A common debate exists as to whether the stock market is efficient or not.
Variations of the Efficient Market Hypothesis propose that the stock market already contains all useful information, and therefore assumes that stock prices are all reasonable. A derived conclusion from this is that one cannot consistently “beat the market” on a risk-adjusted basis, and those that do are simply lucky outliers on the bell curve of success. There are different levels of strictness or literal-ness as to how far the logic of EMH extends.
There are others that disagree with the efficient market hypothesis. Some point out that certain investing styles tend to consistently beat the market over long periods of time. Others point to seeming anomalies, such as 100% useless equities that still hold residual value, or show that sometimes smaller companies can be overlooked by “big money”. Some even go so far as to say that the belief in efficient market hypothesis had a hand to play in this recent financial collapse, and that the result is a massive strike against the hypothesis. They might also argue that different types of markets have different levels of efficiency. A local housing market, for instance, can include vast discrepancies for the knowledgeable local investor. But as a given market increases in volume, liquidity, and attention (which describes the stock market), things will become more and more efficient, but not necessarily purely efficient.
I’m going to focus on one specific question in this article:
Can the Efficient Market Hypothesis take into account both short-term and long-term information and interpret both successfully?
Investors and speculators all have different goals for what they are doing. Some people invest for the long-term, and look three, five, or even ten years or more out when they make investment choices. They look at individual companies that have a bright future and a valuation that they find to be attractive, or they notice entire industry trends that should improve for decades based on practical needs. They’re not very concerned with quarterly reports, technical analysis, momentum, volume, or option interest. They’re not interested in what their returns will be this day, this week, this month, or even this year. Instead, they want to look back years from now and conclude that their investment today was worthwhile. In addition, a subset of these long-term investors are dividend investors that put a high emphasis on sustainable dividend growth and a decent dividend yield.
Others invest with short-term goals in mind. They expect that the next quarterly statement will be a hit or a miss, or that technical analysis or momentum shows that they can make a considerable return in the next few days, weeks, or months. Many financial firms are traders, and even many money managers that might otherwise invest for the long term have to realistically think about those who currently pay them fees with the expectation of success now and in the future. Corporations have quarterly and annual results to worry about.
Can the Efficient Market Hypothesis possibly cater to the expectations of both of these types of investors? They both theoretically have access to the same information, but with drastically different motives, the information leads them to significantly different conclusions. To the long-term investor, expectations and reactions to quarterly reports and technical analysis are nearly useless noise. To the short-term investor, these things are of prime importance, and they’re looking to acquire significant profits from many of their holdings in the near future.
Even if the market reflects all known information, can it possibly take into account all types of motivations? Can it be perfectly priced both for short-term expectations and long-term expectations at the same time? In reality, it must be a complex mix of long-term expectations, short-term trends, psychological aspects, and anomalies. This means that although it’s arguably efficient, it’s arguably neither perfectly efficient towards the short-term or the long-term.
Let’s propose an unrealistically clean example. For this example, we’re omniscient as far as the stock market is concerned for the next ten years.
We know, for instance, that in this example, the S&P 500 is currently at 1,400 and in ten years will be at 2,800. We also know that, a given company X, which is part of the S&P 500, is currently at $50, and will be at $120 in ten years, and pays an equal or higher dividend yield than the aggregate S&P 500. Interestingly, we know one more piece of information. Six months from now, company X will report some bad news, and the stock of the company will dip to $40, but this still doesn’t affect where we know the stock will be ten years from now.
How investors respond to such a scenario, would be fascinating. On one hand, it would be a market-beating idea to buy company X at the current price of $50. While the S&P 500 is only going to double over the next ten years, this stock is going to more than double, while paying an equal or higher dividend yield. It’s a better rate of return. On the other hand, if you know for a fact that the stock is going to drop to $40 from the current price of $50 in six months, then it wouldn’t be rational to buy at $50. Given perfect information, the most rational thing to do is to use our omniscience to wait for the precise stock bottom of $40, and then hold it until it triples to $120, for an even better market-beating return.
What should the stock price do in this first six months? On one hand, it’s already offering superior long-term returns at the current price. Its stock price should be pulled up by supply and demand by long-term investors to match the returns of what everyone knows the S&P 500 as a whole will provide. But on the other hand, the stock price should begin dropping, since we know for a fact it’s going to hit $40 in six months, and who in the world would buy at $50 knowing for a fact that it’s going to go down to $40 and offer a better buy at that price?
The puzzle is unrealistic because we never have 100% future certainty, and the market assesses prices with relevance towards expectations of future prices, based on a complex storm of technical assessment and fundamental assessment with varying timelines used in the estimates. In reality, the puzzle contradicts itself, because the stock price shouldn’t rationally drop to $40 to begin with if we know it’ll be $120 in under ten years. The reason stock prices drop like that in the real world is because it’s a shift in optimism/pessimism; it’s a reduction in assessment of the probability in hitting $120 in ten years.
Suppose that the above example were more realistically replaced with just probabilities. So company X has a wide economic moat, a business that is relevant for the foreseeable future, a strong balance sheet, significant inside ownership, decades of solid performance, and currently growing revenue, EPS, and dividends, and long term plans expressed by management to continue that trend, and that the valuation is rather moderate. But also suppose that technical analysts notice some bearish movements on their graphs, or some short-term traders are making predictions about the next national job report or European debt situations, with negative expectations about these things, which will potentially change macro-economic outlook and stock market valuations over the short term or medium term.
In this scenario, people interested in investing in the company for five years or more, based purely on its fundamentals and current stock price, may be buying. At the same time, people looking at bearish graphs or short-term market news may be selling. The volume of the latter likely exceeds the volume of the former. Is it possible that both parties could be right? Sure. A person could be right that the stock market is going to dip into a correction, and sell before it happens. Another person might not have any interest in playing that game, and instead is simply correct about buying a good company at a good price that provides solid long-term returns. All of this is happening at the same time.
Is it Important?
Perhaps a better question is, does it matter? Does the level of efficiency of the market determine how one invests? For some, it might. It could be justification, for instance, to buy index funds instead of individual stocks. If one accepts a sufficient level of efficiency in the market, and wants as low portfolio maintenance as possible, that could be a valid conclusion.
For others, buying and owning individual companies has no replacement (especially dividend stocks), and the level of the efficiency of the market has no bearing on their choice to buy individual equities. These are not necessarily people trying to “beat the market” (although it can be a fun goal to have), they’re just people buying good companies at reasonable prices, and preferable taking part in company ownership by voting their shares accordingly.
Earning a respectable long-term rate of return is what’s important, and to dividend investors, it’s also important to attain a consistently increasing stream of passive income. The complex mix of different expectations and motivations in the stock market provides value-oriented, long-term dividend investors with opportunities to buy excellent companies at low or moderate prices. If one attempts to take into account all short-term and long-term information, one is working with the same enormous set of variables as the overall market. But if one focuses mainly on either long-term investing or short-term investing (and this site of course is about the former), you’re focusing on only the subset of information that is useful for you, and discounting the rest. One of the best principles for long term investors is to buy shares as though you were buying the whole company; if it would be rational to buy the whole company at the current price, based on what you know, then it’s likely a good stock choice, but if you would not buy at the current price, then the current stock price is not ideal either.
My overall view of market efficiency is that it’s of course a highly liquid and highly followed market, therefore is going to have a large degree of efficiency. I do not, however, believe that it is perfectly efficient, primarily because that even with perfect information, there are so many different motivations involved. By streamlining our investment process and focusing only on the information that is relevant to us as long-term individual investors, we should be able to get good returns as long as the global economy continues to operate decently.
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