Archive for January, 2011

The Myth of Market Efficiency

Saturday, January 15th, 2011

 “Belief in myths allows the comfort of opinion without the discomfort of thought.”     - John F. Kennedy

 The current stock market is exposing the myth of market efficiency.

 The myth says that prices in the stock market will adjust to fully reflect the value of any given stock at any given time.

Stock prices, of course, are supposed to reflect supply and demand.  If the demand is consistent and the company reports record profits or a technological breakthrough, demand for the stock should increase and the price should jump.

When demand softens, stock prices fall.  So why have stock prices been consistently rising over the past seven weeks – even as investors have been pulling billions out of the market?

It almost seems as though there recently has been an inverse relationship between stock prices and demand.  Is some entity buying large volumes of stock to pump up the prices?  If not, what is boosting prices?

As this chart from zerohedge.net shows, stock prices have been going up, as outflows have been increasing, which defies logic.

For the first week of 2011, the Investment Company Institute, reported that, “Domestic equity funds had estimated outflows of $4.23 billion, while estimated inflows to foreign equity funds were $2.42 billion.”

The outflow from U.S. stock funds was the largest since October, according to zerohedge.net, as investors moved their money not only to foreign funds, but to bonds, in spite of a dangerous market for municipal bonds.

So given this outflow, and the alleged efficiency of the market, why have stock prices been going up instead of down?  Because, the market is not as efficient as it’s supposed to be.

If the market were perfectly efficient, there would be no such thing as arbitrage.  High-frequency trading (HFT), which uses computers to identify and make trades based on market inefficiencies, would not exist (see my article, “High-Frequency Trading Scrutinized).  That HFT accounts for a majority of trades on the market should tell us just how inefficient the market really is.

Supporters of HFT argue that it makes the market more efficient.  If that’s true, it does so at the expense of the individual investor.  The money made by HFT is going to big banks and hedge funds … and individual investors are suffering, in many cases, because the prices of their stocks are being manipulated.

Of course, we would argue that it’s not true that HFT increases efficiency.  Stock prices, as we said earlier, have been going up even as investors have been taking money out of the market.

How is that making the market more efficient?  A market that goes up for seven weeks should at least be experiencing a 1% pullback.  That hasn’t happened.  Could it be that high-frequency traders are programmed to a 1300 line of resistance in the S&P 500 (now at 1292)?

As President John F. Kennedy said, “The great enemy of the truth is very often not the lie, deliberate, contrived and dishonest, but the myth, persistent, persuasive, and unrealistic.”

The current market is not efficient – it’s unrealistic.