Stock markets have been on a tear across the globe paying little heed to any risk whether economic or geopolitical, things that would have historically caused a correction of sorts. Whilst markets can remain irrational and inefficient in the short run, it should mean revert to reflect all information adequately in the long run, atleast according to the efficient market hypothesis (EMH). However, some suggest that the EMH doesn’t hold true or at least is broken in the short run. Most vocal among them is the outspoken quant fund manager, Cliff Asness of AQR who late last month published a research paper on the phenomenon. In the paper, he attributes this inefficiency to the rise in passive investing (index funds) and prolonged low interest rates but also the effect of technology and social media. If market efficiency depends on how quickly stock prices reflect information, technology surely should have added to the efficiency?
“In the 1990s electronic trading was the norm, but it was a far cry from the nanosecond version that today dominates. There is also now more information about any stock, which is disseminated more quickly. Speed, competition and greater information have clearly enhanced efficiency in one way: they have brought down the cost of trading.
The trouble is that speed is not precision. “It’s hard to imagine new information doesn’t impact stock prices faster than in the past, and that is a kind of ‘efficiency’,’” writes Mr Asness. “But speed doesn’t imply the level of prices before or after the new information was particularly accurate.” Indeed, he points to evidence that accuracy has fallen.
One source of evidence is so-called value spreads, which compare what investors pay for the priciest stocks to what they pay for the cheapest. The simplest version just looks at the price of a firm compared with its book value (what it would be worth if it were sold for parts). Using this measure, value spreads were stable between the 1950s and the 1990s, before spiking ahead of the dotcom crash. They have since climbed steadily over the past 20 or so years to near all-time highs. The flaw with this measure is that it can be skewed by a changing market make-up (tech firms tend to have higher price-to-book ratios than banks, for instance).
Another, more sophisticated measure devised by Mr Asness includes all kinds of definitions of value by comparing prices with earnings, forecast future earnings, cashflows and so on, and only compares firms within an industry. This shows a similar trend. However things are cut, it is much harder to find a reason why investors are willing to pay today’s prices.”
What about social media?
“…social media produces mobs. Or, as Mr Asness puts it, “instantaneous, gamified, cheap, 24-hour trading…on your smartphone after getting all your biases reinforced by exhortations on social media from randos and grifters with vaguely not-safe-for-work (NSFW) pseudonyms…What could possibly go wrong?” This is an idea that resonates with others. “For whatever reasons, markets now exhibit far more casino-like behaviour than they did when I was young. The casino now resides in many homes and daily tempts the occupants,” Warren Buffett has mused.
As Mr Asness readily admits, he is talking his own book: value spreads inform his investments. Given these have become more inexplicable over time, his returns have been uneven in recent years. A world in which the investing masses are making big errors should in theory be a good one for sharks. However, there is one big challenge: whether they can hold their nerve in the face of obvious chaos. Nvidia, which is one of most valuable and most closely watched firms in the world, shed 10% of its value—$280bn—on September 3rd. The cause? A softish manufacturing data release.”
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