We can reasonably hypothesize that “Mr.
Market” is rational, and knows a lot of stuff, because there are a lot of
people out there looking to make a buck off of any slip-up, looking to get an
edge, to learn something he doesn’t know, and to trade on that basis. Further,
all their trades on the basis of what they learn in that effort make him
smarter. They contribute to determining prices, so that an “edge” that still
worked a month ago may be outdated now, as Mr. Market has learned to factor it
in.
And that is why (especially
according to advocates of the ECMH) stock prices move in a random walk. It is
random to any observer not as smart as Mr. Market himself. Any given neuron
will presumably see the thoughts of the whole of the brain as a random result
of who-knows-what. There is nothing mystical about this – the confused neuron,
in its own trading, helps to bring the situation about.
Now, when I’m asked whether I
believe in ECMH, I generally reply, “yes and no.” It makes points that are very
helpful to keep in mind, and anything that dissuades retail-level stock picking
is probably performing a service. But … there are a lot of “buts.” We’ll get
into them hereafter. The points to retain right now are as follows:
1)
modern finance theory has long used
the bell curve as a randomness base line,
2)
the efficiency of markets (which, as
we will discuss, is itself built upon their liquidity and transparency, as well
as the fact that a lot of very smart people are looking for an edge in
competition with one another) is adequate explanation for random movements,
3)
inefficiencies of markets, which
show up as skewed or otherwise non-normal curves, require other explanations.
So we get back to the question with
which we began, though we may now re-word it more pointedly. Does news of a recommendation from a
brand-name investment bank (not the details of the research, but the bottom
line recommendation – buy, sell, or hold) skew the curves of market share
performance?
The answer is: it is very likely
that it does. We can determine this by applying the ancient epistemological
principle, “money talks, bullshit walks.” The clients of investment banks have
for many years paid significant subscription fees in order to gain access to
these reports before the public at large, and they have done so not because
they enjoy a good read on their kindles but because they expect they’ll be able
to monetize it. They do so because that is their edge.
Their purchases, that is, purchases
directly caused by these recommendations, then have the effect of
turning the recommendation itself into something of a self-fulfilling prophecy.
Morgan Stanley says “buy, because this stock price will go up,” and people
learning this buy – and, of course, the stock price goes up, beyond what the
rest of the market may be doing. It is generally a small bump in the big scheme
of things, and unless supported by underlying realities it will soon vanish,
but the phenomenon does exist.
Does this bump do any broad societal
harm? The ECMH theory after all is a theory not just of what is but of what
ought to be (both “positive” and “normative” if you like). It was the creation
of people who believed that the free market is an ideal way of distributing
society’s resources, and that free capital markets are ideal ways of deciding
whose savings ought to go into which investments.
The people who were hanging on the
early word from the Morgan Stanley about its latest research report, the people
who were in on the conference call, or getting instant messages: those people might be seen as competitors with one
another to harvest a quick profit off of the early bump they’re all about to
create. In that case, half of them will be wrong. The early audience will itself constitute
the bump, so half of that audience at least will be too late to profit from
knowing about the bump. If we look at it
that way, they’re simply gamblers at a table with other gamblers, and the
winning gamblers have no ‘victims’ a very consensual set – the losing gamblers.
But if you believe in ECMH, and if
you believe the normative propositions that go along with it, you’ll see other
victims. Some amount of capital is being misdirected, over some period of time,
so that this poker game can take place. It is being misdirected from its
‘highest, best use.”
We have thus far adumbrated two of the central
notions of modern finance theory, the presumption of bell-curve randomness (and
least as a default) and the notion of allocative efficiency that lies behind
it. Most economists disbelieve in any very strong version of ECMH, although
strong versions still show up in the literature, more-or-less as straw men.
Nonetheless, ECMH hangs in there, because a flawed theory beats no theory, and
no equally useful alternative has made its way into the literature yet.
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