Information Democratization and Market Efficiency

I had a spirited debate this morning with a colleague who I highly respect about value investing.  His thesis is that finding “value” – defined as buying a company’s stock at a discount to intrinsic value – no longer exists (or exists much less than before) because of increased access to financial information. Information of which formerly was only readily available to big players. It’s an interesting question so I thought I’d put to pen some of my thoughts on it.

For you unfamiliar with theoretical finance, by “efficient” we mean that a stock sells at or near its intrinsic value given available public information so no premium or discount can be attributed to any asset. This, of course, is the heart of the Efficient Markets Hypothesis (EMH) authored by Nobel laureate Eugene Fama and argued against by Nobel laureate Robert Shiller. For the record, I’m on the side of Shiller. Still, in the economics of marginalism, the question is not whether information makes the market efficient but, rather, does it make markets more efficient?

Through the lens of a short term trader, the ability to see the immediate direction of momentum appears highly enhanced by the social networks such as Stocktwits.com.  What this seems to accomplish for some traders is an ability to get on a moving trolly with the hopes they can get off before it heads back. To the extent to which this is a successful long term trading approach the jury remains out until such time as it’s tested through a bear market. But, the ability to trade inside short term trends does not address the question at hand – unless one embraces the EMH. And if you do think there’s something to the EMH then trading is a waste of time since “everything is baked in the cake.”

I would suggest that, as far as value discovery is concerned, the efficiency of the market is not only not improved but, in fact, it is reduced.

First, let’s look at market structure and the influences that have changed. Regardless of how engaged individual investors are in trading stocks, the majority volume (outside of HFT “market making”) is still in the hands of institutions. We see the impact of this all the time in a lot of areas. And if you’ve ever been in a trade where a single large position holder rushes to get in or out at the end of the day and you get “VWAPed” you know exactly what I’m talking about. Over the recent run-up back to the highs, BAML has reported that institutions and hedge funds have been actually selling equities while individual retail investors have been the only group buying. Whether or not this proves an example of “sold to you” (aka The Greater Fools Theory) remains to be seen. But the fact remains that “big money” has always been a better indicator of value than the individual investor.

However, since the advent of HFT there is a question of what structurally is actually moving price. There are all sorts of algorithms pushing and pulling prices around which have no relation to fundamental value of the underlying assets. While this has made markets much more liquid it has nothing to do with value. In fact, I believe it distorts value discovery (reduces efficiency) because they are trading on everything but value. Algorithms trading against social media are particularly distorting since they trade purely against sentiment. Now, HFT makes up a whopping 70% of all trades – none of it attached to fundamentals.

My good friend makes the point that even outside of the market structure value is more imputed in price because access to high quality financial reporting is available to nearly anyone. This is true to an extent. However, institutions and hedge funds have seen no discernible improvement in information flow (with the possible exception of getting flags from Twitter) in at least a decade.  Further, even though financial information is easier to access by individuals, how prepared is the investing public to understand what they’re getting? Has the financial sophistication of the general public improved. Call me an elitist but I think the investing public is less sophisticated today that the investing public 30 years ago as a simple matter of the statistics of the denominator.

All of this, of course, has not a thing to do with anyone’s ability to make money. But it has a lot to do with how well the average investor performs. While it’s fashionable to say only price matters at any given point in time – true enough – it’s also true that the market has a real and tangible relationship to the underlying economics of various sectors. The market passes above and below the performance of the “real” economy and that’s also true with individual names.

The market never has been efficient and, as I’ve said, appears less efficient to me today than usual. I could be wrong but, at the end of the day, there is nothing new under the sun. Let the volatility begin.

 

 

 

 

 

2 comments

  1. Insightful piece. I can agree with your friend that information democratization seems like it should tighten up market efficiency. It’s an intuitive conclusion; but like you, I’m firmly convinced contemporary market history doesn’t bear it out.

    There’s a long list of problems, few of which are novel even if the speed and breadth of information made available is.

    First, taking it all the way back to the Enlightenment insistence on “defining one’s terms”: what the hell is “information”, anyway? EMH theorists throw this word out as a prime facie rigid designator of some class of data with an identity so self-evident it doesn’t require explication. But, what we mean by “information” has everything to do with efficiency.

    From what I have gathered, in the service of tractability (when reality is too complex, dilute and twist it into something compatible) “information” reduced to a kind of Platonic archetype: pristine and utterly veracious. It is absolutely and ineffably truthful. And that’s a good thing; because if it weren’t, the question of price efficiency would never escape the question of the integrity of its inputs.

    So that speaks to “information’s” coherence and reliability; but it doesn’t answer what it is. Is it affirmative statements? Is it questions? Is it descriptive declarations of sentiment? Is it simple anecdote? In fact, it’s all this and more. But EMH sneaks a normative connotation into how “information” is characterized: it is the *right* “information” – according to this conception, price is discounting a flawlessly curated subset of information: in a word, market efficiency is the discounting of answers.

    This fanciful idea leads to what I think is the most persistent and difficult question: access v. assimilation. There’s more information than ever; but the ability to get at it (or increasingly, for it to get to you) has nothing to do with our ability to sort it, sift it, analyze it, comprehend it, assign priority to it, deploy it, etc. Even if we assume we get more answers – does that mean we’re asking the right questions? Will we recognize the value of the information and how to integrate it? Can we make all of that part of a repeatable, efficacious process?

    My two cents, condensed: price does efficiently discount information, but more “information” is a potential good only. Price doesn’t care about the world of rainbows and unicorns and imminently rational agents who flawlessly assimilate “information” in their resource/capital allocation, except to laugh at how facile and distorted a caricature it is. Whether information is an actual good has nothing to do with its efficiency but the process by it incorporated (or not) and used.

    What’s lacking is the same thing that’s always been lacking: the skills of discrimination and parsimony. In as far as increased access masquerades as progress, it is actually obscuring the hurdle posed by this problem of skill development. That actually serves to create a new, more meritocratic inefficiency in which an updated breed of “smart money” possesses these skills (or, more importantly, knows it needs them and seeks them) and the “dumb money” is incompetent flotsam adrift on a billowing sea of “information”. At the end of the day, “efficiency” is still much more about the agent and less far about the quantity (and even quality) of information flowing around in front of them.

  2. admin says:

    Thanks for the feedback, Andrew. I agree with everything you say and touched upon it cursorily in my comment about financial sophistication, etc.

    I was raised on EMH as it was the theory du jour when I was in school (along with the Random Walkers that prevailed at the time.) Of course writing about theoretical finance with a target audience that lacks the academic background requires a Cliff Notes rendering of a complex subject.

    Thanks again for your thoughts. They are a valuable addition.

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