Is the market efficient?

[goodrookie]

If so, then 1) why does the stock price move so fast? E.g. Is AAPl really worth billions of dollars more or less every few week? 2) Why isn't the anticipated event (at least the ones that are predictable) built into the price?

[Dodge]

If so, then 1) why does the stock price move so fast? E.g. Is AAPl really worth billions of dollars more or less every few week? 2) Why isn't the anticipated event (at least the ones that are predictable) built into the price?

Yes it is efficient.  Apple is worth 700 billion dollars.  It's value could fluctuate by 0.001%, and that would represent more than a billion dollars.

What makes you think the anticipated events aren't built into the price?

[phillyvalue]

Well I mean to answer the thread title, I think the evidence suggests that it isn't.

But in your example, there are many things that in an efficient market world would go into the pricing of Apple stock, and may indeed change on a day to day basis. In an efficient world, the price of Apple stock is always equal to the discounted value of the expected future cash flows, calculated based on the info that can possibly be known today**, that owning a share of Apple stock will give you. So the ingredients in this are the (a) expected cash flows, and (b) the rate used to discount them to the present.

(A) Expected Cash Flows
-The cash flows you expect from Apple stock could change for a whole host of reasons. Primarily, you may expect the business to generate more or less cash in the future than you did before, perhaps because of a new product announcement, etc. But also, it's worth noting that the cash flows the business generates and the cash flows shareholders receive are two different things. In Apple's case, investors raised their valuation of the stock when they saw that Apple would begin paying a dividend and buying back stock - the cash flow from the business didn't change, but now cash that was just sitting on the balance sheet was being used in a way that was perceived to be more efficient.

(B) Discount Rate
-The discount rate is the rate of return you "demand" in order to invest in Apple stock. Basically you should view the discount rate as the sum of (1) risk-free opportunity cost, and (2) risk premium. The idea is that people invest in risky assets like Apple stock in order to earn a higher return than they could get in a risk-free asset. So you take the "risk-free rate", usually taken to be the rate of return on U.S. treasury securities, and add to that a "risk premium" based on the riskiness of Apple stock. The most popular way of calculating this risk premium is the CAPM (Capital Asset Pricing Model), but there are competing ways of doing this.

So you can infer that anything that changes the expected future cash flows or the discount rate can cause a change in the stock price. If treasury rates move up, the discount rate goes up all else equal, so the value of Apple stock goes down. Perhaps treasury rates went up because economic growth is expected to be higher than previously anticipated - Apple's expected cash flows may go up and the discount rate may go up at the same time, so the effect on the price is uncertain.

**There are several "forms" of the efficient market hypothesis. The semi-strong form says that all publicly-available information is baked into the stock price. The strong from says that all information, public and private is baked into the stock price. In a market where insider trading is illegal, the semi-strong form should be the one to focus on.

[phillyvalue]

If so, then 1) why does the stock price move so fast? E.g. Is AAPl really worth billions of dollars more or less every few week? 2) Why isn't the anticipated event (at least the ones that are predictable) built into the price?

Yes it is efficient.  Apple is worth 700 billion dollars.  It's value could fluctuate by 0.001%, and that would represent more than a billion dollars.

What makes you think the anticipated events aren't built into the price?

.001% of $700 billion is $7 million.. :P

[okonumiyaki]

I think that the markets are efficient at a stock level, but not at a whole market level - i.e. manias & bubbles can & do exist.

Anticipated events are built into the price, but people may well have different views of the chance & impact of the event.  For example, will the US government allow Apple to on-shore their cash?  Will the EU shut down Apple's Irish tax loopholes?  What will the impact be of both?

Evidence shows that when an event becomes certain, prices react very quickly and efficiently, i.e. a takeover, or a crop report (for commodity prices)

[SaintM]

I think that the markets are efficient at a stock level, but not at a whole market level - i.e. manias & bubbles can & do exist.

Efficiency is a measure of information flow. The more information disseminated to the masses, the more efficient the market. Expectations can be built in, which is why you often hear "buy the rumor, sell the news" or big moves following earnings surprises, but information is not built in. The only time information can be built in is if one party acts on insider information, which is illegal because it makes hhe market inefficient.

Manias and bubbles exist not because of a lack of efficiency. The information is all the same. They exist because people do not understand or know what to do with the information. There is nothing preventing efficient markets from becoming overly exuberant.

[hodedofome]

Fischer Black, after leaving MIT for Goldman Sachs: "Markets look a lot more efficient from the banks of the Charles than they do from the banks of the Hudson."

Are markets efficient? It usually depends on who you are talking to. Academics and practitioners have different views on the subject. Academics that become practitioners seem to change their mind over time.

[YoungInvestor]

Clearly not over the short-to-medium term, especially on individual securities, but on the long term, I think they come pretty close.

Were companies in America really worth 50% less after the last crash? Obviously not. Opportunity to profit from market inefficiencies does exist once in a while. Should you always sit around waiting for that? Probably not.

[arebelspy]

Over a long enough timeline, yes, because someone will come along and exploit any inefficiencies and it will correct.

In the short term, because of people's irrationalities, they can be inefficient.

Also, some markets are more efficient than others.

The more transparency/available information, liquidity, and speed (to a point), and participants, the more efficient the market.

For example: Real estate tends to be inefficient due to lack of transparency/available, less liquidity and speed (time for transactions to occur) and less participants in general buying and selling versus stocks that has more publicly available information, more liquidity, participants, etc.

Either can be inefficient for a short time, but generally the one with those benefits is more efficient (and indeed, we see this in real life, the stock market crash corrected quicker than the real estate crash).

So if you're looking to exploit inefficiencies, you'll probably want a market that doesn't have those above things an efficient market does.

[Indexer]

Yes the markets are efficient 'in the shortest terms with respect to information available for the future.'

Apple doesn't swing a billion dollars because something happened at Apple.  (hypothetical)Apple swings a billion dollars because smartphone sells in China moved 1%.   If the current pricing of Apple assumes that smartphone sales in China will increase 10% over the next year, and they only increase 9% or they increase 11% but Android gets 10% of it then Apple looks worse in the long term so people trade in the short term and sell it.  Or it moves because the general market moved and it moved with it. 

Tesla has never traded on what it did today.  It has always traded based on what people expect it to do in the future. 

However the market isn't efficient over the long term.  Look at 2008.  Did anyone really expect the US economy to shrink by 50% and stay down 50%?   Of course not(well for most people), but the market dropped 50%.  Why?  Because people knew the future didn't look as good as they thought it did, and given that they traded based on what they thought would happen to stocks in the short term.  Result: stocks tanked.  (not exact numbers, you get the point)

This is good news for us.  As long as you invest for the long term(which has always trended up) you can take advantage of all this craziness in the short term through dollar cost averaging.  You can also take advantage of it through indexing.  You pay almost nothing while the guys who get paid millions set all the prices for you, again, based on their short term expectations for the long term future. 

[nazar]

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

[innerscorecard]

It is best for individual investors to assume that the market is generally efficient (but prone to overvaluation). However, exploitable inefficiencies do appear with regularity, especially in less liquid securities.

[rmendpara]

If so, then 1) why does the stock price move so fast? E.g. Is AAPl really worth billions of dollars more or less every few week? 2) Why isn't the anticipated event (at least the ones that are predictable) built into the price?

No, it's not. Take energy stocks recently as a prime example.

The biggest reason is that investors disagree about the "right" answer, even if they are (theoretically) operating with the same set of information (this is debatable).

[FFA]

A few great quotes here, but I didn't see the $100 bill story yet.

IMHO the market is inefficient, certainly in the short term and some times even in the long term too. However, I still believe many implications of EMH are instructive (e.g. no free lunches). Therefore I favour passive index investing nowadays, and resist the temptation to beat the market, which I do believe is possible (e.g. Warren Buffett) but far from easy.

[scottish]

Ok, here's the $100 bill story:

An economist and a normal person are walking down the street together. The normal person says “Hey, look, there’s a $20 bill on the sidewalk!” The economist replies by saying “That’s impossible- if it were really a $20 bill, it would have been picked up by now.”

Here's the longer version

A financial economist and passionate defender of the efficient markets hypothesis (EMH) was walking down the street with a friend. The friend stops and says, “Look, there’s a $20 bill on the ground.”

The economist turns and says, “Boy, this must be our lucky day! Better pick that up quick because the market is so efficient it won’t be there for very long. Finding a $20 bill lying around happens so infrequently that it would be foolish to spend our time searching for more of them. Certainly, after assigning a value to the time spent in the effort, an ‘investment’ in trying to find money lying on the street just waiting to be picked up would be a poor one. I am also certainly not aware of lots of people, if any, getting rich mining beaches with metal detectors.”

When he had finished they both look down and the $20 bill was gone!

[FFA]

Ah that's better! thanks scottishstash, and I nice to see it's now become a $20 bill since deflation is the talk of the town these days :)

[goodrookie]

Thank you all for your replies.

This brings to me to the next big question-stock market is essentially an auction system (hence, the BID and the ASK prices). If a majority of the investors just do indexing and avoid market timing, does it make the market less efficient or not? For my example, let's assume passive index only. (Yes, I know that not even S&P is not perfectly passive but that's for a later discussion.) When you buy (i.e. BID) for AAPL, TWTR, GOOG, XOM etc. via an ETF/funds you are also bidding on stocks you may not like to own strongly and can't time at all other than a sector/motif timing at best. Does it make the price/cost of securities less than optimal?

[clifp]

I think you ask very good question GoodRookie.   There was a pretty good thread on this subject on this question last year, but I can't seen to find it.

I think best case the market is only weakly efficient.

There was a very funny and quite thought provoking segment on the efficient market theory in last weeks Newshour http://www.pbs.org/newshour/bb/gangnam-style-can-teach-us-psy-chology-investing/

Turns out both the appearance of good looking CEO on CNBC and Gangnam style have significant and long term impact on stock prices.  I am waiting for an explanation by the EFH fans.

[arebelspy]

I don't see how that article takes away from an EMH philosophy. New information came out, market adjusted. New information may or may not be relevant to the earnings of the company, but seems relevant to the valuation. If overhyped or irrelevant, efficient market takes care of it.

Like the CEO thing. They said prices popped, then drifted down and within 10 days were back to the original level.

That fits exactly with what I said above. The market is inefficient in the short-term, because of human irrationally. Investors watching the TV show see attractive CEO, and buy the stock. Efficient market corrects that, and fairly quickly.

If anything, that seems like proof to me of the market being efficient.  Not 100% efficient all of the time, obviously.  I don't think you'll find anyone on this website willing to argue for strong EMH though.  But yes, the market is mostly efficient, most of the time, and when it isn't, it corrects itself.

[LordSquidworth]

Efficient market theory is false. 2008 was a prime example.

"In finance, the efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient". In consequence of this, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made."

Apple fell to something like $13/share on a split adjusted basis in 2008. There was no rational reason for this. The market cannot be efficient, because human beings act on emotions.

Over the long run they can seem efficient, but they're not short term. They cannot be efficient over one period and not over another and be considered efficient, you either are or are not.

There's nothing wrong with market inefficiency. That's where a lot of the money is made, and not necessarily risky. Apple at $13/share in 2008 had little risk, huge reward.

[arebelspy]

I disagree with almost everything you said, LordSquidworth.

Here is the crux of it:

They cannot be efficient over one period and not over another and be considered efficient, you either are or are not.

Based on your belief in this sentence, and my disagreement, we fundamentally draw different conclusions.  We'll have to agree to disagree.  Just pointing out that what you said, though you may view it as "fact" is opinion, and not one everyone agrees with.  I do understand that applies to my viewpoint as well.  :)

[Terrestrial]

If so, then 1) why does the stock price move so fast? E.g. Is AAPl really worth billions of dollars more or less every few week? 2) Why isn't the anticipated event (at least the ones that are predictable) built into the price?

There are two separate thoughts here.  You are right in that Apple 'the company' is probably not worth billions of dollars less or more over the span of an hour or a day. 

However, Apple 'the stock' is not firmly tied to the actual intrinsic value of the underlying company...it may play a part in how investors go about valuing what a share is worth to them, but when you buy a share of a company what you are really buying most of all is a share of it's earnings, and what investors are willing to pay for that can change quickly.  How quickly stock prices move are a reflection of the flow of information both company specific and on a macro level that have the potential to affect earnings, or how that changes how much of a premium people are willing to pay for those earnings.

[skyrefuge]

Look at 2008.  Did anyone really expect the US economy to shrink by 50% and stay down 50%?   Of course not(well for most people)

Apple fell to something like $13/share on a split adjusted basis in 2008. There was no rational reason for this.

heh...I like this hindsight-ism! "Since we now know the economy did not end up actually collapsing in 2008, that proves there was no chance that it would have collapsed, and thus, any such beliefs were irrational!"

[clifp]

I don't see how that article takes away from an EMH philosophy. New information came out, market adjusted. New information may or may not be relevant to the earnings of the company, but seems relevant to the valuation. If overhyped or irrelevant, efficient market takes care of it.

Like the CEO thing. They said prices popped, then drifted down and within 10 days were back to the original level.

That fits exactly with what I said above. The market is inefficient in the short-term, because of human irrationally. Investors watching the TV show see attractive CEO, and buy the stock. Efficient market corrects that, and fairly quickly.

If anything, that seems like proof to me of the market being efficient.  Not 100% efficient all of the time, obviously.  I don't think you'll find anyone on this website willing to argue for strong EMH though.  But yes, the market is mostly efficient, most of the time, and when it isn't, it corrects itself.

You don't think that stock going up more if the if a good looking CEO happens to be on TV, than an average looking CEO is irrational.  Or that a good looking CEO has permanent increase in stock  price.  Or that stock of a company Di Corp has increased 500% because the CEO of company is also the father of a pop culture phenom Psy and the stock price of the company is tied to the sons musical career. Or that a DFA a firm  founded on Farma principals, the father of the efficient market hypothesis, is the largest investor Di Corp.  Why the heck is DFA investing in DI Corp now as opposed to pre Gangnam style.   

[arebelspy]

You don't think that stock going up more if the if a good looking CEO happens to be on TV, than an average looking CEO is irrational.

That sure is irrational.  Because people are irrational.  But then the efficient market takes care of it, as the price returns to normal.  The market may be short term inefficient due to human irrationality, but is long term efficient as the rational ones exploit those inefficiencies and it moves towards efficiency and reaches equilibrium.

If it weren't, why isn't stuff randomly moving around all the time, nonstop?

[Paul der Krake]

However the market isn't efficient over the long term.  Look at 2008.  Did anyone really expect the US economy to shrink by 50% and stay down 50%?   Of course not(well for most people), but the market dropped 50%.  Why?  Because people knew the future didn't look as good as they thought it did, and given that they traded based on what they thought would happen to stocks in the short term.  Result: stocks tanked.  (not exact numbers, you get the point)

All bets are off in the event of a liquidity squeeze. Fire sales, resulting from market participants being forced to sell just to cover their immediate obligations, is a great recipe for a roller coaster ride.

[FFA]

If it weren't, why isn't stuff randomly moving around all the time, nonstop?

It usually seems like it is to me !!!

[scottish]

So... to paraphrase rebelspy, markets are efficient once they have time to stabilize?

I can buy this.   Every time new information comes out, markets adjust and are not efficient while they're adjusting.

Also this goes well with my $100 (now $20) bill post.

[arebelspy]

So... to paraphrase rebelspy, markets are efficient once they have time to stabilize?

I can buy this.   

Right.

It is market efficiency that causes us to go back to sane levels.

In other words, people point to the bubble in, say, 99 as an example of how the market is inefficient.  That to me is human irrationality and exuberance and it was market efficiency that caused the valuation back to sane levels (crash).

People point to the super low values in 09 as the market being inefficient.  That's people being irrational, and the efficient market fixed that correctly and prices rise to rational levels.

Every time new information comes out, markets adjust and are not efficient while they're adjusting.

They're inefficient other times too (not just when new info comes out, but due to human fear, greed, etc).  This is short term.  Long term they're quite efficient.  See the above Graham quote about voting versus weighing.

Also this goes well with my $100 (now $20) bill post.

Sure.  In the short term, a dropped $100 bill might sit there.  In the long term, the market is rational enough that it'll get picked up.

[Dodge]

"With the market beating 91% of surviving managers since the beginning of 1982, it looks pretty efficient to me."

~Bill Miller, portfolio manager

[hodedofome]

We've found that strategies like value and momentum actually do beat the market, but we can't admit to that as that would make us look really bad. So we're gonna call them Factors instead. - Eugene Fama

[clifp]

Arebelspy, I don't disagree with what you are saying about the market generally reach stability. But that isn't what EMH is about.

DEFINITION of 'Efficient Market Hypothesis - EMH'
An investment theory that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments.

In semi-strong-form efficiency, it is implied that share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on that information. Semi-strong-form efficiency implies that neither fundamental analysis nor technical analysis techniques will be able to reliably produce excess returns.

The good looking CEO effect shouldn't apply under strong EMH,  the multiyear outperformance of DL corp should occur under semi strong.  Nor since the stabilization was over the a period of years in 1999 and 09 instead of days people were able to earn excess returns, does semi strong EMH apply to those two markets.

Weak-form efficiency

In weak-form efficiency, future prices cannot be predicted by analyzing prices from the past. Excess returns cannot be earned in the long run by using investment strategies based on historical share prices or other historical data. Technical analysis techniques will not be able to consistently produce excess returns, though some forms of fundamental analysis may still provide excess returns. Share prices exhibit no serial dependencies, meaning that there are no "patterns" to asset prices. This implies that future price movements are determined entirely by information not contained in the price series. Hence, prices must follow a random walk. This 'soft' EMH does not require that prices remain at or near equilibrium, but only that market participants not be able to systematically profit from market 'inefficiencies'. However, while EMH predicts that all price movement (in the absence of change in fundamental information) is random (i.e., non-trending), many studies have shown a marked tendency for the stock markets to trend over time periods of weeks or longer[19] and that, moreover, there is a positive correlation between degree of trending and length of time period studied (but note that over long time periods, the trending is sinusoidal in appearance).[20] Various explanations for such large and apparently non-random price movements have been promulgated.

I personal don't understand technical analysis (although have decent grasp at the basics.) But just because I don't understand something doesn't mean it might not be real. My suspicious is that good technical analysis can achieve alpha over long periods of time. What I don't know is that just the billion coin flipper some will get lucky or is it true skill.

I think people act pretty irrationally economically in general and combining a bunch of irrational folks together doesn't make the whole group rational.   I think it is fairly rare individual individual who can look at stock and say I don't care what Mr Market thinks today it is worth $100 not the $50 it is trading (or 100k, vs 50K for real estate) and even more rare person who can say the $100 stock is only worth $50 and short it.

I do think most of the time the market is somewhat efficient, and the level of inefficiency isn't sufficient to justify paying somebody a couple of percent to manage your money.

[scottish]

That's the trouble with economic ideas that haven't been tested against the real world.    They usually don't work  agree with what really happens.

I think its perfectly obvious that any time a new piece of information comes out it will take some amount time for the market to determine what that information means and for the price to adapt.    This is the way physical systems work.

There's a newer branch of economics - experimental economics - that doesn't try to figure out how everything works solely by thinking about it.     There's a book I read about this a few years back:

http://www.amazon.com/The-Origin-Wealth-Remaking-Economics/dp/1422121038

that was really very interesting.    Now that I think about it, it's time to read it again.