Has the efficient market hypothesis breathed its last breath?
The markets are moving and Elon is grooving.
Despite more than 55 years having passed since Eugene Fama conceived the efficient market hypothesis, it remains steadfast in the minds of many economists. Much has changed in recent years and, while economists remain divided on the topic, current events warrant us revisiting the hypothesis.
What is an efficient market?
Financial markets are said to be efficient if the current price of an asset reflects all publicly available, relevant information about the underlying asset. Meaning that the current price is a good estimate of the intrinsic value of the asset at any point in time. This has several implications:
- Investors cannot consistently achieve risk-adjusted returns above the market rate of return (i.e. cannot outperform the market in absolute terms, except by bearing more risk)
- Stock prices follow a ‘random walk’, meaning that previous stock prices have no bearing on future price movements
- There is never a ‘good’ or ‘bad’ time to invest; the price you pay is the fair value of the asset (assuming no transaction costs)
Another assumption is that when material information is released to the public relating to a stock, the market price will respond by incorporating this new information immediately and completely.
Essentially, if the efficient market hypothesis (EMH) holds, there is no opportunity for arbitrage or exploitation of securities to profit consistently.
The below demonstrates this with a tongue-in-cheek story:
An economics professor and a student are walking down a street when they come across a $100 bill lying on the ground. The student thinks it’s his lucky day and lunges to pick it up.
The professor stops the student and says, “Don’t bother, if it were real someone would’ve picked it up already.”
This anecdote serves two purposes: 1) it provides a fairly good example of the intuition behind how the EMH leads to the elimination of opportunities in the markets, and 2) it conveys how wildly unrealistic it can be.
I’m sure many of you reading have found not-insignificant amounts of money on the floor before, just as many of you will have profited from your endeavours in the stock market.
These are of course not equal statements — there are not robots scouring the streets for loose £20 notes like complex algorithms are scouring the stock market for arbitrage opportunities, but the intuition that no system is flawlessly efficient remains intact.
It stands as a reminder that, as with any economic model, the foundational assumptions — rationality, self-interest, informational efficiency — are often the least reliable.
Investors and, least of all, Redditors, are not rational beings!
Dogecoin and Elon Musk
Social media has changed the investing landscape significantly. Many would argue that it has equalised the informational disparity between institutional and retail investors and reduced search costs. Before the advent of the internet, you would need a Bloomberg Terminal to access instantaneous market updates. Today, all you need is a smartphone.
This has also enabled influential figures to broadcast their opinions to the world, having a real impact on financial markets. To avoid repeating what many have already said about GameStop, let’s take Elon Musk’s promotion of Dogecoin as an example.
On the morning of January 28, the Dogecoin cryptocurrency began gaining traction on the Reddit forum WallStreetBets, leading to the price jump from its fairly stable equilibrium level. The rally continued until around 10 pm, when Elon tweeted nothing but a picture of a dog on the cover of ‘Dogue’ (a play on Vogue, click here to see the tweet), which sent the price of Dogecoin briefly into orbit.
This price rise was driven by no fundamental change surrounding Dogecoin, but by the attention driven to the asset by Elon. Retail investors raced to invest as the price continued to climb, ultimately topping out at more than 250% above the price before Elon’s tweet.
Looking at the chart, you may be about ready to kiss the efficient market hypothesis goodbye and sail off into the sunset with the rest of Reddit. However, while it is clear there is some degree of inefficiency, all may not be lost.
The price remained elevated for a few days, peaking at around 5 am on the day following the tweet. Interestingly, the price settled on January 30 at around the same price level that was seen immediately before Elon’s tweet. This suggests that, although there was a period of extreme volatility surrounding the tweet, the market did eventually determine that the ‘information’ conveyed by Elon was of no material value to the price of Dogecoin.
Therefore, while the market may not immediately incorporate novel information into the price in an accurate manner, it does appear to determine the relevancy of information with some accuracy.
So, are markets efficient?
As with all economic theories, they are useful under certain assumptions and for providing structure to economic models. Outside of theoretical economic discussion, the EMH does not claim that financial markets actually react with complete and immediate efficiency. However, it does provide a compelling argument for how prices are determined, despite its critics. This criticism means little without the recommendation of a worthy alternative — which we are yet to encounter.
I’m not going to pretend that I can provide any degree of clarity with this very high-level discussion on a debate which has been raging amongst economists for nearly six decades. However, what I have tried to convey in this article is that we do see some semblance of efficiency, even in the most untraditional of assets.
So, whether markets are efficient or not is not really the question, it is: to what degree are markets efficient, and under what circumstances do stonks only go up?
