How to Exploit an Inefficient Market
The Efficient Market Hypothesis is a mainstay of academic thinking about financial markets. It is rejected by many traders and money managers. Warren Buffett, for example, famously said that he would be on a corner, selling pencils from a tin cup if markets were efficient.
I do not expect to settle this decades-long debate in a single blog post. Instead, I will share how my own personal thinking changed along with my career – from college professor, to financial analyst, and to investment manager. I hope to stimulate and to provoke; we can all benefit from some wise comments. I will also suggest a few ideas we might consider to exploit inefficiency.
Provocative Examples
It is often useful to have a specific example in mind. Let’s start with Facebook (FB), a company familiar to all. Here is a chart of recent stock action:
Let’s consider four time periods.
- Before the Cambridge Analytics announcement. The stock was comfortably trading at the 185 level. Was the market efficient and rational? Was all information reflected? Try doing a custom Google search ending just before the news was announced. I used “Facebook use of personal data” ending on 3/15/18. The Cambridge story was different in magnitude, but not a surprise to anyone carefully following the stock.
- Right after the announcement, with the stock at 173. Was the market efficient and rational? That was the market-clearing price for a day.
- What about the Zuckerburg silence effect, taking the stock to 165 for a day or two. Was the market efficient and rational?
- What about the current levels, with the (highly predictable) news that every attorney general trying to make a name – at any level of domestic or foreign government – is suing the company and demanding testimony. Is the market now efficient?
My question, and it is a question, is whether the market was efficient at both the start of this process and at the end. This seems inconsistent.
Let’s try Nvidia (NVDA).
- The stock was trading around 250. Did that reflect an efficient market?
- News broke about the tragic death of a pedestrian in Arizona, struck by a self-driving car. The stock dropped to the 240 range. Was that a reflection of market efficiency? Please keep in mind that the self-driving tests generally show superiority over human drivers. Are we really surprised that millions of miles of testing resulted in a death? This seems like a predictable event.
- The stock rallied back to 250. Was this a rational market response?
- The stock dropped to 235 and rebounded, once again, to 250. Does this reflect an efficient market?
- Today’s trading took the stock to the 220 range. The company announced “a suspension” of self-driving tests. Viewers of CNBC got the analysis from two sources. First, the Nvidia story sparked selling in all artificial intelligence stocks. Then Art Cashin explained that the selling started with tech stocks and spread to the S&P 500 and then the DJIA. Was any of this efficient?
My Take
I try to separate pre-news trading from what happened later. I call it “local market efficiency.” It means that the dramatically different original price in the stocks might make sense, varying according to daily news – until the big story hits. It is a bit like The Big Short. Even though the heroes were accurate in their assessment, payday was years away. Disgruntled investors did not understand. The thesis was taking forever to play out, and the logic was difficult to explain. (In my reviews I try to make points not seen elsewhere, and I thought I really nailed it with this one).
Today’s trading unreasonably crushed the AI and supporting chip stocks. This is the kind of knee-jerk reaction that can be exploited both by traders and by long-term investors building a position.
I am also considering social media stocks that do not share the Facebook model of selling customer data.
I especially like artificial intelligence stocks. There will be some setbacks, but this is a dominant market direction. Here are some good ideas:
- NVDA itself;
- Some general AI ideas (Zacks).
- 10 Best, large and small (U.S. News)
- AI without FANG.
Conclusion
I hope that my thoughts about efficient markets were provocative, and I invite comments. I hope that others see the inconsistency involved in claiming that these markets were efficient both before and after news – drawn out and not completely unexpected.
Those of us who believe in exploiting inefficiencies got some great opportunities today!
Jeff, you ask some interesting questions regarding what market efficiency means. There are further distinctions that help clarify what efficient markets do and do not reflect. In terms set out originally by Fama and French, and recently articulated by Aswath Damodaran in Investment Philosophies (165-167), “an efficient market is one where the market price is an unbiased estimate of the true value of the investment.” This does NOT imply that
1) “Stock prices cannot deviate from true value.” The deviations, however, are random.
2) “No investor will beat the market in any time period.” and
3) “No group of investors will beat the market in the long run.”
In short, financial markets reflect supply and demand based on market agents’ abilities to leverage available information. Markets are not perfect as neither the understanding and leveraging of available information nor transactions costs are zero.
Of course, one must keep in mind John Maynard Keynes’ observation that “the market can stay irrational longer than you can stay solvent.”
So what does this mean for investors? In my view, intrinsic valuation is based on the discounted present value of future class flows. Of course, investors can differ in such assessments; so it is critical to both test the sensitivity of the investor’s valuation to critical assumptions, such as a new piece of news or event, and determine how much uncertainty can be tolerated.
Marty — Thanks for your helpful and authoritative comment. Our economics colleague, the late Jim Dana, had a question for me on my first visit after starting work with a trading firm. “Do you still believe in the efficient market hypothesis?” I had to admit that my view as a practitioner was different from my view as a professor. My nominee of local rationality is interesting. It explains why a stock can react to news quite promptly, and also why there can be 20% macro adjustments when something changes.
A point where we disagree is on the long-term deviations. There are many occasions when the prevailing Street conclusions are influenced by corporate incentives rather than accuracy. These myths can persist for many years, as I have learned.
You have encouraged me to elaborate with some more examples, but one of them is quite familiar to you. Nearly everyone accepts the Shiller approach to value. Damodaran, who we both prefer, has quite a different viewpoint.
How long must an inaccurate approach persist and still be “rational?”
Once again — thanks for your valuable contributions.
Jeff
Facebook has never sold any user data and never will. This whole debacle was a result of, for the time, new Facebook practices a few years back. They very soon found that it would hurt users privacy and took away the features.
Some companies took advantage of this misses in privacy features and Facebook tried to take actions against it.
Now you can blame FB for many faults in this matter, but selling user data is not one of them.
Thanks for the post!
I’ll have to take back the statement that “Facebook never sold any user data”. They previously let third party apps access user data and took a part of the charge that users paid to use those apps.
This was at a time that FB thought it was a platform company. They soon found out that they really were an advertising company and would never let third parties access more valuable user data than the least needed. And they also show users very clearly what data apps can access nowadays.
To Marty Finkler:
“an efficient market is one where the market price is an unbiased estimate of the true value of the investment.” This does NOT imply that
1) “Stock prices cannot deviate from true value.” The deviations, however, are random.
2) “No investor will beat the market in any time period.” and
3) “No group of investors will beat the market in the long run.”
I don’t how the first sentence is not implying the following claims.
In short, the key word is unbiased. It doesn’t mean perfect; thus, 1) stock prices can deviate from true value for extended periods, 2) in any period, since not all investors have the same estimated true value when they buy or sell, some investors will beat the market and some will lose, and 3) over time, no significant group of investors will be the market else their strategies will be employed by others to absorb the excess returns they received.