I Have Met the Efficient Market, and It Is Us
There’s a famous mathematical puzzle that goes something like this: on an island, there live 200 supremely rational, law-abiding, non-suicidal people, some of whom have brown eyes and some of whom have blue eyes. They are bound by a sacred rule: they must not learn the color of their own eyes. If they do, then they must kill themselves by nightfall. One day, a green-eyed fairy descends from the heavens and proclaims, “I see at least one person who has blue eyes.” What happens?
I won’t dissect this puzzle in detail, as others have already done so. The crux of the solution (spoiler alert!) lies in understanding that even if everybody knows a certain fact (everybody can see blue-eyed people around them), the public statement of that fact can still add information to the public knowledge—sometimes with drastic consequences!
I immediately thought of this puzzle after reading Josh Barro’s alleged debunking of the efficient market hypothesis. The efficient market hypothesis says, roughly, that the price of a security incorporates all publicly known information. Now, this isn’t really a “hypothesis” in the scientific sense of the word, since it’s not making a concrete, testable prediction, but that never seems to stop people from trying to refute it.
Barro’s argument goes as follows. On Thanksgiving, he wrote an article about falling prices of taxi medallions. This wasn’t some big investigative scoop—the few people who pay attention to taxi medallion prices already knew that prices were falling. Barro merely put that information in a prominent place, the front page of the New York Times the following morning. When the stock market opened on Friday, the stock of Medallion Financial, which invests in loans secured by taxi medallions, was down 6%.
Aha! Gotcha, efficient market hypothesis! Despite no new information being released to the public, and nothing else substantial changing in the taxi medallion situation between Wednesday’s close and Friday’s open, Josh Barro single-handedly tanked Medallion’s stock. But wait—is it really true that no new information became available? Even if everybody already knew the information in Josh’s article, the fact that it appeared on the front page of the New York Times brought the situation to a head. Now, everybody knows that everybody knows. More to the point, if I’m a canny trader and I read Josh’s article in the morning paper, I picture hordes of mindless retail-investing zombies shambling over each other in an attempt to sell off their shares of Medallion. What this means is that there’s a great buying opportunity somewhere well below the current price, so certainly I shouldn’t be trying to buy anywhere near where the stock was on Wednesday’s close. And if I hold Medallion, I need to sell—fast!—hoping to catch the one buyer who was in too much of a hurry to read the paper that morning.
“Buh-buh-but,” you may object, “that has nothing to do with the fundamentals of the company! It’s based on a bunch of people behaving irrationally!” Well, tough cookies! Nobody said anything about people behaving rationally, or that the price would clearly reflect the company’s fundamentals. The market is doing exactly what the efficient market hypothesis says it does: it’s incorporating new public information instantly. It just happens that the relevant information is not the information contained in the article, but rather the effect that information will have on the buyers and sellers in the market.
Here’s the thing. Let’s say you think you’ve found some inefficiency in the market. Do you (a) exploit it to make lots of money, or (b) decide you can’t be bothered and maybe write an article crowing about how you’ve debunked the efficient market hypothesis? If, like most financial pundits, you choose option (b), then you haven’t really proved anything, since at a bare minimum, you need to show you can actually buy low and sell high based on whatever public information you think hasn’t been incorporated into the price. And if you choose option (a), well, you’re using your human and technological capital in exchange for a profitable trade. Markets are collections of human beings and machines who turn (typically) public knowledge into profitable trades. Seeing a profitable trade without any secret information doesn’t disprove the efficient market hypothesis: making that trade is what makes the market efficient.
If this all sounds like a load of sophistry, it is, but there’s nothing wrong with that. As I said before, the efficient market hypothesis shouldn’t be taken as a statement of scientific fact, but rather as a lens through which we can try to understand how markets work. I would argue that, contrary to the claim that people exploiting public information for profit disproves the efficient market hypothesis, the efficiency of markets is what makes trading financial products even possible. If you had to know everything there is to know about a financial product in order to be able to trade it without worrying that it’s horribly mispriced, then nobody would ever trade anything. It’s the confidence that, to first approximation, everything is priced correctly that allows traders to actually do what they do.