021, 09:53:00 AM »
When I did my MBA around the turn of the Millennium, we not only we indoctrinated into the idea of EMH; we were tortured by being made to "prove" it was so (and I mean ad nauseum) with the ONE HIGH AND HOLY MATHEMATICS ([AMEN]).  I actually came to believe it myself.  It was a tortuous path that changed me from an equity and bond indexer to an active trader focusing on options. 

In my opinion, the markets are "largely" efficient.  All available information is priced in.  But two caveats 1) not all information is publicly available, at least not timely 2) Keyne's 'animal spirits' play a role in determining how individual investors interpret the impact of the publicly available information. 

Inefficiencies in pricing are thus exploitable, but only by the nimble.  Portfolio size is the enemy of returns.  Buffet still claims he would expect to return 50% a year on average if investing less than a million dollars.  He has missed his own benchmark at BRK-B of 20% book value growth for several years now.  I suppose initiation of a distribution or buyback policy at Berkshire should have its own thread.

NorCal

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Re: Efficient Market Hypothesis (EMH)
« Reply #17 on: April 11, 2021, 02:39:52 PM »
When I did my MBA around the turn of the Millennium, we not only we indoctrinated into the idea of EMH; we were tortured by being made to "prove" it was so (and I mean ad nauseum) with the ONE HIGH AND HOLY MATHEMATICS ([AMEN]).  I actually came to believe it myself.  It was a tortuous path that changed me from an equity and bond indexer to an active trader focusing on options. 

In my opinion, the markets are "largely" efficient.  All available information is priced in.  But two caveats 1) not all information is publicly available, at least not timely 2) Keyne's 'animal spirits' play a role in determining how individual investors interpret the impact of the publicly available information. 

Inefficiencies in pricing are thus exploitable, but only by the nimble.  Portfolio size is the enemy of returns.  Buffet still claims he would expect to return 50% a year on average if investing less than a million dollars.  He has missed his own benchmark at BRK-B of 20% book value growth for several years now.  I suppose initiation of a distribution or buyback policy at Berkshire should have its own thread.

I also learned this in my MBA ad-nauseum.  Although it's been over 10 years since I studied EMH, I've always thought the FI blogosphere had some severe misperceptions about how the EMH functions in practice.  The concept of risk-adjusted returns and the efficient frontier are central to the theory, but rarely brought up in discussions.  For example, in the constant discussions of invest vs. mortgage payoff, an implied risk-free rate and a risk premium are the two most valuable inputs.  Yet they are rarely discussed directly.

One fundamental component of the EMH is that stock prices reflect all publicly available information (with slight variations depending on the version of EMH).  I've seen this lead to some absolutely incorrect conclusions about what EMH says or doesn't say.

In fact, the entire opening post in this thread was about using EMH to discredit momentum investing.  If I remember my theory correctly, I think EMH may imply that momentum investing won't work, but the underlying theory never addressed momentum investing specifically.  My studies are more than a decade in the past, so I might be mis-remembering some of the details though.

Based on my studies, EMH and momentum investing are not incompatible.  Momentum investing is a valid form of using market information to make investing decisions.  According to EMH, momentum investors would see similar risk adjusted returns (minus fees) to other styles of investing when viewed over the long term. 

Many of the individual momentum strategies do involve higher risk than value investing strategies.  Momentum investors will frequently target small cap high-beta stocks, use leverage, or use futures.  All of these add to long term risks and long term returns.  This means momentum investors can out-perform index investors over the long term, as they are taking on more risk.  This is fully compatible with the EMH.


ChpBstrd

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Re: Efficient Market Hypothesis (EMH)
« Reply #18 on: April 12, 2021, 08:17:42 AM »
EMH is more of a philosophical exercise than an actionable perspective on the world. If a market goes up 3% today and down 3% tomorrow, EMH says there must have been some information out there in the world causing this fluctuation, and if you don't find any, you must have not been looking hard enough. In reality, there is always a ton of information swirling around, so EMH can always be used to explain a fluctuation as being caused by this or that bit of information. If information comes out and does not cause a fluctuation, EMH can say that information didn't matter. There's a lack of scientific falsifiability with the strong version.

The weak version is more defensible. Technical analysis has been hit or miss ever since it was invented (despite a million enthusiastic youtube videos saying otherwise, and selling the "secret"), and if future prices could be predicted from past prices, that advantage would surely have been arbitraged away in this fourth decade of high frequency trading.

Keyne's 'animal spirits' play a role in determining how individual investors interpret the impact of the publicly available information. 

^ Perhaps this is the root cause of my problem with falsifiability and why sometimes information matters to the price and sometimes it doesn't. The overall market definitely goes through bullish and bearish "moods" and this may be due to the large numbers of irrational humans who are still at the helm controlling trillions of dollars. Of course, the flip side would be true in a market controlled by computers doing either technical or fundamental analysis. Perfectly rational computers would have an even harder time than humans understanding the value of qualitative information, such as a CEO being admitted to the hospital or the enactment of a new law that may or may not affect a company in some hard-to-decipher way. I suspect most funds represent a symbiotic combo of rational machines that can't understand qualitative info and irrational humans with a better grasp on the qualitative than the quantitative.

shinn497

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Re: Efficient Market Hypothesis (EMH)
« Reply #19 on: April 12, 2021, 08:37:18 AM »
If you consider that almost all investors and active traders can't beat the market, than the EMH is true enough to investors of our level of skill and resources. People get it wrong in looking at the short term performance of the market as its failure. That isn't evidence that the market isn't efficient, just , in the short term, it has some level of stochasticity.

MustacheAndaHalf

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Re: Efficient Market Hypothesis (EMH)
« Reply #20 on: April 12, 2021, 09:47:47 AM »
Momentum purely looks at past prices, and historically has beaten the market most years.
Really?  Can you name some funds that have a long track record of doing this?   
After finding etfdb.com has incorrect starting dates, I searched for the oldest momentum fund, which trails both it's benchmark and the S&P 500:
https://www.morningstar.com/etfs/xnas/pdp/performance
https://www.morningstar.com/etfs/arcx/voo/performance


If you consider that almost all investors and active traders can't beat the market, than the EMH is true enough to investors of our level of skill and resources. People get it wrong in looking at the short term performance of the market as its failure. That isn't evidence that the market isn't efficient, just , in the short term, it has some level of stochasticity.
Over the past 10-20 years, 83-86% of funds underperformed the market.  In that long time frame, "almost all" funds do trail the market returns.
https://www.spglobal.com/spdji/en/documents/spiva/spiva-us-year-end-2020.pdf#page=9

But looking at 2020, about 43% of funds beat the market.
https://www.spglobal.com/spdji/en/documents/spiva/spiva-us-year-end-2020.pdf#page=1

maizefolk

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Re: Efficient Market Hypothesis (EMH)
« Reply #21 on: April 12, 2021, 10:09:43 AM »
EMH is more of a philosophical exercise than an actionable perspective on the world. If a market goes up 3% today and down 3% tomorrow, EMH says there must have been some information out there in the world causing this fluctuation, and if you don't find any, you must have not been looking hard enough.

This may represent a fundamental misunderstanding of the EMH, but my understanding is that the EMH doesn't require that all price changes to be explained by real world information, but solely that all real world information is reflected in the price.

So, based on my understanding, which could well be wrong, if I can actually predict the market will drop 3% tomorrow, that's a violation of the EMH. But if the market drops 3% tomorrow and no one could predict it based on any information, that would not falsify the EMH.

ChpBstrd

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Re: Efficient Market Hypothesis (EMH)
« Reply #22 on: April 12, 2021, 11:13:46 AM »
EMH is more of a philosophical exercise than an actionable perspective on the world. If a market goes up 3% today and down 3% tomorrow, EMH says there must have been some information out there in the world causing this fluctuation, and if you don't find any, you must have not been looking hard enough.

This may represent a fundamental misunderstanding of the EMH, but my understanding is that the EMH doesn't require that all price changes to be explained by real world information, but solely that all real world information is reflected in the price.

So, based on my understanding, which could well be wrong, if I can actually predict the market will drop 3% tomorrow, that's a violation of the EMH. But if the market drops 3% tomorrow and no one could predict it based on any information, that would not falsify the EMH.

Your first sentence raises the question in my mind: "What inputs other than information can possibly change the price of things, according to EMH?" My understanding (could be wrong) was that EMH assumes the price is 100% based on information. All information is reflected in the price and the price reflects all information. <- This sounds like a truism, but it's not; we need to establish that the theory doesn't say the price reflects all  information plus some other factors.

We could separate information into "available information" and "insider information", but I think that's a different detail than the big question of "is there another factor besides information?". What I'd be looking for is some kind of force that does not involve information, such as falling barometric pressure in NYC causing enough migraines to put traders in a bad mood, or chaotic pathways.

This is also a problem with philosophical proofs for determinism. If all effects have causes, we've only set ourselves on a task to find causes, and maybe whatever causes we find must have been the true causes, which proves the hypothesis in circular logic. To prove the negative - that something happened without a cause - would have to scour the universe for uncaused effects, and eliminate all possible causes despite the chaotic universe. E.g. This chicken hatched where there was no egg. So far, science has done an excellent job of finding causes and making very tight cases for them being the causes of whatever effect is being studied. An ever-diminishing list of things we don't know, like a unified theory in physics, is the remaining realm of possibility for us to find uncaused effects. But what exactly would disprove determinism, and what would that proof look like? This is the same challenge with disproving EMH.

Disclosure: long determinism, neutral EMH

shinn497

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Re: Efficient Market Hypothesis (EMH)
« Reply #23 on: April 12, 2021, 12:26:10 PM »
This supports my point. For a 1 year period you may notice some overperformance. OVer the long term you won't. And actually knowing which fund will overperform is difficult. Also what are we considering, "The market"? The SP500? That is just one risk premium. If you compare active portfolios to a 5 factor portfolio it will be incredibly hard to find one that beats it, even if you look at robust time periods and multiple countries.  The notion that you, asn investor, can gain information to beat, "the market" is well wishing at best and out of touch with reality at worst.




If you consider that almost all investors and active traders can't beat the market, than the EMH is true enough to investors of our level of skill and resources. People get it wrong in looking at the short term performance of the market as its failure. That isn't evidence that the market isn't efficient, just , in the short term, it has some level of stochasticity.
Over the past 10-20 years, 83-86% of funds underperformed the market.  In that long time frame, "almost all" funds do trail the market returns.
https://www.spglobal.com/spdji/en/documents/spiva/spiva-us-year-end-2020.pdf#page=9

But looking at 2020, about 43% of funds beat the market.
https://www.spglobal.com/spdji/en/documents/spiva/spiva-us-year-end-2020.pdf#page=1

maizefolk

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Re: Efficient Market Hypothesis (EMH)
« Reply #24 on: April 12, 2021, 12:31:31 PM »
Your first sentence raises the question in my mind: "What inputs other than information can possibly change the price of things, according to EMH?" My understanding (could be wrong) was that EMH assumes the price is 100% based on information. All information is reflected in the price and the price reflects all information. <- This sounds like a truism, but it's not; we need to establish that the theory doesn't say the price reflects all  information plus some other factors.

So your understanding of the EMH asserts both:

1) All information is reflected in the price

2) and the price reflects all information [and nothing but all information]

Mine is that it asserts only #1. I agree in that the EMH does take on a very different flavor if #2 is included, and I'd have a much harder time buying into it as a concept if it does include both 1 and 2 and not solely 1. Could anyone else weigh in on their understanding of what the EMH says on this point?

We could separate information into "available information" and "insider information", but I think that's a different detail than the big question of "is there another factor besides information?". What I'd be looking for is some kind of force that does not involve information, such as falling barometric pressure in NYC causing enough migraines to put traders in a bad mood, or chaotic pathways.

The second set is definitely more what I am thinking of. A trader has a fight with his girlfriend the night before. Short on sleep he hits sell instead of buy on a big order for a microcap stock. The sell order freaks out a could of high frequency trading algorithms which pay to front run order flow, causing them to guess that whole sector is about to drop. They dump shares of both the microcap and a few of its larger cousins, causing a margin call on a small edge fund that was heavily invested in one of the stocks. As the hedge fund liquidates some of its assets to post collateral it causes a minor blip in the bond market but as it happens a major bank has a rookie trader riding one of its desks devoted to hedging currency risk who figures it is better to over react and under react his first day and throws down a big hedge against a rising USD as more foreign capital flows in to take advantage of higher interest rates ... and so on.

Lots of unpredictable events happen every day in the stock market. Many of them have no effect, of the ones that cause long strings of unpredictable consequences many cancel out, some of them don't. But because the effects of these random events are stochastic, even having information on these random events as they happen wouldn't help a person beat the market.

MustacheAndaHalf

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Re: Efficient Market Hypothesis (EMH)
« Reply #25 on: April 13, 2021, 06:28:56 AM »
Also what are we considering, "The market"? The SP500? That is just one risk premium. If you compare active portfolios to a 5 factor portfolio it will be incredibly hard to find one that beats it, even if you look at robust time periods and multiple countries.
https://www.spglobal.com/spdji/en/documents/spiva/spiva-us-year-end-2020.pdf#page=9
In the page I referenced, the market was the S&P 1500 index.  There's additional comparisons to S&P 500 for large caps, S&P 400 to Mid Cap, and S&P 600 for Small Cap.  Also worth noting that SPIVA decides and publishes the S&P 500 index.  Vanguard pays them a fee to use "S&P 500" in their fund names.

The original risk model was just the market (CAPM), followed by the 3 factor model that tracked small and value factors.  But both the 4 factor (adds momentum) and 5 factor (adds Buffet's factors) explain 95% of returns - sounds like a tie.  Which means if I invest in momentum, I can't ever beat the market - because momentum is a recognized factor in the model.

The weird thing is that momentum is purely calculated from prices... so it's like something that defies EMH is included in risk models of the market.

This may represent a fundamental misunderstanding of the EMH, but my understanding is that the EMH doesn't require that all price changes to be explained by real world information, but solely that all real world information is reflected in the price.

So, based on my understanding, which could well be wrong, if I can actually predict the market will drop 3% tomorrow, that's a violation of the EMH. But if the market drops 3% tomorrow and no one could predict it based on any information, that would not falsify the EMH.
...
Your first sentence raises the question in my mind: "What inputs other than information can possibly change the price of things, according to EMH?" My understanding (could be wrong) was that EMH assumes the price is 100% based on information. All information is reflected in the price and the price reflects all information. <- This sounds like a truism, but it's not; we need to establish that the theory doesn't say the price reflects all  information plus some other factors.
...
https://en.wikipedia.org/wiki/Efficient-market_hypothesis
https://www.investopedia.com/terms/e/efficientmarkethypothesis.asp

investopedia: EMH claims "share prices reflect all information and consistent alpha generation is impossible."
wikipedia explains that under EMH "is impossible to "beat the market" consistently on a risk-adjusted basis since market prices should only react to new information."

The time frame is up for debate, but Buffet's decades of outperformance are a problem.  And asset bubbles are supposed to be a problem as well, although I'm not sure I agree.

I like to use Fed Chair Alan Greenspan's "irrational exuberance" speech... it took years before the market crashed.  If you invested right after that speech, and held through all 3 years of losses in the dot-com crash (-20%/-10%/-10% as I recall)... you still made a profit.  Using the Fed Chair's prediction to get out of the market was actually a losing decision compared to staying invested.  If you can't predict where an asset bubble leads from available information, I claim EMH still holds.

lemonlyman

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Re: Efficient Market Hypothesis (EMH)
« Reply #26 on: April 15, 2021, 07:34:29 AM »
@ROF Expat lemonlyman - My personal view is you should invest beyond the horizon of the market.  Investing in index funds takes a very long term view, beyond what active funds are able to predict.

The short version of my story is that I started 2020 as a passive index investor, then invested one quarter of my portfolio on the theory that "stocks recover".  Stocks like Macy's and Carnival Cruises dropped to 1/3rd of their earlier prices, meaning those that survived would pay 3x on the investment - or collapse.  I felt less than half would go bankrupt, and even then would be profitable.  I also thought in an election year, Congress won't let every travel, entertainment and retail business collapse.

Were those stocks mispriced by the market?  Market participants weren't alive for the last global pandemic, so they had no idea how to react.  Personally I think it's a flaw where the news media refuses to take the risk of projecting Covid-19 cases because math bores their viewers and loses revenue for them.  But this situation only continues through a recovery - then the advantage is gone, and I hope to return to an easier point on the risk curve.

I see. I think if you had a really good 2 years and then went back into index funds indefinitely, your total lifetime beat the markets because those two years of outsized gains would continue to compound. I don't know if it's a violation, but it seems to me like it would be.


Quote
Speaking of risk, you mentioned that "risk adjusted basis" is a moving goalpost, which I'd like to hear more about.  I assumed there was a narrow range of confidence intervals (like in medical research), and disagreement over a narrow range.

The calculation is subjective. It's also useless outside of comparing indexes and mutual funds with large amounts of holdings. Warren Buffet's expected returns compared to the S&P 500 for example is incredibly difficult to calculate using a risk adjusted basis. It's easy using real returns from the past, but anyone claiming to use the risk adjusted calculation to aid in future decision-making for investments should be considered highly suspect. Who do you trust to decide the expected return for a stock?

Quote

I know Buffet beat the market for decades, but for the past decade or so Berkshire is too big to buy anything but the largest stocks.  The 5-factor model replicates his returns with "quality" and "profitability" factors, in addition to the market, small and value factors.  There's also George Soros' quantum fund which had a 20 year track record of beating the stock market using what he called "reflexivity", or doing experiments to test how the market responded to events.  Are those examples considered contradictions of EMH?

I thought a contradiction for EMH is something anyone can do, like momentum, that persists for enough years to not be random chance.  But when I ran a momentum experiment, it worked initially then failed longer term.  I don't know of a long-term momentum fund, so I just have academic studies so far.

There are many traders who have beat the market for decades. There are the Market Wizards books for example. All those managers and traders have been audited at a minimum of 20 years. I wouldn't say momentum generally works, but I'm not going to claim it doesn't work for everyone. I honestly don't know enough about momentum. Every Market Wizards book I've read, I skimmed those users, haha. It's wholly uninteresting to me and dubious for sure. EMH says no one should be able to beat the market because all the information is present in the prices. I think no matter what method you choose, there is going to be a distribution of the successful and not successful. In general, I think behavioral economic studies have poked enough holes in EMH. Fund managers, for example, have very different incentives and risk profiles compared to anyone using their own money.

It's clearly not testable, but I would consider Buttet's age just as much for recent underperformance. I certainly don't expect to do my best work in anything from 80-90 years old.
« Last Edit: April 15, 2021, 07:36:44 AM by lemonlyman »

ChpBstrd

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Re: Efficient Market Hypothesis (EMH)
« Reply #27 on: April 15, 2021, 09:13:18 AM »
Your first sentence raises the question in my mind: "What inputs other than information can possibly change the price of things, according to EMH?" My understanding (could be wrong) was that EMH assumes the price is 100% based on information. All information is reflected in the price and the price reflects all information. <- This sounds like a truism, but it's not; we need to establish that the theory doesn't say the price reflects all  information plus some other factors.

So your understanding of the EMH asserts both:

1) All information is reflected in the price

2) and the price reflects all information [and nothing but all information]

Mine is that it asserts only #1. I agree in that the EMH does take on a very different flavor if #2 is included, and I'd have a much harder time buying into it as a concept if it does include both 1 and 2 and not solely 1. Could anyone else weigh in on their understanding of what the EMH says on this point?

We could separate information into "available information" and "insider information", but I think that's a different detail than the big question of "is there another factor besides information?". What I'd be looking for is some kind of force that does not involve information, such as falling barometric pressure in NYC causing enough migraines to put traders in a bad mood, or chaotic pathways.

The second set is definitely more what I am thinking of. A trader has a fight with his girlfriend the night before. Short on sleep he hits sell instead of buy on a big order for a microcap stock. The sell order freaks out a could of high frequency trading algorithms which pay to front run order flow, causing them to guess that whole sector is about to drop. They dump shares of both the microcap and a few of its larger cousins, causing a margin call on a small edge fund that was heavily invested in one of the stocks. As the hedge fund liquidates some of its assets to post collateral it causes a minor blip in the bond market but as it happens a major bank has a rookie trader riding one of its desks devoted to hedging currency risk who figures it is better to over react and under react his first day and throws down a big hedge against a rising USD as more foreign capital flows in to take advantage of higher interest rates ... and so on.

Lots of unpredictable events happen every day in the stock market. Many of them have no effect, of the ones that cause long strings of unpredictable consequences many cancel out, some of them don't. But because the effects of these random events are stochastic, even having information on these random events as they happen wouldn't help a person beat the market.

Everything I've ever read about EMH has referred only to information, and information is the only factor mentioned. However, I doubt the most ardent EMH supporter would deny the existence of chaotic events.

I suppose a defender of EMH would say if a non-information chaotic event nudged the price away from the value which is supported by all available information, it would soon revert to a value supported by all available information. They would also downplay the significance of such events, if they truly don't involve changes in information.

However even this concession would open up the possibility that one could in theory trade around non-informational chaotic events and beat the market.

MustacheAndaHalf

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Re: Efficient Market Hypothesis (EMH)
« Reply #28 on: April 15, 2021, 09:19:27 AM »
In my thread "An Experiment", the criticism is that my experiment is much riskier than the S&P 500, and so higher returns are expected.  One measure of risk is Beta, by which measure my experiment's risk adjusted returns (returns divided by stock's Beta) are less than the market.  So maybe the experiment does confirm EMH.

I viewed the stocks I picked as having very high default risk, with most investors being unwilling to take those risks.  When I started, I thought people like Buffet were investing the same way I was, and would have a great year.  So I was sad to learn Buffet dumped his position in Delta Airlines (at a loss).  I bought and held two airline stocks that did very well (especially when I switched to call options).

I think I just collected more information about Covid-19 than most investors, and was more comfortable when panic hit.  Back in March 2020 the NY Times published an expose of U.S. Covid-19 testing, which reflected the mainstream view.  About the same time, a Corona virus task force member announced cases were about to increase because testing was increasing exponentially.  I checked the data - the NY Times was 2 weeks out of date, which in terms of exponential growth, is just wrong.  So I went with data almost nobody was using, and predicted the end of the panic on Mar 20-21 (real date was Mon, Mar 23).  There's a post I can dig up where I predicted the bottom, and nailed it within 2%.

I don't expect to do that again, nor do I expect the opportunity to occur again.  Can EMH just be invalid in 2020?  Or does that invalidate EMH overall?

Personally, I'm allowing the contradictions to co-exist.  When I'm on top of something like Covid-19 prediction, I tried to beat the market.  When I lack any data better than the market, I'm back with EMH.

lemonlyman

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Re: Efficient Market Hypothesis (EMH)
« Reply #29 on: April 15, 2021, 10:22:17 AM »
Personally, I'm allowing the contradictions to co-exist.  When I'm on top of something like Covid-19 prediction, I tried to beat the market.  When I lack any data better than the market, I'm back with EMH.

IMO, your knowing you had good, actionable information that allowed you to beat the market at any time period is an invalidation of EMH for you. And not currently have any actionable ideas doesn't mean you won't come up with another tomorrow.

In reference to your experiment, invalidating momentum is not a validation of EMH. EMH and index fund investing aren't the same thing.

maizefolk

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Re: Efficient Market Hypothesis (EMH)
« Reply #30 on: April 15, 2021, 10:51:06 AM »
Everything I've ever read about EMH has referred only to information, and information is the only factor mentioned. However, I doubt the most ardent EMH supporter would deny the existence of chaotic events.

I suppose a defender of EMH would say if a non-information chaotic event nudged the price away from the value which is supported by all available information, it would soon revert to a value supported by all available information. They would also downplay the significance of such events, if they truly don't involve changes in information.

However even this concession would open up the possibility that one could in theory trade around non-informational chaotic events and beat the market.

I don't think the bolded follows from the above. Chaotic movements in price which are inherently not predictable don't create the opportunity to systematically beat the market. Someone could get lucky, but that's demonstrably true of the market today anyway. If you happen to buy stocks that are going to go up each day and sell the ones that go down, you can easily beat the market by huge amounts over time.

The EMH simply states that there is no effective way of reasoning or identifying which stocks will go up and which will go down until it has already happened.

ChpBstrd

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Re: Efficient Market Hypothesis (EMH)
« Reply #31 on: April 15, 2021, 12:04:10 PM »
In my thread "An Experiment", the criticism is that my experiment is much riskier than the S&P 500, and so higher returns are expected.  One measure of risk is Beta, by which measure my experiment's risk adjusted returns (returns divided by stock's Beta) are less than the market.  So maybe the experiment does confirm EMH.

I viewed the stocks I picked as having very high default risk, with most investors being unwilling to take those risks.  When I started, I thought people like Buffet were investing the same way I was, and would have a great year.  So I was sad to learn Buffet dumped his position in Delta Airlines (at a loss).  I bought and held two airline stocks that did very well (especially when I switched to call options).

I think I just collected more information about Covid-19 than most investors, and was more comfortable when panic hit.  Back in March 2020 the NY Times published an expose of U.S. Covid-19 testing, which reflected the mainstream view.  About the same time, a Corona virus task force member announced cases were about to increase because testing was increasing exponentially.  I checked the data - the NY Times was 2 weeks out of date, which in terms of exponential growth, is just wrong.  So I went with data almost nobody was using, and predicted the end of the panic on Mar 20-21 (real date was Mon, Mar 23).  There's a post I can dig up where I predicted the bottom, and nailed it within 2%.

I don't expect to do that again, nor do I expect the opportunity to occur again.  Can EMH just be invalid in 2020?  Or does that invalidate EMH overall?

Personally, I'm allowing the contradictions to co-exist.  When I'm on top of something like Covid-19 prediction, I tried to beat the market.  When I lack any data better than the market, I'm back with EMH.

There's no doubt the Experiment was a higher-risk portfolio than the index. Borrowing on margin to buy the index in March 2020 would have yielded a similar risk-return outcome. This is all compatible with EMH and the CAPM. Investors demand higher returns (will only pay a cheaper price) for cash flows that are less certain or more volatile.

Additionally, the pandemic was a new piece of information affecting the size and probability of future cash flows for all companies. Once the pandemic became known to investors, there were multiple decision trees of uncertainty and different paths events could have taken. For example:

1) The Trump administration could have coordinated with CDC experts instead of opposing them, for example acting on the recommendation to mail a week's supply of cloth masks to every US address, invoked the DPA to increase production of PPE, allowing more imports of PPE, not spreading misinformation, not holding rallies, etc. These decisions were completely unpredictable.

2) Operation Warp Speed might never have been launched, or it could have been administered incompetently by the known-incompetent administrators, and the tsunami of research money that produced at least 4 approved vaccines within months might have never flowed.

3) Had the deadliness or contagion factor of the virus been a couple decimal points higher, we'd have millions of deaths by now instead of ~600k, prolonged shortages of things, and perhaps mass panic.

4) Had stimulus legislation not passed, had it been smaller, or if it passed but funding was held up in bureaucracy set up to reduce fraud, the economy would be in a much worse place today - possibly a deflationary spiral. Recall the small, ineffectual checks mailed out by the IRS in the summer of 2008.

5) Had the new more contagious / more deadly variants evolved a few months sooner than they did...

6) Had vaccine development proved to be more technically tricky... (at the time, no vaccine had yet been made for a coronavirus)

7) Small cultural things - like the percentage of churchgoers refusing to social distance or the likelihood for teachers to be strict in rule enforcement - could have made a big difference in the rate of spread.

8) Was the Trump administration using the pandemic crisis as an excuse to delay or prevent the 2020 election? If that turned out to be the plan, the ensuing conflict would have been very bad for stocks, as it was in Turkey, Egypt, etc. (It could be they really were making that plan, but the polls were close enough they chose to take their chances with the election instead of taking their chance with the other option. Again, very unpredictable.)

etc...

But these were all bits of information. That's why I'm thinking about chaotic events, or even informational events that don't affect the probability of future cash flows. E.g an internal issue at company X affects the stock price of completely unrelated company Y by causing investors or index funds to rebalance their portfolios by selling company Y. In that example, the market or index as a whole would incorporate all available information, but company Y's stock would be depressed compared to what the info would predict, at least until arbitrageurs step in. That time period between the rebalance and the arbitrage would be a violation of EMH that someone could, in theory, capitalize on. This arbitrage might look a lot like momentum investing.

ChpBstrd

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Re: Efficient Market Hypothesis (EMH)
« Reply #32 on: April 15, 2021, 12:17:41 PM »
Everything I've ever read about EMH has referred only to information, and information is the only factor mentioned. However, I doubt the most ardent EMH supporter would deny the existence of chaotic events.

I suppose a defender of EMH would say if a non-information chaotic event nudged the price away from the value which is supported by all available information, it would soon revert to a value supported by all available information. They would also downplay the significance of such events, if they truly don't involve changes in information.

However even this concession would open up the possibility that one could in theory trade around non-informational chaotic events and beat the market.

I don't think the bolded follows from the above. Chaotic movements in price which are inherently not predictable don't create the opportunity to systematically beat the market. Someone could get lucky, but that's demonstrably true of the market today anyway. If you happen to buy stocks that are going to go up each day and sell the ones that go down, you can easily beat the market by huge amounts over time.

The EMH simply states that there is no effective way of reasoning or identifying which stocks will go up and which will go down until it has already happened.

Suppose for a 2-minute span of time, the rational value for stock X which objectively incorporates all available information, is $10. During those 2 minutes, the stock trades for 9.99 - 10.02 for chaotic reasons. In theory, a computer which could incorporate all available information and derive the rational price of $10 could enter limit buy orders at 9.99 and sell orders at 10.01. In practice, our AI is probably insufficiently advanced to objectively incorporate rapid streams of qualitative information into asset prices in real time, but if that changed these computers would be making profits that violate EMH.

maizefolk

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Re: Efficient Market Hypothesis (EMH)
« Reply #33 on: April 15, 2021, 12:23:17 PM »
Everything I've ever read about EMH has referred only to information, and information is the only factor mentioned. However, I doubt the most ardent EMH supporter would deny the existence of chaotic events.

I suppose a defender of EMH would say if a non-information chaotic event nudged the price away from the value which is supported by all available information, it would soon revert to a value supported by all available information. They would also downplay the significance of such events, if they truly don't involve changes in information.

However even this concession would open up the possibility that one could in theory trade around non-informational chaotic events and beat the market.

I don't think the bolded follows from the above. Chaotic movements in price which are inherently not predictable don't create the opportunity to systematically beat the market. Someone could get lucky, but that's demonstrably true of the market today anyway. If you happen to buy stocks that are going to go up each day and sell the ones that go down, you can easily beat the market by huge amounts over time.

The EMH simply states that there is no effective way of reasoning or identifying which stocks will go up and which will go down until it has already happened.

Suppose for a 2-minute span of time, the rational value for stock X which objectively incorporates all available information, is $10. During those 2 minutes, the stock trades for 9.99 - 10.02 for chaotic reasons. In theory, a computer which could incorporate all available information and derive the rational price of $10 could enter limit buy orders at 9.99 and sell orders at 10.01. In practice, our AI is probably insufficiently advanced to objectively incorporate rapid streams of qualitative information into asset prices in real time, but if that changed these computers would be making profits that violate EMH.

This would require not just that the computer had access to all relevant information which really existed, but also that the computer knew with complete confidence that there was no relevant information it didn't have (no "unknown unknowns" to quote Donald Rumsfeld).

I agree that it is theoretically possible that a computer could have access to all relevant information and theoretically possible that, from this information it could calculate what the price "should be" and identify deviations from that price, but I don't think it would ever be possible for such a computer to rule out the possibility of additional unknown relevant information existing which could explain the price change.

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Re: Efficient Market Hypothesis (EMH)
« Reply #34 on: April 15, 2021, 12:33:31 PM »

I think I just collected more information about Covid-19 than most investors, and was more comfortable when panic hit.  Back in March 2020 the NY Times published an expose of U.S. Covid-19 testing, which reflected the mainstream view.  About the same time, a Corona virus task force member announced cases were about to increase because testing was increasing exponentially.  I checked the data - the NY Times was 2 weeks out of date, which in terms of exponential growth, is just wrong.  So I went with data almost nobody was using, and predicted the end of the panic on Mar 20-21 (real date was Mon, Mar 23).  There's a post I can dig up where I predicted the bottom, and nailed it within 2%.


Might I humbly suggest that you merely interpreted the data differently than most investors? Fortunately, your interpretation of the information worked out well. 

Two people can read the same pieces of information and reach different conclusions as to the proper course of action.

ChpBstrd

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Re: Efficient Market Hypothesis (EMH)
« Reply #35 on: April 15, 2021, 12:52:26 PM »
Everything I've ever read about EMH has referred only to information, and information is the only factor mentioned. However, I doubt the most ardent EMH supporter would deny the existence of chaotic events.

I suppose a defender of EMH would say if a non-information chaotic event nudged the price away from the value which is supported by all available information, it would soon revert to a value supported by all available information. They would also downplay the significance of such events, if they truly don't involve changes in information.

However even this concession would open up the possibility that one could in theory trade around non-informational chaotic events and beat the market.

I don't think the bolded follows from the above. Chaotic movements in price which are inherently not predictable don't create the opportunity to systematically beat the market. Someone could get lucky, but that's demonstrably true of the market today anyway. If you happen to buy stocks that are going to go up each day and sell the ones that go down, you can easily beat the market by huge amounts over time.

The EMH simply states that there is no effective way of reasoning or identifying which stocks will go up and which will go down until it has already happened.

Suppose for a 2-minute span of time, the rational value for stock X which objectively incorporates all available information, is $10. During those 2 minutes, the stock trades for 9.99 - 10.02 for chaotic reasons. In theory, a computer which could incorporate all available information and derive the rational price of $10 could enter limit buy orders at 9.99 and sell orders at 10.01. In practice, our AI is probably insufficiently advanced to objectively incorporate rapid streams of qualitative information into asset prices in real time, but if that changed these computers would be making profits that violate EMH.

This would require not just that the computer had access to all relevant information which really existed, but also that the computer knew with complete confidence that there was no relevant information it didn't have (no "unknown unknowns" to quote Donald Rumsfeld).

I agree that it is theoretically possible that a computer could have access to all relevant information and theoretically possible that, from this information it could calculate what the price "should be" and identify deviations from that price, but I don't think it would ever be possible for such a computer to rule out the possibility of additional unknown relevant information existing which could explain the price change.

The "unknown unknowns" might as well not exist, except that their possibility is baked into the investors' required rate of return. That is, earnings could be predicted with very high certainty if not for unknown unknowns, and this is why stocks are not priced in the same way that treasury bonds are priced. It is why even the best analyst estimates must be taken with a grain of salt.

Unknown unknowns are not information (if they were info, the would be knowns), and because they do affect stock prices by increasing investors' required rate of return, we can say "here is a non-information factor affecting stock prices, a violation of EMH".

This is a much stronger argument than my earlier reference to chaotic fluctuations causing potentially exploitable deviations. The risk premium is hands-down the biggest factor driving stock prices, and you've just pointed out one of the key drivers of the risk premium.

maizefolk

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Re: Efficient Market Hypothesis (EMH)
« Reply #36 on: April 15, 2021, 02:04:15 PM »
Suppose for a 2-minute span of time, the rational value for stock X which objectively incorporates all available information, is $10. During those 2 minutes, the stock trades for 9.99 - 10.02 for chaotic reasons. In theory, a computer which could incorporate all available information and derive the rational price of $10 could enter limit buy orders at 9.99 and sell orders at 10.01. In practice, our AI is probably insufficiently advanced to objectively incorporate rapid streams of qualitative information into asset prices in real time, but if that changed these computers would be making profits that violate EMH.

This would require not just that the computer had access to all relevant information which really existed, but also that the computer knew with complete confidence that there was no relevant information it didn't have (no "unknown unknowns" to quote Donald Rumsfeld).

I agree that it is theoretically possible that a computer could have access to all relevant information and theoretically possible that, from this information it could calculate what the price "should be" and identify deviations from that price, but I don't think it would ever be possible for such a computer to rule out the possibility of additional unknown relevant information existing which could explain the price change.

The "unknown unknowns" might as well not exist, except that their possibility is baked into the investors' required rate of return. That is, earnings could be predicted with very high certainty if not for unknown unknowns, and this is why stocks are not priced in the same way that treasury bonds are priced. It is why even the best analyst estimates must be taken with a grain of salt.

Unknown unknowns are not information (if they were info, the would be knowns), and because they do affect stock prices by increasing investors' required rate of return, we can say "here is a non-information factor affecting stock prices, a violation of EMH".

This is a much stronger argument than my earlier reference to chaotic fluctuations causing potentially exploitable deviations. The risk premium is hands-down the biggest factor driving stock prices, and you've just pointed out one of the key drivers of the risk premium.

I disagree, but perhaps this is a question of terminology.

Suppose I am a computer watching the stock price. I have access to a vast library of data from which I've derived that the price should be $10/share. If I see the price is currently $10.15 cents, I could conclude the price has temporarily deviated from its correct value as a result of random factors (in which case I can make a profit from selling short). Or that other participants in the market have access to some piece of information I don't, which means my estimate of the correct price is wrong. Since I can never confidently have access to all information that all other market participants have access to, even with a hypothetically perfect ability to predict what the price should be given a set of information, unpredictable fluctuations in the stock price still don't let me consistently beat the market.

And I still disagree with you that the EMH requires that only information be reflected in the stock price. I agree with you that the EMH requires that all information be reflected in the stock price, but those two statements are synonymous.

MustacheAndaHalf

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Re: Efficient Market Hypothesis (EMH)
« Reply #37 on: April 16, 2021, 10:18:10 AM »
I think I just collected more information about Covid-19 than most investors, and was more comfortable when panic hit.  Back in March 2020 the NY Times published an expose of U.S. Covid-19 testing, which reflected the mainstream view.  About the same time, a Corona virus task force member announced cases were about to increase because testing was increasing exponentially.  I checked the data - the NY Times was 2 weeks out of date, which in terms of exponential growth, is just wrong.  So I went with data almost nobody was using, and predicted the end of the panic on Mar 20-21 (real date was Mon, Mar 23).  There's a post I can dig up where I predicted the bottom, and nailed it within 2%.
Might I humbly suggest that you merely interpreted the data differently than most investors? Fortunately, your interpretation of the information worked out well. 

Two people can read the same pieces of information and reach different conclusions as to the proper course of action.
I only used publicly available information, which backs up your point that I interpreted data differently.  Maybe media outlets are just going to report the numbers, and not even try the math.  But the stock market missing it is more puzzling ... maybe markets priced in uncertainty, and really didn't see 10,000 cases as certain.  But even the day before it happened?

By far the weirdest sequence of events, and my most profound disrespect for stock markets, happened from Mar 8-10 of 2020.  Mar 8 the Fed sounded the alarm (met days early, interest rates to zero, quantitative easing) ... Mar 9 the market dropped -7% (limit) because of Covid-19 and an oil price war.  Fears of the oil price war abated, and the market rose +3% on Mar 10, leaving it -4% in the face of Covid-19.  In every single country Covid-19 appeared, it grew from 1,000 cases to 5,000 cases in a week - without fail, be it Italy or Korea.  So to see the markets ignoring experts and pricing Covid-19 as a -4% problem seemed crazy.

All data outside the U.S. seemed to point in the same direction.  U.S. experts all pointed in the same direction.  Maybe U.S. stock market investors simply ignored international data?  Otherwise I'm not sure what explains stocks -4% for Covid-19.

MustacheAndaHalf

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Re: Efficient Market Hypothesis (EMH)
« Reply #38 on: April 16, 2021, 10:57:57 AM »
I viewed the stocks I picked as having very high default risk, with most investors being unwilling to take those risks. 

...  I checked the data - the NY Times was 2 weeks out of date, which in terms of exponential growth, is just wrong.  So I went with data almost nobody was using, and predicted the end of the panic on Mar 20-21 (real date was Mon, Mar 23).
... the pandemic was a new piece of information affecting the size and probability of future cash flows for all companies. Once the pandemic became known to investors, there were multiple decision trees of uncertainty and different paths events could have taken. For example:
...
2) Operation Warp Speed might never have been launched, or it could have been administered incompetently by the known-incompetent administrators, and the tsunami of research money that produced at least 4 approved vaccines within months might have never flowed.

3) Had the deadliness or contagion factor of the virus been a couple decimal points higher, we'd have millions of deaths by now instead of ~600k, prolonged shortages of things, and perhaps mass panic.

4) Had stimulus legislation not passed, had it been smaller, or if it passed but funding was held up in bureaucracy set up to reduce fraud, the economy would be in a much worse place today - possibly a deflationary spiral. Recall the small, ineffectual checks mailed out by the IRS in the summer of 2008.
...
Your points are well taken, and I agree with the uncertainties you listed - except for these 3 points above.  While granting you are right on most points and make a good point overall, I want to pick on those 3 for a moment:

(2) Pfizer did not participate in Operation Warp Speed, and was the first company to produce a vaccine.  More than half of vaccinations in the U.S. so far have been the Pfizer vaccine.  I concede the point that Moderna needed the money, though.
https://www.statista.com/statistics/1198516/covid-19-vaccinations-administered-us-by-company/

The vaccines made by Russia and China didn't receive anything from the U.S. government.  I think if Warp Speed had not happened, most vaccines would still have come to market.

(3) People change their behavior when the virus is more deadly.  Do you remember a total lockdown of the U.S. in 2009?  It didn't happen, even though 60 million Americans caught swine flu.  There were just 12k deaths, compared to almost 600k U.S. Covid-19 deaths.  Much deadlier virus, much larger response.
https://www.cdc.gov/flu/pandemic-resources/2009-h1n1-pandemic.html

(4) Republicans certainly recall what happened after the 2008 crisis: they lost their majorities in the Senate, the House, and saw a Democrat elected U.S. President.  Back in Mar 2020 I knew it was an election year, and that Congress had a choice: spend other people's money, or end their careers.  Not their jobs, their careers - the very lucrative consulting and speaking fees that members enjoy after leaving office depends on not being reviled by everyone.  Counting on their own self interests, I thought it very unlikely a relief package would be thwarted.  I think the chances are much lower than you estimate in your point - partly because of history.

And again, I haven't hurt your argument that much.  Vaccines could still have been ineffective, or people could have been even more willing to socialize, etc.  There's a lot of chaos in predicting the outcome.

An extremely high percentage of crashes are followed by recoveries.  Exceptions doom the economy of entire countries, so highly risky portfolios and indexing both collapse in that scenario.  The most likely outcome was a recovery, in which case stocks like Macy's and Carnival Cruises rise about 3x during a recovery.  That situation persisted until vaccines were announced, at which point the recovery started.

Ironically, I didn't expect vaccines to work.  Nearly all prior pandemics ended with the disease spreading as far as it could.  But even with that history, I expected a day would come when the pandemic would end - and stocks would recover dramatically as that happened.  With vaccine research underway, I switched to call options (higher leverage) to await some of the vaccines succeeding (of dozens).

waltworks

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Re: Efficient Market Hypothesis (EMH)
« Reply #39 on: April 16, 2021, 03:40:01 PM »
There is probably a ThreeFourthsofaMustache out there who made the opposite bet (in fact our own @junioroldtimer famously sold everything in March of last year) using pretty much the same set of facts, though, right?

I mean, I put a bunch of money into the market in the spring, because I figured everything would basically turn out fine and I'd make money (and because I always tend toward optimism). I did.

I could VERY easily (as ChpBstrd points out) have been wrong and lost a ton of money if just one of many things had gone differently.

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Re: Efficient Market Hypothesis (EMH)
« Reply #40 on: April 23, 2021, 09:26:08 PM »
I didn't read half of the posts.

My two cents:

EMH is a concept with some truth behind it developed by someone (I don't know who - nor do I care) who wanted to gain from pushing the concept. Like a popular stock, other's jumped on the bandwagon and made hay selling advice.

The truth that can be found in the theory is exaggerated and in essence destroys the credibility of a more tempered proposition.

The idea makes no allowance for market(herd) psychology which is a significant mover of stocks, indices and markets. Humans are utter suckers for a dumb idea propounded by someone with tremendous confidence and this kind of mania cannot be priced and must be observed to be useful.

If you have some skill to recognize unreasonably extreme love or hatred for a stock/market/product, you can benefit from the herd's movement.

Example: Oil is extremely hated these days so I'm heavier on oil at this time. I expect my opinion to change by the fall and after that if I don't see an extreme that I can benefit from, I'll go fully balanced.

Go ahead... tell me how oil is dead. Prove my point!

maizefolk

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Re: Efficient Market Hypothesis (EMH)
« Reply #41 on: April 23, 2021, 09:53:58 PM »
If you have some skill to recognize unreasonably extreme love or hatred for a stock/market/product, you can benefit from the herd's movement.

Sometimes this'll work and you'll make some money. Other times you run into a Tesla, where people can make a very clear and rational case for it being unreasonably loved by the market ... and those same people have lost billions and billions betting it was going to decline when the market came to its senses. ... or GME for that matter. Which is back up to $150 dollars a share for some reason or another.

MustacheAndaHalf

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Re: Efficient Market Hypothesis (EMH)
« Reply #42 on: April 24, 2021, 01:14:04 AM »
There is probably a ThreeFourthsofaMustache out there who made the opposite bet (in fact our own @junioroldtimer famously sold everything in March of last year) using pretty much the same set of facts, though, right?
Mar 11 2020, markets rose +3% as fears of an oil price war subsided.  So the prior day's -7% was about half from oil price, and half from Covid-19 fears.  Do you think Covid-19 was an event with a -4% stock market impact to the United States?

I think the market ignored epidemiologists who warned of millions of deaths.  The market ignored reality playing out in other countries, where exponential spread took hold every single time (as of March 9).  So I disagree that the market was operating with the same set of facts when it priced Covid-19 as a -4% loss to the US market on March 11 2020.

waltworks

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Re: Efficient Market Hypothesis (EMH)
« Reply #43 on: April 24, 2021, 08:29:29 AM »
You expected the market to react to all Covid news in ONE DAY? That's never how it works.

I guess I don't really know what you're trying to argue. Your case (I made the same decision, to invest more) is pretty weak here, because it's being made with the benefit of hindsight. If you establish a track record of beating the market by interpreting publicly available economic/political data, you have an amazing and rare (nigh-nonexistent) talent. That's awesome if it's the case, of course. I attribute my own success to optimism (which has a long track record of working out well) and luck.

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GuitarStv

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Re: Efficient Market Hypothesis (EMH)
« Reply #44 on: April 24, 2021, 03:50:29 PM »
If you have some skill to recognize unreasonably extreme love or hatred for a stock/market/product, you can benefit from the herd's movement.

Sometimes this'll work and you'll make some money. Other times you run into a Tesla, where people can make a very clear and rational case for it being unreasonably loved by the market ... and those same people have lost billions and billions betting it was going to decline when the market came to its senses. ... or GME for that matter. Which is back up to $150 dollars a share for some reason or another.

Same thing but writ larger for bitcoin.

maizefolk

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Re: Efficient Market Hypothesis (EMH)
« Reply #45 on: April 24, 2021, 04:03:27 PM »
If you have some skill to recognize unreasonably extreme love or hatred for a stock/market/product, you can benefit from the herd's movement.

Sometimes this'll work and you'll make some money. Other times you run into a Tesla, where people can make a very clear and rational case for it being unreasonably loved by the market ... and those same people have lost billions and billions betting it was going to decline when the market came to its senses. ... or GME for that matter. Which is back up to $150 dollars a share for some reason or another.

Same thing but writ larger for bitcoin.

I haven't heard about many folks who have lost a bunch of money betting against bitcoin. Generally the people who don't get excited about it also don't get excited about the financial instruments they'd need to invest in to bet against the price of bitcoin.

The critics of the enthusiasm for Telsa or GameStop have historically been much more willing to put their money where their mouth is, so my guess is that the financial losses from being either wrong (or at least misjudging the timing) have been much larger for the Telsa and GameStop bears than the bitcoin critics.

NorCal

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Re: Efficient Market Hypothesis (EMH)
« Reply #46 on: April 24, 2021, 04:30:02 PM »
If you have some skill to recognize unreasonably extreme love or hatred for a stock/market/product, you can benefit from the herd's movement.

Sometimes this'll work and you'll make some money. Other times you run into a Tesla, where people can make a very clear and rational case for it being unreasonably loved by the market ... and those same people have lost billions and billions betting it was going to decline when the market came to its senses. ... or GME for that matter. Which is back up to $150 dollars a share for some reason or another.

Same thing but writ larger for bitcoin.


Well said.  I've met tons of people who can semi-reliably identify a mis-pricing in the market, including a few on this forum.  I've met none that can use this information to reliably generate alpha without an informational advantage.

I have seen one small fund that consistently makes above-market returns in the venture capital world, but this is a fund that operates with an informational advantage and seems to have found a niche to use insider information without running afoul of insider trading laws (presumably).

BicycleB

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Re: Efficient Market Hypothesis (EMH)
« Reply #47 on: April 24, 2021, 06:14:59 PM »
When I did my MBA around the turn of the Millennium, we not only we indoctrinated into the idea of EMH; we were tortured by being made to "prove" it was so (and I mean ad nauseum) with the ONE HIGH AND HOLY MATHEMATICS ([AMEN]).  I actually came to believe it myself.  It was a tortuous path that changed me from an equity and bond indexer to an active trader focusing on options. 

In my opinion, the markets are "largely" efficient.  All available information is priced in.  But two caveats 1) not all information is publicly available, at least not timely 2) Keyne's 'animal spirits' play a role in determining how individual investors interpret the impact of the publicly available information. 

Inefficiencies in pricing are thus exploitable, but only by the nimble.  Portfolio size is the enemy of returns.  Buffet still claims he would expect to return 50% a year on average if investing less than a million dollars.  He has missed his own benchmark at BRK-B of 20% book value growth for several years now.  I suppose initiation of a distribution or buyback policy at Berkshire should have its own thread.

Amen to just about all of this!!

I doubt I will be nimble and focused enough to reap a lot of benefits soon. If so, I'll be more lucky than good. But I'm tuning in to the possibilities, and intrigued by real life examples (much respect to you btw, @Financial.Velociraptor). Hoping to profit wisely over time.

Would like to follow a good discussion re Berkshire buybacks.

clarkfan1979

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Re: Efficient Market Hypothesis (EMH)
« Reply #48 on: April 24, 2021, 07:09:24 PM »
Warren Buffet once gave a baseball analogy for his investing style. He cannot make an out on a "called strike". He can only make an out if it's a swing and miss. He waits for the best pitches to hit. Out of 100 strikes, he might pass on 97 of them and only swing at 3 of them.

I think part of the reason why mutual fund managers do poorly is that they are pressured into high volume trading to justify their job. If they were allowed to sit around and do nothing most of the time and only swing at the best pitches, I think their returns would improve.

I recently bought Southwest airlines at $23.05 in May 2020. The 52-week low is $22.46. I bought on the lowest trading day within 15 minutes. I tracked the stock for 2 months before pulling the trigger. I did it with a friend. He wanted to buy at $35. I told him that I was waiting for maximum pessimism. I don't have a specific number in mind. It's more an emotional condition of the entire country.

In 2020, my 401a account went up by 33.84%. I didn't buy any individual stocks, but I changed my asset allocation 3 different times during the COVID-19 pandemic. (Bonds/Small-Mid Cap/Large Cap/International). I have Ph.D. in Applied Social Psychology and I took two graduate level courses in Epidemiology. I am familiar with Pandemics and their recovery cycle. I used that information to make some strategic bets.

At a theoretical level, I studied behavioral economics. The field provides endless examples of when people get emotional they make bad decisions. The EMH assumes rational and non-emotional decision making by everyone. I don't think that represents the real world.