Efficient markets, and their puzzling inefficiencies
IHAVE to admit that I am somewhat baffled by the markets’ behaviour over the past few days. Having languished in the doldrums for almost a week as deliberations over the government shutdown in the US continued, the JSE along with global stock markets leapt yesterday on news that the US government was close to reaching an agreement to raise the debt ceiling until February and reopen government departments until January.
Emerging-market stocks went up to a four-month best level, the German Dax reached a record high, while the FTSE is once again less than 1% shy of a new closing high. All of this in the midst of widespread market uncertainty and persistent threats that the global economy is on a knife edge and the end of the world (read: US Federal Reserve tapering) is upon us.
Perhaps I’m missing something, but stocks rallying to near or record highs on news that the US government will reach a deal, is a bit like celebrating when you arrive home from holiday and your house hasn’t been burgled. When last I checked — and I am sure I will be roundly criticised by the libertarians among you — the government is meant to serve the people, and your house is meant to remain unmolested if you go away. So why the sudden rally? Perversely, some of the market strength we’ve witnessed over the past two days is derived from an assumption that the longer there is internal chaos in the US, the greater the chance that the Fed will delay its decision to taper.
From an emerging market perspective this is in itself problematic, unless we assume that emerging markets were already strongly oversold on earlier news of tapering and investors have climbed back in lest they miss out on several more months of gains. Of course, this merely means that emerging markets will plummet again when the bad news does finally come.
If it is the case that the government shutdown will have a negative effect on growth, and thus delay tapering — something that weaker industrial commodity prices over the past week seem to
It is hard to believe an entire market is choosing to ignore valuable pricing information
suggest — then surely the market should react negatively?
Whether or not the House of Representatives reached a deal last night hardly seems to matter. Aside from the $120bn owed by the Treasury for short-term bonds maturing on October 17, the US still has debt in the region of $16.7-trillion.
Raising the debt ceiling in this instance is little different from wanting to take out another credit card because you’ve maxed out the first three, while at the same time committing yourself to buying a new car.
All of this uncertainty and second-guessing makes me think that awarding this year’s Nobel Prize for economics to three economists on different parts of the asset pricing spectrum is nothing short of brilliant.
Gene Fama, Robert Shiller and Lars Peter Hansen shared the award for their research on forecasting of long-term asset prices, most notably Fama’s Efficient Markets Hypothesis. In its simplest form it says that beating the market is pretty much impossible because share prices already reflect all known information about their value. In other words, the price is always right because all known information is taken into account, so there are no bargains to be had (even if you think there are).
The idiosyncrasy of the award is that Shiller is best known for how his research into market efficiency revealed the shortcomings of Fama’s work, namely that there are persistent market inefficiencies that cannot be explained.
Along with showing that prices — especially in the short term — are near impossible to predict, his research also showed that markets are, as economist Tim Harford put it, “irrationally exuberant”, as they were before the US housing bubble in 2007.
In the context of the current uncertain and unpredictable market movements this makes the Nobel Prize committee’s choice particularly relevant.
Given all that we know about the risks inherent in the global economy at the moment and the “exuberance” of current market prices, it would appear that Shiller is right; however, it is hard to believe that an entire market is choosing to ignore valuable market-pricing information. Perhaps, as John Authers pointed out in the Financial Times, the efficient market hypothesis may not occur very often in real life, but provides a useful framework from which to start.