Yes Virginia, Markets are Efficient

By Ocean in Current Events, Featured, Investing, Our Theory

In the wake of the recent controversy surrounding Free Markets, and more specifically, the “How could we be so stupid as to believe markets could work?” statements, we feel it is time to clear the air and make a couple blanket statements:

Efficient Markets does Not mean continuous growth
It is excusable in a way. We equate efficiency with working well, and we assume that an economy which works well will continue to rise. On the other hand, for an economy to work well it will have to get rid of the dead weight companies every now and again. Schumpeter famously called this “Creative destruction” and we (not as famously) declared that once the dust settled, our economy should be better off thanks to this downturn. Lehman Brothers, Bear Sterns, AIG and the like were riddled with bad management, overly risky investment, unrealistic expectations and outright fraud. Are these companies that deserve to continue operating? And what does it take for them to stop? A financial crisis, that’s what.

Free Markets does not mean “at no cost”
Although we sort of assumed this was obvious, we have seen some misconception in this regard (this might be our fault for following AlterNet.org on Twitter). Free Markets means Free of intervention, so that market forces can operate without obstruction. It does not mean Free as in the “Buy one get one free” variety. There are obviously costs for participating in the market. If markets are efficient, the costs are entailed and understood. Every time a stock rises, someone buys and someone else sells, then when the stock falls, someone sells and someone buys. By definition, someone will have gained and someone will have lost. On the other hand, these are the risks entailed. The interesting thing is that outside of the stockmarket, there can be many participants, all of whom are winners.

No, Virgina, stocks won’t always rise
This brings us to the final point. While the first two points were more a question of semantics, this is an outright fallacy. If you had bought into the S&P 500 at the beginning of 1999, right now you would have an 8% loss, and this is not counting for inflation. You can argue that we are in a downturn. On the other hand, between this recession, the dot com bubble, the 1987 crisis, etc. we can see these downturns are more commonplace than we might have thought.
A stockmarket should, in theory, reflect the economy as a whole, which is where this fallacy arises. On the other hand, the S&P 500 (generally agreed to have the broadest scope), lost more in the 00’s than in the 1930’s, while the economy grew at around double the rate. As more online companies and small business start gaining credence and traction, the top 500 companies of the country will be having less and less influence. Expect it.