Market Efficiency

What investors must learn about stock pricing

Suppose that you chance upon a neighborhood garage sale one pleasant Saturday morning. You stop for a quick browse and find nothing of particular use—just the usual inventory of old clothes, utensils, broken appliances and other junk.

Then you see the book resting on a stack of old magazines. As a serious student and collector of rare books, you immediately recognize its value. It’s worth several thousand dollars. The seller is asking one dollar for it.

You cannot believe your eyes. Obviously, the seller has no idea what he’s giving away. You snatch up the book and pay for it quickly. You leave with pounding heart and sweating palms, feeling quite lucky.

Finding a collector’s item at a garage sale may be a rare experience. But savvy shoppers frequently uncover “bargains.” When they recognize the value of merchandise and know where to find it, they can exploit opportunities arising in this secondary market.

Information as value

In most cases, mispricing results from a lack of sufficient information. In this example, the seller doesn’t know what he’s selling and with only one informed buyer present, a lack of competition keeps the price under market. Your reward is a bargain purchase of a valuable item.

The neighborhood garage sale is one classic example of an inefficient market where time, distance or some other barrier prevents the sales price from reaching an accurate level.

A more complete flow of information changes the mechanism, however. If you wanted to get maximum value for your rare book, you would take the item to a rare book auction where expert buyers can more accurately judge its value and compete for ownership.

This auction market is characterized by sophisticated buyers and sellers who have access to a well developed information network. And if such an auction were conducted nationally or on a worldwide basis, you might expect the book’s final selling price to reflect all available knowledge—and particularly if all qualified and capable buyers had access to it.

In such a case, the bidding would stop when the price reaches the balance of perceived value. The efficient market offers few, if any, bargains due to abundant information.

Stock market efficiency

Most academics concur that the stock market is efficient to some degree. The debate arises in the strength of efficiency and whether managers can exploit mispricing while keeping their costs low enough to enhance their gains. A strong form of the Efficient Market Theory states that stock prices are valued accurately because the market has factored in all available information. This would include facts and developments pertaining to the company, its industry and markets, future strategies, technological developments, and all other factors that would impact financial performance.

Stock analysts and traders intensely compete to obtain new information on stocks with hopes of converting this intelligence into profits. But today, the stock market operates at the center of a highly developed global information network. News travels faster and to more professionals than ever before. Stock prices adjust so quickly that a manager is unlikely to consistently identify and exploit temporary mispricing.

You will constantly hear claims to the contrary by stock traders. They claim that expertise and sophisticated analytical tools enable them to find “undervalued” stocks and trade them for profit. Yet if the market is truly efficient, this approach will not produce consistently positive results, particularly over the long term.

Following efficient market rationale, a stock or entire market segment cannot be undervalued or overvalued because all known information is factored into prices. So much for following “hot tips”, picking up “cheap” stocks and buying stocks “poised for a run-up.” If markets are truly efficient, you might as well read tea leaves.

Stock prices appear to move randomly from day to day because the future is unknowable. So the next time someone tells you about an underpriced stock, remember that you don’t buy stocks at garage sales.

How efficient is the stock market?

Advocates who believe in an efficient stock market usually accept one of the following theories describing degree of efficiency:

Weak Form: Past information, such as historical price patterns, provides no insight into a stock’s future movements. Charting stock prices and seeking out trends are not considered to be meaningful analytical activities.

Semi-Strong Form: Agrees with weak form, and adds that no past or current information regarding a company will offer insight into future returns. This version believes that the market quickly absorbs new information and factors it into the stock price. Only non-public, or inside, information might provide a consistent trading advantage. However, only a few people will have access to privileged information.

Strong Form: Proponents claim that even inside information is of little utility because the market price will adjust quickly in response to trading activity driven by that information. (The company might begin to repurchase its stock shares on the market.) The faster the flow of information, the more instantaneously prices adjust.

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