An Absurd Idea
Take the notion of the efficient market. What does that mean? Today, hordes of people are coming out of economics and finance majors believing an absurdity. Yes, I said absurdity. They think that, if the market is efficient, it’s impossible to beat the average investor. This is based on the premise that stock prices (or commodity prices, bond prices, etc.) always incorporate all relevant information.
What everyone knows is sometimes false. For example, at one time people thought the world was flat. No matter how unpopular it may be, it’s always possible to discover the truth. When this happens in regards to the value of an asset, the discoverer can make money. This fact should be uncontroversial. So how did it become controversial?
Part of the answer may be that the philosophy departments have long ago defaulted. It is accepted in the mainstream that knowledge is out there, literally in the universe. In this view, prices are right out there with knowledge.
A famous book based on the “efficient market hypothesis” – this is the cover of the updated version, which continues to ignore the fact that skillful investors do exist, although Malkiel asserts that they cannot exist.
Where Understanding Takes Place
Information, and more importantly understanding, only incurs in here—in your head. It takes an individual mind to process information, and form an understanding. This means that there is no direct transmission process from information to prices. It is a process of each individual mind coming into contact with the information, deciding for itself whether it even agrees and if so, what importance to ascribe to it. And then, and only then, whether to buy or sell.
Case in point, I can say that the information is out there that all fiat paper currencies eventually collapse. I have put some of that information out there myself. Does that mean that all market participants sell their fiat paper currencies and bid up the price of gold to infinity (or permanent backwardation) instantly? They haven’t done so yet.
As Ludwig von Mises explained: the same special skill required of the historian – namely “understanding” – is also required of those who invest or undertake any other future-oriented entrepreneurial activity. Mises referred to speculators as “historians of the future”.
Photo credit: Mises Institute
Some people know how fiat currencies fail, but most people don’t. Price is set at the margin, so we can say that the marginal gold trader doesn’t know about fiat currencies. Or, it could be that he doesn’t care. The marginal seller could be a gold mining company with a lot of dollar-denominated debt. It will not stop selling gold, no matter what the CEO believes. If he does not sell the majority of the mine’s output, the company will be in default and the creditors will take over. Different actors in the markets have different motivations, let alone different knowledge.
So what on earth could efficiency mean? What could the original intent of this word have been?
How Markets Become more Efficient
There was a time, not too long ago, when a commodity could have a different price in different markets within a city. Communication was slow, and transportation even slower. Economists of the day were aware of this, and concerned about it. If wheat could be had for 4 shillings in the north of London, and 3 shillings in the east end, then many people were making an obvious mistake. Buyers in the north were overpaying, and sellers in the east were accepting too little.
Wheat, lots of. In the market economy, prices of commodities tend to equalize quickly across different locations (excl. transport costs). Any price differences will quickly be arbitraged away (note also, physically identical goods are not necessarily the same goods. It partly depends on ancillary circumstances. When drinking a cup of coffee near the Vienna opera house, one pays a premium for the location – the same cup of coffee will cost less in Hicksville, Nowhere, because the location only provides views of the occasional tumble-weed).
Photo credit: Alamy
Distributors entered the market. They developed ways of knowing the price in different places, and sought to profit by buying where goods were cheaper and selling where they were more expensive. The result of this activity was a price closer to 3 ½ shillings in both north and east London. Suppose that wheat was trading higher in Scotland, but cheaper in France. This is the same problem, on a larger scale. It’s nothing that can’t be fixed by adding telegraphs, railroads, and boats.
Similarly, one might observe a wide spread in wheat. The bid might be 2 ¼, but at the same time the ask is 3 ¾. The market maker comes into the wheat market, ready to buy at the bid and sell at the ask. In so doing, he and his competitors narrow the spread. It could become a bid of 3 and an ask of 3 ¼.
Another kind of spread occurs across calendar time. Suppose the wheat harvest comes in, on August 1. The price of wheat collapses for a while. But bakers will still want this commodity next month, and every month through July next year. By late Spring, the price of wheat skyrockets. So warehousemen enter the market, able to buy spot wheat and sell forward contracts for future delivery.
Economists of the day might say that the wheat price reflected all available information. This does not mean that 3 ¼ shillings is right in any intrinsic sense. These arbitrageurs are not supposed to be omniscient. In fact, all they are doing is closing the price gaps they find, and earning a small profit to do so.
This is the original idea of efficiency. It had to develop, as these market innovations were occurring. Note that these have nothing to do with the belief that the current price represents the absolute or universally right price for wheat. Perhaps wheat demand will soon drop off due to a new diet. Perhaps the price will rise due to an insect working its way west out of Russia. These vague concerns have nothing to do with the arbitrageurs.
Efficiency in this original sense is a concept pertaining to the losses one will take to trade in and out, to buy at one’s preferred location, to buy when one chooses, etc. Efficiency exists when a variety of arbitrageurs are active in the market, able to close gaps of distance, spread, or even calendar time.
The arbitragers can be said, in an abstract sense, to be using information to impact prices. However, one should look past the abstract idea to the mechanics of where the rubber meets the road. The simple processes of arbitrage cannot provide the sort of guarantees in which today’s efficient market theorist believes.
The Role of Speculators
The modern idea of efficient markets switches to an entirely different kind of actor. The speculator is no arbitrageur. The distinction is important, because arbitrage is a powerful lever than can narrow any spread. Speculation cannot do what arbitrage does. Speculation, subject to uncertainty, overshooting, undershooting, and risk, is a generally weaker and always inconsistent force than the lever of arbitrage.
Suppose Joe the speculator thinks that the price of wheat will collapse, because of the paleo diet. He and his buddies may sell wheat short, taking down the price. At the same time, Jen the speculator thinks that the price will rise due to some insect in Russia which is eating wheat. So when Joe is about done selling wheat down, she and her friends begin buying it up. Perhaps Joe and his buddies get squeezed, and are forced to buy wheat at a higher price, and their buying pushes up the price even further.
Traders in the corn options pit at the Chicago Board of Trade
Photo credit: Reuters
The result is that the price moves around chaotically. At no point in this maelstrom can we say that the price incorporates all information. Sure, Joe and his buddies have pushed the price down based on their diet theory. Then Jen and her friends push it up, leading Joe and his friends to (unintentionally!) push it up further. Next, it may be too high and now Bob and company can short wheat once more, to get the price down to what Bob calculates is the point where supply meets demand. Jen and her friends could get stopped out, and so the price undershoots to the downside.
The wheat market is not like a pond coming to equilibrium after you toss in a pebble. It can often be more like a pinball machine, with lots of automatic bumpers and actuators slamming the ball this way and that. It should be noted that there is an important asymmetry between selling short and buying long. Short sellers have the risk of unlimited price rises, but can only make a finite amount when the price drops. They will therefore tend to be timid, and only enter for short periods of time.
There is no way to say that speculators make prices perfect—or make markets efficient — in according with the information they trade on. Unlike arbitrage, speculation cannot guarantee any particular market outcome. It involves numerous risks (sometimes lopsided), uncertainty, doubt, incomplete understanding, and many other challenges.
Hunting for investment tips in the EU a few years ago …
Cartoon by Joe Heller
When reading any economics work (including mine!) you should strive to understand the meaning, nature, and consequences of the ideas. If something is said to be true, ask how that is so. Who would have to do what in order for it to be so? Look at real markets, and ask yourself is the theory working out in practice, or do you observe the exact opposite of what the theory predicts?
Sometimes a writer may not be as clear as he could be, especially if he thinks a relationship is obvious or takes a word or concept for granted. Other times, the problem may be that his choice of words is imprecise. No matter what, never fail to drill down, ask deeper questions, and look beyond the mere word to the truth of how markets work.
An efficient market is one which maximizes the marketability of the goods or securities traded in it. The higher the marketability, the lower the costs of doing business such as getting into and out of a good. An efficient market is one with the minimum possible spreads: bid-ask, geographic, calendar, brokerage commissions, etc.
An efficient market is not omniscient. The concept is closer to frictionless. A car with frictionless bearings does not guarantee you will drive to the right destination. It simply drives with the lowest possible fuel bill.
Image captions by PT
Dr. Keith Weiner is the president of the Gold Standard Institute USA, and CEO of Monetary Metals. Keith is a leading authority in the areas of gold, money, and credit and has made important contributions to the development of trading techniques founded upon the analysis of bid-ask spreads. Keith is a sought after speaker and regularly writes on economics. He is an Objectivist, and has his PhD from the New Austrian School of Economics. He lives with his wife near Phoenix, Arizona.