Market Efficiency: Exploring The Stock Market’s Nature
The debate on whether or not the stock market is efficient, has been going on for decades, and unfortunately, the conclusions seem to be all over the place. It is a question that requires dissecting various aspects of the stock market to derive a useful conclusion.
Efficiency is a rather broad term, but in the stock market, it refers to the degree to which market information can influence performance. An entire theory called the efficient market hypothesis (EMH) was developed based on the idea that market information affects prices. The hypothesis assumes that all the information relevant to the stock price is freely and openly available, which means no investor has an edge over other investors.
According to the EMH, exchanges offer stocks at fair market value, which suggests that they cannot be undervalued or overvalued at any given point. It also suggests that it is not possible to beat the market, and many investors have challenged these principles. Perhaps the answer might not be absolute but rather relative, which might be supported by historic market performance.
Exploring the market efficiency question through historic data
Analysts and market experts consider an efficient stock market to be characterized by random price movements. An inefficient market would thus be predictable, and traders would be able to identify trends. According to SPGlobal, the S&P 500 index outperformed 82% of U.S-based fund managers, the TSX index outperformed 90% of Canadian fund managers, and the S&P Europe 350 index outperformed 80% of European fund managers.
The number of fund managers that outperformed the stock market indexes in their respective countries was very few. These findings support the hypothesis that the stock market is very efficient and that timing is almost impossible. If that is the case, then the fund managers seem to outperform their respective index had a combination of market knowledge and luck.
A predictable market would be inefficient and problematic. Besides, many factors are going on every day that influences stock prices. A stock may release favorable earnings that boost its price one day, and the next day, an unexpected event such as a huge ship blocking a major cargo corridor would wipe out some of the previous gains. This unpredictability of the market, combined with the fact that there are buyers and sellers, contributes to market efficiency.
Why do some investors succeed where others fail?
The EMH suggests that information in the stock market is freely available to everyone. However, those that find the information early have a better chance of taking advantage of the potential price movements than those who do not receive any news. This is why earnings reports are such a powerful tool at determining potential price direction. Investors decide whether to buy or sell based on whether a company reports positive earnings and positive future expectations. However, many other factors may still affect the same stock, which means the potential gains will be short-lived.
On the other hand, one may argue against the idea that the market is random. For example, company A has an attractive product portfolio and strong demand in the local and international market. It is also constantly working on improving its products and hitting its sales targets. Analysts would argue that strong demand for the product and its ability to meet that demand while efficiently managing its capital expenditure, debt-to-equity ratio, and other important aspects will reflect positively on the stock.
One would reasonably argue that company A’s stock has a lot of potential upside, especially if the company is focused on expanding its market and assuming there are favorable market conditions. However, the stock market is a mixed bag because some believe at any given time that the stock is overbought, while others believe that it has a lot of room for growth. This is why the efficient market hypothesis seems to be in favor of many investors.
A game of risk and reward
If the market is unpredictable, why do many people still invest in it? Probability is an important aspect when making investment decisions. There are many opportunities for making money in the stock market, and the core principle for retail traders is to buy low and sell high. The unpredictable nature of the market means there is a risk of loss. However, owning a stock means you will still be the owner even if the price goes down, but it cannot go down forever, especially if the company is in good shape.
Retail traders invest in the hopes that the stock price will go high enough to afford them a decent profit. It is this reward that many seek, and so they are willing to risk the potential downsides. Past performances have shown that it is possible to predict market direction to some degree, although accurately predicting the level of gains is a bit of a stretch. Predictability, therefore, plays an important role in trend investing.
Although predictability exists to some extent, it is not a consistent phenomenon. There will be times where some variables will allow some level of market predictability, but those factors are usually seasonal or subject to change. One cannot consistently make accurate predictions about the markets due to the many variables and uncertainties involved, thus supporting the efficient markets hypothesis. Again it comes down to the reward and the potential risk that traders are willing to take.
The idea that the stock market is efficient has received a lot of support and heavy criticism. The Wallstreetbets Reddit group challenged this idea through the Impressive Gamestop rally earlier this year. However, that was an isolated case of a huge group hijacking the market and influencing its direction, something that does not happen on a regular trading day.
In an ideal setting where there are many participants and no one group rallying others and influencing trades in a certain way, the market appears to be relatively efficient.