We recently came across a blog by Charles Davi, and more specifically an entry entitled The Not So Efficient Market (Theorem) Hypothesis. Here Davi gives a very mathematical argument against the Efficient Market Hypothesis. While we like the fact that he states his argument in equation form, we cannot help but disagree with him.
To use his example, his argument is predicated on the fact that if a certain big investor (A) thinks she has made a bad investment, and others (T1, T2, T3…) who are invested in the same securities catch whim of this, they will certainly dump the stocks of this investment (ABC), so as to get rid of the stock before A liquidates her position. This will of course drive down the price of ABC, based solely on A’s opinion. As to what the T’s personally think, he states this:
Personally, each thinks that A is out of her mind, that ABC is well positioned to ride the current credit crisis and that current equity valuations of ABC are rational. However, they know that given A’s belief, she will certainly liquidate her position.
We have two problems with this. First of all, this is a theoretical example, therefore as soon as information is obtained it is acted upon and hence reflected in the stock price. In other words, as soon as A feels ABC will not perform well she will liquidate her position. She certainly will not wait around for the end of the quarter to do so. Therefore, the value of T’s investments will already have lowered. It is then up to them to decide whether the price has decreased erroneously and to therefore hold their position (or buy more shares more cheaply), or that a sell-off has started and to therefore liquidate their position and limit their losses.
The second problem deals specifically with information economics. If A feels a certain way about a stock, the T’s can theoretically find out about it through the media or public company information. The other method, private information, is illegal. Once again, A would be well aware of this, knowing that disclosing this information would trigger reactions. Therefore A would make her move (liquidation) before (or at the moment of) announcement.
In fact, if the financial world worked the way Davi describes, there would be a tremendous opportunity for A. She could take another stock she feels good about (XYZ) and give the same signals she gave for ABC. Since all the T’s will liquidate their positions, A can then buy many more shares extremely cheaply, thereby dollar cost averaging her position and gaining even more of a profit when XYZ attains success. At this point the T’s will not longer take her signals as transparently as before.
Original article here.
