09 Sep 2015

3 Stock Market Tips From an Economist

Economics, Efficient Markets Hypothesis, Shameless Self-Promotion 17 Comments

My latest at FEE. (They picked the title mostly for irony, I think.) You guys think you’ve placed me in a neat little anti-EMH box, don’t you? And then BAM I write something like this:

Suppose your brother-in-law says: “I’ve got a great stock tip! I found this company, Acme, that makes fireworks. Let’s wait until the end of June, and then load up on as many shares as we can. Once the company reports its sales for July, we’ll make a fortune because of the holiday numbers.”

Clearly, your brother-in-law would be speaking foolishness. Just about everybody knows that fireworks companies do a lot of business around July 4, and so the price of Acme stock in late June would already reflect that obvious information.

More generally, the different versions of the efficient market hypothesis (EMH) claim — with varying degrees of strength — that an investor can’t “beat the market” without access to private information. The reason is that any publicly available information is already incorporated into the current stock price.

My blog is arguably a random walk at this point. You have no idea what I’m going to post tomorrow.

17 Responses to “3 Stock Market Tips From an Economist”

  1. Major.Freedom says:

    Baseball playoffs aren’t even here yet and Murphy is throwing October level curveballs.

    Sometimes I think EMH is true..when I have those occasional feelings of financial inadequacy and try to convince myself that the only difference between me and Warren Buffet is luck. Then I can blame the cosmos rather than my inferior relative skill and expertise.

  2. Transformer says:

    “Studying economics won’t show you how to become rich, but it will spare you from making a fool of yourself at the next cocktail party.”

    Does this apply even to those who study Post-Keynesian economics ?

    • Major.Freedom says:

      Murphy said economics.

  3. Anonymous says:

    Your blog will hit a resistance level, form a H&S reversal pattern, break though the 200DMA, and go south until it shirts the Bollinger band, at which point it forms a hammer candle stick pattern, signals a buy cross on MACD, breaks out from the previous higher high, and head north until it forms a blog content and subscriber volume divergence.

    That’s my tip for your blog.

  4. Major.Freedom says:

    One of the easiest ways to know EMH is wrong (and there are many) is to realize there is no such thing as an investor who knows and thinks what all other investors know and think. In other words there is no such thing as public information, or rational expectation for that matter.

    Even if Reuters publishes a material change in a company’s management, like the unexpected quitting of the CEO and CFO, that information is not and never will be “publicly known” in the sense that everyone who influences stock prices, will know this information, or care about that information, or put the same weight on that information, or, importantly, know or care or weight that information at the same time. It takes time for informatiin to disseminate. Sure, the investors who watch companies like a hawk will “quickly” take into account the information.

    But it takes time for the information to be digested by the entire investing population. Actually, I should not say that. It takes time for information to be digested by what is most often less than the full population of investors.

    Even if the most savvy and informed investors try to “price in” this information, the actual stock market price, which is what we’re trying to explain by way of this information and all other information, will still be influenced by the demand from the less savvy and less informed investors. And, importantly, even if we see a “bump” in the stock price right after the news is published (or more likely just before it is published), this does not mean the the information was priced in, as the price can still be influenced later on by investors who subsequently incorporate that information in the stock price, by way of their own demand.

    Stock prices are only moved by a subset of all information at any given time.

    Knowledge is dispersed, and there is always an environment of “private” information influencing investor behavior in the aggregate and in stock pricing.

    Other investors don’t know you will be purchasing a stock tomorrow, but you know. If other investors knew what you haven’t done yet, then you will never buy any stocks because they would all be too expensive on account of other investors front running you in such a way that they raise the price that you otherwise would have caused by way of your demand. The whole reason you buy a stock is because you think the price is less valuable than the stock itself, and the sellers think the stock is less valuable than the price.

    If stock prices were ever to “incorporate” all so-called non-private information, nobody would ever trade any stocks for any price.

    So what is the alternative? What does all this mean?

    It means that stock pricing is always and fully a function of “private” information only, and those who do the hardest work, acquire the best skills, and most improve their knowledge of private information, those people will perpetually beat the market…until other investors start to work harder, acquire better skills, and better improve their knowledge of private information. Then they will beat the market.

    Passive investing only works if there are non-passive investors who EMH theorists claim are just lucky. This is the embarrassing truth for EMH proponents. They have to accept that if investors incorporated EMH into their investment strategy, then the capital markets would collapse, as every single investor would attempt to buy only index funds that nobody else is selling because they too want to buy them.

    Now surely, in an environment of private information it is of course possible for throwing darts at a dartboard to result in last month’s superior stock picks. But that would best the market as long as you just happen to replicate what the harder working, more skilled investors are doing at the time. If you replicate what the less skilled are doing, then you will lose against the market.

    There is a reasonableness to EMH for sure, but when we really analyze it closely, and knowing what we can know, it falls apart. It falls apart in so many ways.

    It think a prominant reason why EMH is so widely believed is that it serves as a weapon against the tide of irrationalism in socialist aggression. We “must” believe in EMH or else the state will destroy capitalism altogether. For if the market cannot be just and fair, cannot help us allocate capital in an efficient manner, no matter what we do, no matter how hard we try, then there is little to stand in the way of anti-capitalist “progress”.

    • Tel says:

      Your first problem is to be able to test it, given that your “Knowledge is dispersed” claim automatically prevents any practical method of measuring the difference between theoretical perfect knowledge and the actual market. The only indirect observation we have is the market price and dispersed knowledge would require godlike powers to measure directly.

      But strangely, in repeated real world tests, where the true answer was known (not the stock market), your objection turns out to make very little difference. The classic example is the “guess the weight of the cow” competition, where the ups and the downs tend to average out, and the crowd can get a surprisingly good guess, even when huge numbers of the individuals are way off. This is the basis of my claim that while preferences (and also prejudices) are properties of an individual, a market price is a statistical property of large groups of individuals. They are not the same thing, not even conceptually in the same bucket.

      Logically though I get your point… all statistical norms necessarily hide information. For example, if the market price is a median, then by design it hides both the high and low tails… that’s what’s so good about it. Thing is, to “beat the market” means to make a profit from movements in that market price itself, knowing that some hidden information exists far out on the tail doesn’t help you beat the market, you need to know something that is hidden right now, but will be revealed at some future point.

      Knowing something that never gets revealed is useless.

  5. guest says:

    “If stock prices were ever to “incorporate” all so-called non-private information, nobody would ever trade any stocks for any price.”

    Truth.

    Which is why the concept of perfect competition is irrational.

    It also means that it’s impossible for businesses to function without utilizing insider information / trading.

  6. Andrew_FL says:

    Nice work Bob. Having gotten into a number of EMH arguments myself lately, mostly right here, it behooves me to note that what bugs me most about the EMH is the way those who employ it in arguments tend to switch between versions of it mid argument even though different versions imply different things about the point under dispute.

    Also the information that would be necessary to short circuit a business cycle is neither public nor private information at the early stages of the business cycle-it doesn’t become information that any individual’s mind possesses until during the bust phase.

    • guest says:

      “… it doesn’t become information that any individual’s mind possesses until during the bust phase.”

      Because a bust / correction is when individuals again base their actions on consumer preferences, which was previously hindered by price distortions.

      The bust is in the artificially propped up sectors of the economy.

  7. Joker says:

    “My blog is arguably a random walk at this point. You have no idea what I’m going to post tomorrow.”

    I suggest a post about a recipe for libertarian cookies.

    Everyone likes cookies.

    Use emmer wheat flour, cause it’s in the bible. And chocolate chips are clearly a capitalist invention.

    Even the guys at GMU would love libertarian cookies, because they provide the greatest amount of food to the greatest amount of sheeple.

    If Friedman had popularized the “I, Cookie” version of the “I, Pencil” tale, we wouldn’t be in the minority today. It’s 2015 and people still say that minimum wage legislation is a great way to defend the poor from those capitalist pigs. Libertarians don’t know how to connect with people hearts. A pencil is dear to designers and accountants, but a cookie is dear to every lad and lass.

    The customer is always right.

    • khodge says:

      Cookies? The things gumming up my computer after I’m through surfing? No, I don’t think libertarians like them except they do make life a little easier…does a good libertarian accept cookies because he does not want to remember passwords?

    • Tel says:

      I think it’s a lot easier to build a cookie from scratch, than it is to build a pencil from scratch. Depending on how high your standards are for cookies and pencils of course.

  8. Khodge says:

    “Even if I knew, it would ruin my advantage to tell everybody.”

    Words to live by (and not too dissimilar to psychics.) So, yes, I do have a method and, no, I’m not going to let anybody examine it.

  9. Darien says:

    I’m betting on something about Scott Sumner tomorrow. I’m sure I’ll be right… especially because there’s no way Bob will read this and make sure to post something else instead.

  10. Harold says:

    If I can figure out what rationality means in the context of a bunch of pirates, I may have a chance at following EMH.

  11. Tel says:

    My blog is arguably a random walk at this point. You have no idea what I’m going to post tomorrow.

    With a random walk we would have an expectation that the difference between what you post today and what you post tomorrow should be less than a known amount.

  12. Tel says:

    In this scenario, when the share price drops from $5 to $4, the community suddenly owns only $400,000 worth of ABC stock. And yet, there is no flow of $100,000 someplace else — certainly not into the local bank. It still has exactly $20,000 in various checking accounts. All that happened is Alice’s account went up by $4 while Bob’s went down by $4.

    This fact tends not to disturb people anywhere nearly as much as I think it should do. The same effect happens with physical stock (e.g warehouse stores) as well as equities. Indeed it happens with capital assets as well, and even intellectual property.

    Thus, we have very large “ghost” flows of money, that don’t map to any genuine cash, or other tangible money. This is basically a massive flaw in the whole accounting concept.

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