Are Markets Informationally Efficient?

A key assumption in many mainstream macroeconomic models (both formal and informal) is the Efficient Market Hypothesis. Very simply, this is the belief that markets are informationally efficient — that they reflect information with little (or no) delay, leaving few (or no) arbitrage opportunities.

So the real question here is what information do markets (and by markets, I mean free markets where market participants are free to pay and receive any negotiated value for an asset) really reflect? When we see the price of an asset or asset class fluctuating, what does this movement signify? Is it fluctuation in the fundamental value of the asset? Is it just a fluctuation in the market’s perception of an asset? Is it some combination of these two factors? Or is it just random noise? Fundamentally, markets are composed of a series of transactions, each between a bidder and a seller. Each transaction in itself reflects a discrete set of information — specifically, what the bidder and the seller are willing to pay for, and take for that specific asset. This in turn is typically (although not always!) influenced by a some or all of the following: what others are willing to pay and accept for an asset presently, the use-value of an asset, notions of fundamental value (price-over-earnings, stock-to-flow, EBITDA, cashflow, etc), notions of momentum and what others may be willing to pay and accept for an asset in the future (trendlines, gut feelings, “hot stock tips”, etc).

An intriguing addendum to this is that the automation of trading (high-frequency trading) has created bidders and sellers who are acting on the instructions of algorithms. As these instructions are programmed by humans — usually automating some form of technical analysis — the only real difference is that of (extreme) speed. The beliefs reflected in high-frequency trading reflect the underlying algorithmic instructions programmed by the humans who created the algorithm.

Ultimately, whenever we purchase an asset for the purpose of speculation or investment (and even use-value — prices can change, and the price we paid last week or last year could end up looking very expensive, or very cheap) we are taking a guess as to whether the current bid or sell value is worth it. Each agent makes their guess based on a different set of data and expectations. What the prices in markets signify is the operation of this mechanism — different agents evaluating information and making guesses about the future.

Let’s consider the example of Bitcoin, the price of which is currently soaring. Some choose to buy Bitcoins based on momentum, or their liking of the cryptography, or Bitcoin’s inherent deflationary bias or some other positive belief. This is a speculation that the price may continue to climb. Some may choose to buy bitcoins based on their use-value, as an anonymous, decentralised currency that can be used to buy a wide array of things. Holders of Bitcoins may be motivated to sell by the fact that the price has risen since they bought or mined their coins, or by the belief that bitcoin is “in a bubble”, or some other negative belief.

What the market reflects is the net weight of different opinions and resultant human actions. If those who are motivated to buy outweigh those who are motivated to sell, the price  rises and vice versa. This means that the beliefs of big players in a particular market can have strange and disproportionate effects. Consider the effect of the Hunt Brothers’ attempts to coin the silver market in 1980. The price of silver rose from $11 an ounce in September 1979 to almost $50 an ounce in January 1980, as the Hunt Brothers bought more and more. The market was very efficient at reflecting the fact that the Hunt brothers were willing to buy more than the market could supply at lower prices. And once the Hunt Brothers faced margin calls, the market quickly adjusted to reflect the fact that they were now selling instead of buying, and prices fell.

That’s what (transparent) markets are guaranteed to reflect — bidders and sellers, supply and demand. This information is still useful to firms trying to gauge what, and how much to produce.  Everything else — the information that bidders and sellers are acting upon — is not necessarily reflected in market activity. Very often, bidders and sellers are brought to the market by new information regarding a large number of things — price changes, earnings, business decisions, technologies and inventions, macroeconomic data, etc — but there is no systematic or reliable way to predict what humans will respond to, or how they will respond. Human psychology and human action in this sense is totally unstable and nonlinear — consider the recent contrast in market reaction to earnings data from Apple and Google. This instability is an alternative explanation for why consistently beating the market is indeed very difficult, as the Efficient Market Hypothesis implies.

And prices do not even reflect an aggregation of sentiment toward an asset or asset class — they only reflect the sentiment of those who are involved in the market, in proportion to their level of buying and selling activity. This means that the opinions of big players who buy or sell a lot, are reflected many times more than those of small players who buy or sell a little. And irrationality can create a feedback loop — if stock prices are rising, and macroeconomic fundamentals are weak, many market participants may initially be sceptical. Yet as more participants pile into the stock market purely for reasons of sustained upward momentum, more and more participants may begin to suspend their disbelief, if only to not miss out on a profit opportunity. This is one mechanism (of infinitely many) through which price bubbles can form.

Yet accurately reflecting supply and demand is not the same thing as informational efficiency. Empirical data show that arbitrage opportunities are widely exploitable and exploited even in modern marketsOne of the largest forms of high frequency trading is of course statistical arbitrage. This reality should probably be a final nail in the coffin of the idea that markets reflect anything more than the actions of bidders and sellers. Unfortunately, very many models rest on the assumption of informational efficiency in markets, meaning that this approach is very unlikely to die out any time soon.

16 thoughts on “Are Markets Informationally Efficient?

  1. Great post, as always.
    I know I’m about as far from economic accumen as a 7 year old so perhaps I’ve misunderstood, but the paragraph on HFT seems too simplified. I’m not so sure “the only real difference [in HFT and algorithms] is that of (extreme) speed” since I’ve read via nanex and other sources of how algorithms can extrapolate beyond the human input and distort/obscure/influence the information further. Obviously human inputting of astrological or other controversial data doesn’t help much either.

    • Algorithms reflect the beliefs of the people who programmed them (just at a much faster speed), just as human market activity reflects beliefs.

      • Yes, now you say it, of course. Thanks, John. But… do humans continue to control the information expressed by the inital algorithm or does the algorithm take on a life of its own and prompt new stuff the human had no intention of relaying? I know this probably is just as reflected in the human world, but it seems more ominous that a digital map does it. We are influenced and determined by algorithms enough in our daily lives. Obviously I might have an irrational, medeival superstition about HFT, but I just don’t like it…!

        • I just added the sentence on HFT in order to qualify that all market activity reflects the beliefs of those who initiate it, and that is just as true with algos as it is with someone with a mouse.

          I actually think a lot of the outcomes of HFT (the speed and the arbitrariness of the instructions) are potentially dangerous and destabilising, and that these problems potentially outweigh the often-stated advantage of “providing liquidity” and “providing price discovery”. Evidence on retail investors implies HFT is driving ordinary investors out of the market, because the speed is such a huge advantage.

          To answer your question, HFT today doesn’t write its own instructions. Algos respond to instructions pre-written by humans based on market levels. But as we have seen in the past, flash crashes (and also flash smashes, where the opposite happens) can happen when a “sell” signal appears, algos start selling, which triggers more sell signals in the program, etc, and you get a feedback loop. Of course, that can happen with real humans too, just at a lower speed….

  2. Considering the idea that increasing complexity leads one further and further from the Truth, wrapped up in the conjecture that the human mind is simply incapable of understand the simplest of things, all balled-up in the notion that we exist outside of intellectual time, I would say that a free market exists only between one producer and one consumer, with any increase in complexity leading [proportionally?] to distortions and corruptions, to the degree where today, markets can only be described as some of the greatest shell games ever devised by the collective human mind.

    • Perhaps the most alarming thing about this is that EVERYBODY understands [to some degree], BUT, the allure of potentially getting something for nothing is SO powerful, that people allow this insanity to go on…..and on…..and on…..

      It’s sort of like internet pornography, that is, the allure of having such available [to the responsible adult user :] outweighs having this stuff available to kids of all ages. Bizarre.

      Desires truly are limitless!!

    • A friend of mine a retired trader in commodities market says that due to the increased power of computers a strategy that combines mean reversion and programs that create heightened volatility ( he says this was pioneered for commodity trading 15 years ago but only in the past several years have computers powerful enough become available for application in equities) operate like a cartel with several linked computers programed to make primary, secondary and some times even third trading moves before the exchanges computers can react. He says this strategy creates and unfair advantage and is particularly efficient at extracting profits during a bull market.

  3. I have no confidence in the authorities to stop insider trading. Bureaucrats are incompetent or can be bought. A cartel of major players can push the market up or down luke a rubber band, causing feedback loops in HFT programs or retail traders. Anything outside Big blue chips is easily manipulated and is gambling. Big blue chips are self fulfilling monopolies, with regulatory capture of trust busting organisations. Too many people have their 401k investments in these monopolies. Buy them, receive the dividends or you will lose through higher prices. For the poor who can’t invest. Bad luck. Nobody has your back anymore.

      • It pays to be the close friend of the PA. Those Bozos can’t scratch their backside without the PA knowing. And PA’s are usually extroverted blabber mouths

  4. Pingback: Are Markets Informationally Efficient? | Liberty Hall

  5. The main difficulty people have in attempting to understand the validity of [fill in the blank] is with the quality of the inputs. Assuming that each input along the way [an infinite number] is corrupted [by some degree], and, when you kind of figure that any event is determined by the infinite number of events preceding, you end up with absolutely no clue as to whether something has a particle of truth in it or not.

    If you accept this as being the case, only switching modes to the non-intellectual can save your sanity, while at the same time allowing you to see things exactly how they are, without aggrandizement, debasement, quantification, or editorial opinion.

    Reality truly exists outside of the human intellect.

    • “Reality truly exists outside of the human intellect”

      “An example would be, where someone is sitting inside a building with no windows, which is balanced over the edge of a cliff. All observations and calculations from within the building will be totally incapable of determining the fate of its occupant. But to an observer outside, the situation will be very obvious”

      from: Einsteins Search & the Illusion of Reality

  6. John, have you read this book ?…. compelling argument in support of what I believe is the view you frequently express….

    The Second Law of Economics

    Energy, Entropy, and the Origins of Wealth

    Series: The Frontiers Collection

    Kümmel, Reiner

  7. Pingback: Nietzsche, Austrianism, Neoclassicalism & Subjectivism | azizonomics

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