The Efficient Markets Hypothesis (EMH) is a form of academic dogma that is taught in many traditional finance programs. The idea is that any time the price of a stock incorporates all the available information of a company, so the amount you pay to buy a share would be precisely equal to the intrinsic value of the company.
There are three degrees of market efficiency :
- The weakest form of EMH theorises that current prices incorporate all historical price movements, so Technical Analysis does not work.
- The semi-strong form of the EMH theorises that current prices incorporate all public held information so Fundamental Analysis should not result in any advantage for the investor.
- The strong form of the EMH theorises that all private and public information is incorporated in market prices, so even insider trading cannot benefit the investor.
In the mind of many retail investors, the EMH is a relic of academic programs primarily taught by finance professors who are stuck in their ivory towers with no real investment. Practitioners know that a lot of theories and investment models do not survive actual contact with stock markets. Furthermore, the best investors like George Soros, Warren Buffett and Jim Simons continue to baffle markets with stories of outperformance. The Medallion Fund, managed by Jim Simons, managed gains of over 30% during the COVID-19 crisis.
The theories of market efficiency are a lot more useful when we stop seeing them as academic dogma but as a practical concept to guide investment decisions. For someone like Warren Buffett to make money, there has to be mispricing at the start. But the stock price has to move to its intrinsic value before Buffett can sell it at a profit, so the emerging market efficiency is actually a condition for outperformance to take place.
A more useful way to understand market efficiency is to see it as a process.
To be fully reflected in the stock price, information needs to go through three stages:
- Firstly, someone must disseminate the information. If the information is not published anywhere, there is no way the stock price will react to the news.
- Secondly, the investing public must process the news. Market participants must review the news and decide what it means to the intrinsic value of the stock. There must not be systematic bias or groupthink at this step. Investors must arrive at their numbers independently.
- Finally, market participants must incorporate their independent view by taking action in the markets. Investors must act so that the price of the stock will attain its intrinsic value.
Without all three conditions, stock prices will not reflect their intrinsic value so markets will remain irrational longer than an investor can stay solvent.
We are unsure as to whether we will experience a V-shaped recovery or a U or W shaped recovery.
Here are the reasons why I took the stand that the market will experience a V-shaped recovery.
- Even for market participants, not everyone is aware of the latest developments in the fight against COVID-19, we have a suitable candidate for a vaccine by Moderna, which was shot down by a report last night. News on other vaccine candidates is not getting the same amount of media attention so has yet to see dissemination. There may be potentially more good news when it does.
- People may not have processed that the equity risk premium is high at the moment. The gap between the earnings yield of the STI index and the 20-year bond yield is over 8%. Historically, this gap was even higher than the 5-6% that the market experienced before a recovery in 2009. Even halving the earning yields would still result in a reasonable risk premium. Instead, the group seemed focused on the likelihood of a W-shaped recovery and worried about the repeat of 2009 when stock markets can still fall 30% further.
- Finally, there is a significant difference in behaviour between V-Shape investors and W-Shaped investors. V-shaped investors are incorporating their beliefs and buying equities or even applying leverage. W-shaped investors, on the other hand, are doing nothing. They are not shorting the markets; they seem just to want to hunt for bargains as markets move lower.
While a market downturn can still occur, especially if the vaccines are ineffective, I see the upside as being more probable than a downside.
If you like to know more about concepts like how I derive the bond-equity yield differential, come to my seminar.
My next webinar on 21st May 2020 at 7.30pm is entitled “Three Icons of Investing”, and it discusses how retail investors can channel certain aspects of investors like George Soros, Warren Buffett and Jim Simons.
Sign up here: https://www.drwealth.com/ermintro/