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The idea of a strong efficient-market has always been more academically entertained than actually believed, and whatever supporters it had have been hemorrhaging away over the last couple of decades. It is implausible on its face–and it would be even without federal monetary policy scrambling market signals.

The intention isn’t to puff myself up by knocking down a straw man, but the idea fails a simple test of logical consistency: If the market has already priced in all available information, I should be able to, while blindfolded, throw a dart at the wall to pick a stock and do just as well as if I gather as much relevant information as I am able to about potential buys ahead of my trade. Given this, due to the opportunity costs associated with spending time researching what I invest my money in, I am better off picking at random. But in the aggregate, myself and others like me choosing randomly inflates the valuation of the stocks we happen to pick at the expense of those we do not, indicating a market that is clearly operating at a sub-optimal level of efficiency.
• Category: Economics • Tags: Finance 
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  1. I can’t tell if you are discussing just the stock market, A.E. or markets of any sort. I’m gonna assume the former.

    The market may have been more rational and efficient back 50 years ago when a stock was seen for what it was, a share of the capitalization of a company that made profits. Dividends would let the company part-owners get their share of profits that were not reinvested.

    Now, it’s just a game of musical chairs, because it’s about buying low and selling high no matter if the company has real growth in sales/profits or not. If someone sells high, that’s someone else buying high. Then you’ve got the high-frequency trading programs that make money off the small changes. It’s the FED having forced interest rates down to unnatural levels that has kept people in the market for the once decent returns, as risky as it is.

    The information that, in real markets, results in appropriate pricing, is nothing but psychology in today’s stock market. It’s not so much about Company XYZ will grow next year because of this, but how much other traders will believe Company XYZ will grow because of this. The winners are the guys that put out the newsletters that recommend certain trading, while the writers do the opposite side of the deal.

  2. @Achmed E. Newman

    oops, para 3, last sentence, should read “… only decent returns.

  3. The ‘perfect foresight’ form of the EMH is obvious nonsense, but nobody has ever genuinely thought otherwise.

    Nobody knows how any single piece of information affects expectations-formation, for a start. For seconds there are known-knowns that are not fully reflected in alpha because of other constraints (e.g., mandate constraints, portfolio-weight constraints). Most importantly, new information can arise and disappear on timescales that cannot show up in the MONTHLY data used by Fama & co.

    The Kahnemann clique tries to pretend that ‘perfect foresight’ is the default approach in modern economics, but they’re full of shit. It basically reveals that their understanding of economics ends at 2nd year undergrad pedagogic models.

    My one actual publication was actually about different ways of modelling expectations formations in the financial sector of a macroeconometric model: the two expectations formation mechanisms were
    ① a “quasi-rational” mechanism that formed unbiased expectations about post-shock equilibria (which generates expectation errors when the forecast length is less than the period required to re-equlibrate); versus
    ② full model-consistency (the same as the strong form of the EMH).

    The best way to think about the EMH is as a variant of the REH (rational expectations hypothesis) – which just says that agents gather and use information efficiently: they will continue to amass information (including information about the model itself) until the marginal cost of doing so equals the marginal expected benefit.

    And there’s the problem with supposed ‘refutations’ of the pure form of the EMH: nobody knows the actual model, so researchers claiming that such-and-so an observation is ‘counter to’ the EMH, assumes that the people generating the decision were using a given model that was known with certainty – which is nonsense.

    Operationally, it matters. It also sets up a knowledge environment where non-domain experts are taken seriously, when they shouldn’t be.

    In some unconditional pedagogic world, all asset prices are random walks – which ought to mean that Pr(Up) = Pr(Down) where Up and Down are some small ε move of the same size between T and T+ΔT (ΔT fixed).

    That’s taught because it gives some stylised facts that are crude approximations to reality, and it’s easy to grade… not because it is a sensible model to carry around and deploy in the real world.

    A year or so later the kiddies have to be winnowed again, so the mathematics is ratcheted up: they get the limiting case (where ΔT → 0) and the algebra gets complicated-but-easy because it reduces to Ito Calculus. It kills about half the class, who might fully grasp the concepts (I say this as one of the kiddies who found it easy in squiggle form; I went on to teach it).

    Anyhow – CompSci, Engineering and Physics majors find the mathematics easy, but can ignore the conceptual stuff. The solution just becomes a thing that they know how to implement in MATLAB (or R or Python if they want to be employable). It is a trap for those who try to arb across to the world that rightfully belongs to quant econometricians.

    Quants who are not no-finance-background people know from our understanding of expectations formation, that markets frequently get ‘overcooked’ in one or other direction – at which point there is a significant ’tilt’ in favour of contrary positioning at all lengths of run smaller than ΔT… that often blossoms into a reversal on ΔT timescales.

    It is imperceptible in ΔT until after the fact, but stands out like dog’s nuts if you’ve got half a clue.


    The ‘pure’ REH/EMH is unassailable; the ‘perfect foresight’ REH/EMH is nonsense and are known to be such.

    Markets are fractally-inefficient because of the different types of participants – what I refer to as ‘supertankers, speedboats, dophins, and krill‘, each smaller set is affected by, but does not affect, the larger classes.

    They have different expectations formation mechanisms – the supertankers research all large-caps to death, so there is no leftover alpha lying around on timescales that matter to the supertankers (i.e., holding periods of 3months or longer) in stocks that matter to the supertankers.

    The supertankers cannot respond to obvious short-term moves )or predictable things in relatively small-cap stocks at any length of run), because they can’t get into a position large enough to make a difference across the entire portfolio.

    And all that, taken together, is why supertankers cannot generate alpha.

    That’s why they have to make their living by clipping the ticket – charging ad valorem fees based on FUM, when the whole world knows that bigger FUM forces them to have smaller deviations from benchmark, driving alpha downward.

    By contrast, the smaller players are far more nimble, but are less competent (by and large) and less evidence-driven – which is why the ‘Dumb Bull Ratio’ (non-commercial longs as a proportion of total long open interest in the CoT data) is such an important part of any sensible composite indicator for sentiment extremes in equity indices (along with some standard shit – put-call ratios; valuation measures; AAII extremes; TICK and TIKI on intraday).

    And for dolphins and krill, alpha is a meaningless measure(of which, more below).

    The proof of this jaundiced view of non-Econ quants is the existence of two separate runsheets that show over 100 consecutive profitable closed trades (short and long, on several different timeframes, in a dozen different instruments… and in different years): one run of 110-odd, and one of 160 (163 if I recall correctly).

    The odds against 160 straight coin tosses coming up ‘Win’ is, of course, 2^(-160), which is unlikely ever to happen. The mere existence of a 160-length ‘streak’ therefore makes it obvious that the DGP generating returns from that strategy is fundamentally different from a coin toss; this would not be possible if returns were generated by an Ito Process (or its discrete time analog).

    The shorter ‘streak’ is vastly more likely, but still astronomically unlikely.

    Both runsheets are mine: they were done on a real-money CFD account with a ‘proper’ broker. (I’m in the process of moving house, but I will dig out screenshots of the account page and post them a bit later).

    They were small potatoes (starting balance ~1000) – the account was set up because I bet a mate that racking up 30 consecutive wins was ridiculously easy as a ‘smart contrarian‘ if you took your time.

    I also contended that it was possible to do that, with a trading strategy that had negative alpha if you marked to market on a daily basis.

    We agreed that it didn’t have to have positive daily MtM alpha: a win wasn’t a win until it was closed, and likewise holding losses didn’t crystallise until the position was closed. (That was consistent with the broker’s report layouts).

    More important: NO STOPS (except margin calls, if they happened); exits at fielder’s choice. A genuine ‘balls out’ strategy.

    Once I got past 30, we decided that we would double-or-nothing at each 10 additional trades until one of us cried Uncle. He gave up at 110; he was regaling another mate with the story and the gauntlet was thrown down again, so I did it again.

    This time I had to hit a streak of 50 before the stakes started doubling, and they doubled every 15… at 155 we agreed that he would pay me half the current stake and I would continue out of interest.

    Screenshots when I get to my desktop.

  4. AE — hate to say it cuz I don’t wanna be disrespectful, but all your assumptions are simply wrong here. You say things like, “The idea fails a simple test of logical consistency” when in fact logic has no bearing on the subject. Adam Smith is old and irrelevant news, and David Ricardo is simply wrong, or, more probably, lying. Stop reading economic textbooks and read some more I Ching. Keep in mind that Talmudic logic is not actually real logic. Achmed E. Newman above comes closer to the mark, but even he doesn’t go quite far enough.

    The modern global economy has been abstracted, chopped into pieces, digitized (I mean that both in the metaphoric way and in the actual binary-bits comp sci way), dehumanized, and most importantly, Judaized. It bears absolutely no relation to what you old fogies think of as “market logic.”

    Oddly enough, there’s a pretty good book on this written by, improbably, one of those po-mo Leftard Euro “theorists,” a species I normally kill on sight, but this guy makes actual sense. It’s called “The Uprising,” written by an Italian Pomo jackass named Franco Birardi, and despite referencing Deleuze and all the usual suspects, it actually makes a form of twisted sense. Worth a look, if you can tolerate the jargon, and as I say, a far more clear-headed explication de texte than what you’ll find in The Economist or the WSJ, may their torments in Hell be multiplied.

    • Replies: @animalogic
  5. @The Germ Theory of Disease

    “The modern global economy has been abstracted, chopped into pieces, digitized (I mean that both in the metaphoric way and in the actual binary-bits comp sci way), dehumanized….”
    At one end of the scale is a degree of complexity that makes climate look predictable. At the other end is gross interference in markets: ie various multi-billion /trillion dollar market interferences by central banks & governments which have rendered
    genuine price discovery a fantasy.
    Markets have never been “discoverable” in any real sense, however today it is many times worse.
    But, as it ever was, & as it is now: business people are rational gamblers.

  6. iffen says:

    What kind of puny post is this?

    No buy or sell tips included, sheesh.

    • LOL: Achmed E. Newman
  7. >due to the opportunity costs associated with spending time researching what I invest my money in

    People don’t weight this nearly as heavy as they should. The time and mental energy spent chasing after an 8% return on 50 grand is insane to me. Obsessing over this stuff, to make a few thousand bucks a year. I think if you don’t have 7 figures to play with, it’s not really worth your time to get involved in the stock market. Buying a zero turn and getting 25% more free time on summer weekends is a better way to spend money. “Investing” looks like the professional class equivalent of the dog track to me, except less fun

  8. Michael S says:

    If the market has already priced in all available information, I should be able to, while blindfolded, throw a dart at the wall to pick a stock and do just as well as if I gather as much relevant information as I am able to about potential buys ahead of my trade.

    Um, no. It’s called information asymmetry, and even if we didn’t have information asymmetry, efficient markets don’t predict future value, they only decide present value.

    If we develop the technology to pull in an asteroid full of platinum, then it would crash the value of that particular metal, but that doesn’t mean the markets are wrong to value it highly today, based on present scarcity. And indeed, if we developed that technology, the commodity price would start declining as soon as it looked like we could use it, long before we actually did use it.

    Not one of your better posts, sorry. And triumphantly claiming that “hardly anyone believes it anymore” (paraphrasing) is not only a false premise, it wouldn’t be an argument even if it were true. The popularity of an idea isn’t a reliable signal of truth, and in clown world, the relationship is often inverted.

    Assuming efficient markets – really, such a simple heuristic – has led to better financial decisions for me than 99% of my peers. Everyone seems to think you can get something for nothing, efficient markets say you probably can’t.

    Incidentally, the vast majority of investors do get the best returns by throwing darts – or more specifically, putting their money into an index fund.

    • Replies: @Audacious Epigone
  9. This post reads like the author is fishing for some tips on his portfolio.

    • Replies: @Bert
    , @Audacious Epigone
  10. Bert says:

    Perhaps so. Here’s my very general view. I think the overbought condition of the market reached its zenith last Friday.

    • Agree: Audacious Epigone
  11. @Kratoklastes

    Here are summary screenshots… including an earlier ‘streak’ from 2014, which was my first “100 not out“, to use the cricketing term.

    The annotations on the 2014 were added to clarify why there is a big dip in the equity line (it’s a withdrawal of all initial capital; I found the capital reduction a bit constraining so the next time they offered a bonus on deposits I topped it up).

    2014: (100 on the nose, over 6 months)

    2015: (111, in roughly 2 months)

    2016/17: (163, over the course of a year)

    The obviousness of contrarianism: orgasm-levels of selling during a waterfall decline (2014):

    The screenshots for each entire trade log are very long (each has a table with over 100 entries, after all); here’s a link to the 2014 one).

    I’ll dig out the .HTM files (they’re in an archive somewhere) and mount them on a server.

    • Replies: @Audacious Epigone
  12. anon[282] • Disclaimer says:
    @Achmed E. Newman

    >It’s not so much about Company XYZ will grow next year because of this, but how much other traders will believe Company XYZ will grow because of this.

    Known as Greater Fool Theory.

    >The winners are the guys that put out the newsletters that recommend certain trading, while the writers do the opposite side of the deal.

    Those guys don’t move the market on anything but microcaps. Mass proliferation of index investing is the theory du jour– the whole feedback loops and fragility argument.

  13. @Kratoklastes

    That was kind of a long comment, and I couldn’t tell for sure whether your are talking about the stock market or going to the crap tables in Vegas with your brother Rain Man, who, BTW, can’t help you at the crap tables.

    Seriously though (for the most part), as much as I can do the math, I don’t see how it apples to a market that is based on psychology, not much on fundamentals. I used to read Zerohedge for more their political-economic articles, but those trading advice ones they used to have were so damn bogus. All this talk about “support” and “head and shoulders” curves, and “death crosses” is BS from people who think they have a system. Peak Stupidity rants in “Technical” Trading – The stupid you’ll always have with you.:

    “Technical Trading” is a total load of bullshit, and, believe me, that WAS putting it in a nice way. There is absolutely NOTHING TECHNICAL about technical trading. A better name for it would be “playing with graphs”. Ever since the first stock numbers came ticking off on a paper tape, there have been people making graphs of it. That’s fine, but there have been others trying to make predictions based on the shapes of graphs of stock values and any other kind of economic indices. That’s the stupidity that has “always been with us.”

    It be one thing if, as in at least something resembling science or engineering, these “analysts” were connecting some theory with what they saw in the graphs. “This curve trends down when a company’s sales reach this percentage of … blah, blah….” … probably lots of baloney, but one could do some math to relate theory and observation. No, these technical traders and advisers just look at shapes of graphs – they’ve got “head and shoulders” curves that mean this, “support” at various round numbers that mean something else, and in the ZH article, as an example, a DEATH CROSS that is the 50-day moving average crossing below the 200-day moving average. Yeah? What do you know about anything behind which way each of these commodities, markets and currencies will go from that?

  14. AE you’re a brilliant dude and I learn from you all the time… but you’re obviously operating way way outside your area of education and expertise here. You’ve picked up a couple terms (ex: “strong efficient markets”) so I’m guessing your researching the topic (great!) but you’re not even using the terms you’re learning correctly (it seems clear you’re thinking of “semi strong form efficient markets” which is not at all the same thing).

    Your central thesis is so off it’s (to quote Pauli) “not even wrong”. It would take a lot to correct you enough that you could achieve wrongness, and then to systematically correct that good solid wrongness into actual rightness would basically be to write a textbook on the subject. Sorry but that’s tiresome for my thumbs and for hypothetical readers too.

    Again, I’m really not trying to run you down here, but man… some of your readers might have actually studied this stuff and/or done it for a living and/or know lots of people in this business and/or actually be used to playing this game with more than a couple chips. You really ding your considerable credibility when you speak confidently about other topics in a manifestly confused way.

    Please don’t be the right wing economic version of Bill Nye the bachelor degree in mechanical engineering guy. You’re awesome at what you do!

    • Replies: @Audacious Epigone
  15. @Kratoklastes

    I understand about half of that but that part I understand seems kinda legit to me.

    If I am understanding you, with that MTGOX chart you were basically dead cat bouncing stocks people were panic selling? Or futures? I realize MTGOX is bitcoin so maybe trading futures, which I’ve never done.

  16. @Achmed E. Newman

    That fundamentals and technicals are two distinct methodological approaches for asset valuations is evidence enough.

  17. @Kratoklastes

    I’ll have to masticate on this, but I’m able to follow it and it resonates.

  18. @Michael S

    Why must skepticism of the efficient market hypothesis and acknowledging that real returns can be (are) enjoyed assumed to be mutually exclusive?

  19. @Kratoklastes

    Because when whales break ranks the ocean gets destroyed? I’m not sure I follow re: bitcoin.

  20. @Anonymousse

    I was referring to the strong form efficient market hypothesis, not semi-strong. My point is that if it is impossible to beat the market, then trying is inefficient. But if trying is inefficient, it makes sense to expend zero effort and just invest. And if people are doing that, the market can surely be beat.

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