Is the market efficient? 1 comments

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The Efficient Market Hypothesis (EMH) has been a bone of contention among stock market players since it was first postulated in the 1950s to 1960s. It states that the market is perfectly efficient in pricing in the fundamentals of stocks in the market, from its long-term fundamentals to breaking news concerning the stock. How true is this?

There is some basis for this hypothesis, and it is not all just theoretical. For example, there is a well-known anecdote about opinions of experts being sought concerning the coordinates of a ship that had sunk. Although views were varied, it turned out that the answers, when averaged out, were within 1% of the actual coordinates of the sunken ship!

Clearly, whether one believes in the EMH will affect one's investing behaviour. An implication of the EMH is that the market price action is random, a basis for the Random Walk theory. This surely means that fund managers don't add any value (and nor does the small investor himself, for that matter), and one would do best by just buying and holding an index fund. But clearly there are people like Warren Buffett who have prospered by buying distressed companies, which have turned out to be massively underpriced at their bottom.

Everybody hopes to be able to do that but few have managed to succeed consistently in the market over the years. My view is that the market is very good at pricing in the effect of breaking news, such that it is difficult to make money by trading on such news. Suppose an SGX company announces a big contract during the SGX lunchbreak; it would already have had a price rise in the morning, might have stagnated or turned upwards slightly further after lunchtime, but by the next day it would more or less have priced in the news. To the small investor who works in the office during the daytime, the news would already have been efficiently priced in by the time he returned home and looked at the day's closing stock prices.

In fact, I can go one step further and argue that the market is efficient in pricing in trading themes once they establish themselves. When I attempt to catch a trend that has already established its momentum in the market (eg. oil at the moment) I find that approximately 50% of the time the stock I buy goes up further and the other 50% of the time it stagnates or starts to reverse. In other words, it looks like the strong market optimism embedded in the trend is already priced in and I might as well be taking a random walk down Shenton Way by buying into the trend only after it has bared it horns.

It is the ability to spot new medium-to-long term trends that will give one a better chance of succeeding. Thus one will be able to position himself before the market focuses its attention and optimism to the sector/industry in question. Clearly one has to read widely and be aware of the long-term implications of local and world news in order to visualise new trends. Once one has spotted a trend and bought into it, then the next thing that one needs is --- patience.