Efficient Capital Markets Hypothesis

I said a few posts back that in order to understand the assumptions behind the efficient capital markets hypothesis (ECMH), it will help us to state the case for that hypothesis with some clarity.

Here we go: when there is a way for someone to make alpha, that way comes about because there is some exploitable inefficiency in the system. For example, XYZ may be listed on stock exchanges in two cities: Philadelphia and Pittsburgh. Due to some inefficiency, XYZ trades at a lower price in Philly than in Pittsburgh. We know that’s inefficiency because the equity of XYZ is worth only what it is worth; there is only one possible complete discounting of all relevant information on that matter. If Pittsburgh and Philadelphia differ, one or both are wrong.

Since listed exchange prices are themselves public information, arbitrageurs will almost instantly pickup on this, and will quickly start buying XYZ at the lower price in Philadelphia and then selling it for a risk-free profit for a higher price in Pittsburgh. [It would be simpler than, say, buying pumpkins early in the season and re-selling them in October.] The arb activity itself increases the demand for XYZ in Philadelphia and sates demand in Pittsburgh. Thus, the trans-Pennsylvanian trade eliminates the disparity, in the process discovering the intermediate price that does discount earnings power properly.

The ECMH, then, is that real-world prices seldom allow for arbitrage at all, and that when they do, they create a window that traders close quite quickly.

So: the Assumptions?

The most important assumptions of this reasoning are: that markets are liquid (that is, that the arbs can easily buy and sell the assets involved and realize their profit); that markets are transparent (prices in the exchanges in both Philadelphia and Pittsburgh are easily obtained), and that the property rights of participants are protected (a government authority that purported to cancel trades after they had been settled, restoring title to earlier parties in the chain of transmission, could wreak havoc). If one or more of these premises fail, then the mechanisms that make the ECMH plausible don’t work.

There may be another assumption at work: that many – perhaps that most – of the participants in the system are working on the basis of a rational estimation of their own interests. No one believes it is necessary that everyone who buys or sells be just a bloodless profit calculating robot. Heck, some people might well be buying for sentimental reasons. Maybe the CEO of XYZ was my college roommate, and our alma mater is in Pittsburgh. In such a case, I may sentimentally want to buy XYZ stock at the Pittsburgh exchange, even at some sacrifice in cost, even knowing I could get it for a better price in Philadelphia.

ECMH can survive some such “noise” trades, so long as there aren’t so many of them as to drown the “signal” trades on which it depends.   

Cause and Effect

Let’s summarize where we are on the issue of the Morgan Stanley downgrade of XYZ stock and the immediate drop in its price:

1)      We have made the philosophical point that this downgrade is a candidate for a cause of that  price move in a straightforward sense of that word: it is analogous to the action of a human hand in pulling an apple off a tree;

2)      We have made the case that the downgrade probably is the cause of some price movement, inferring this from the substantial sums of money that gamblers are willing to pay to have this information as early as possible;

3)      And we have wondered whether the social costs of that gamblers’ den are large: how much misallocation of resources do such downgrades and speculation about such downgrades create.

Now we can make our final point on this subject. Though in principle there are such costs, they are small and fleeting. Any of the markets in which XYZ would have to be listed in order to make this matter at all are extremely transparent and quite liquid. They are accordingly subject to lightning-speed arbitrage. Price distortions created by the gamblers’ den are accordingly akin to a piece of meat thrown into an especially piranha-ridden stretch of the Amazon River.