Inefficient Market?

[prawn_86]

I know this topic has been touched on in a few different threads before, but I think it is worth having its own thread.

There are plenty of quotes out there along the line of "the market is never wrong" etc etc.

From a current share price perspective I can appreciate those quotes, as the current price is what makes up portfolio values.

However taking a view anything longer than the very instant, I think that the market is hugely inefficient.

IMO, this affects both traders and investors.

These are just my musings and as yet are not backed up by any empirical evidence (although perhaps it would make a good honours thesis for me later )

1. The uprise of technolgy has helped increase liquidity, however it hasnt really improved education. Fear and greed are more prevalent now than say 10 years ago 9not that i was investing back then). The Interent has caused a lot more 'herd' like mentalities hence increasing inefficiency, when theoretically liquidity should increase effciency.

2. How is it that stocks within the same industry, with similar structures, earnings (or lack of), books, etc etc can be priced so vastly differently? Inefficiency, one way or another.

3. Stocks that are well marketed seem to perform better. From a theoretical "high horse" view, this shouldnt happen in the market, due to everyone having access to the same information (which doesnt actually happen). Again i think it comes down to investor/trader education.


I could probably go on, but that will do for now.

Comments/discussion?

 

[jonojpsg]

Hey Prawn,
I saw your post re inefficient markets in another thread and thought it was an interesting idea.

I think definitely in Australia with a small population, even though we have a relatively high share ownership ratio, that our market is at risk of not having enough volume to be able to maintain "fair" value in all the listed stocks. As your tag says, "so many stocks so little capital", which means that there will always be stocks left behind.

As far as information flow goes, I agree that unless one has a fair amount of time to research, which the majority don't, then the stocks that get traded are going to be the ones that get marketed, eg anything that appears in mainstream media will get more trades/volume than others. Actually that would be interesting to check on - anyone got the time

As a consequence of the two points above, there will inevitably be variance in the value of stocks that have similar businesses because we (the investing community) only have so much to go around. I suppose with the amount of money going into super funds though as well as the global nature of trading, one could argue that this is not the case, but super funds are extremely unlikely to be investing in micro/small caps.

Where does that leave us then? With an inefficient market - I guess we just have to live with it and stick to our trading plans.

 

[prawn_86]

Where does that leave us then? With an inefficient market - I guess we just have to live with it and stick to our trading plans.

Yeh im not having a whinge, despite what some may think.

My main point of interest is the fact that the stock market has always been built around freedom and efficiency of information, yet this is becoming less and less so.

Even regulators like ASIC do not police things. IE - lack of recent disclosure of directors margin loans.

I suppose one question is:

How can we improve the efficiency in the market?

 

[doctorj]

How can we improve the efficiency in the market?

As an investor, why would you want to improve it? Inefficiency gives profit opportunities.

YT is the perfect example - do you think he'd have been as successful as he's become if the small end of the market was as well covered as the big end of town?

 

[ROE]

As an investor, why would you want to improve it? Inefficiency gives profit opportunities.

YT is the perfect example - do you think he'd have been as successful as he's become if the small end of the market was as well covered as the big end of town?

Yeah I don't want an efficient market ...... I cant buy good stock for cheap.
when you are in this game you want Uni and business school to continue to teach Efficient Market Theory.

When you compete in an Olympic you want to make sure all your competitors take drugs and tell them they will never be caught

 

[prawn_86]

As an investor, why would you want to improve it? Inefficiency gives profit opportunities.

YT is the perfect example - do you think he'd have been as successful as he's become if the small end of the market was as well covered as the big end of town?

Fair point. I agree that it is what presents profit opportunities.

But you do see disparity between large stocks also.

If we cant/dont want to improve it then i guess my next question is why is it inefficient (apart from what i have outlined) and will it become more so in the future?

IE - will there be some stocks that are simply never recognised by the market?

Or will there be a huge crash clearing out all the 'punters' and all those 'serious' about it can get back to creating efficiency again?

 

[jonojpsg]

Very true doctor, this is an excellent point for us to muse on as we troll through the micro end of the market!!

A big thanks to all those on ASF who spend the time researching and point out the stocks that the market has overlooked

 

[ROE]

Fair point. I agree that it is what presents profit opportunities.

IE - will there be some stocks that are simply never recognised by the market?

Who care and this is why
If I buy a stock for a $1 and pay 6c dividends to start off with
then as years go by it increase to 7c, 10 cents, 15 cents, 20 cents

I don't care if the market doesn't recognize it I still pocket my endless supply of yield which eventually pay for itself. But in a real world if you can show consistent earning and grow your earning the market WILL always comes to the party. Have you seen any company that grown their earning and never have a price rise? NEVER...

It may trades too far above its value and go backward but never ever it stand still

 

[chops_a_must]

It's funny how efficient market theorists can't explain why they make money. If you truly believed the market was efficient, you'd put money into an index fund and be done with it.

At some point there is a level of efficiency. You don't always get stocks at absurd prices. If they are, it's a bubble. But the bubble itself is evidence against this argument.

Conversely, pricking the bubble is an efficiency. So at some point the argument is true, it just depends at what point you draw the line.

FWIW I don't agree with efficient market theory. Peaks and troughs are not smooth.

But it's the same argument with random walk theory. Stocks don't go from $100 to 1c and back again every 30 seconds, every day. But at some level it has an element of truth because no-one can predict every move at any time.

At what point do you draw the line for these things?

 

[doctorj]

Why is it inefficient?

I don't know, but here is my theory.

Inefficiency means there is an arb opportunity in the market and hence a profit motive for those that spot it. The next possible step is the thought that if there are arb opportunities out there that are taking a long time to be resolved, people obviously aren't spotting them.

Why not?

Perhaps a large amount of the 'hot' money is still held by people relying on brokers and the like for investment advice. The 'know your client, know your product' rule essentially means that a broker cannot offer stocks to their clients not covered by the company's analysts or the like.
With something like 1700 (??? just a guess ???) stocks on the market at the moment its tough getting the analyst coverage you need.

The reality is the people that frequent ASF are in the minority. Most are happy to have their investment choices spoonfed to them and would never go to the efforts many here do to spot a good opportunity.

 

[prawn_86]

The reality is the people that frequent ASF are in the minority. Most are happy to have their investment choices spoonfed to them and would never go to the efforts many here do to spot a good opportunity.

How come my "good opportunities" lose me cash? LOL

 

[cuttlefish]

Who care and this is why
If I buy a stock for a $1 and pay 6c dividends to start off with
then as years go by it increase to 7c, 10 cents, 15 cents, 20 cents

I don't care if the market doesn't recognize it I still pocket my endless supply of yield which eventually pay for itself. But in a real world if you can show consistent earning and grow your earning the market WILL always comes to the party. Have you seen any company that grown their earning and never have a price rise? NEVER...

It may trades too far above its value and go backward but never ever it stand still

Thats it - spot on.

The most important thing for a fundamental investor to assess in the small end of the market is the likelihood that they will get their money back (and more) via dividends and when. This isn't as simple as running a few metrics and requires qualitative assessment as well - i.e. the business that is underlying the stock needs to be assessed and that can not be done by running a set of numbers - it must involve a qualitative assessment of management, of the growth opportunity/projects/prospects, of the timing of those projects, of profitability, of competitive risk etc. etc. Of course the quantitative factors need to be compelling as well. If that is done succesfully it doesn't matter what "Mr Market" says the share is worth because you will profit anyway - but as ROE says - the market does eventually come to the party on price for assets that generate an income (i.e. dividend paying stocks).

A flat market is a great time to pick up good assets for less risk because the market often doesn't react to new information that improves fundamental value thus the risk is reduced. On the other hand in a flat market you have to do your homework properly because the hype won't save you only the future dividend stream.

 

[wayneL]

<musing>

Maybe efficiency is looked at the wrong way. Stepping outside of EMH, I believe liquid markets ARE efficient at pricing perception rather than value. Let's face it, value has been long gone for quite a while, risk has not been priced in (though that may be starting). Ignoring value, the market will always efficiently arrive at the perception of value.

Value is nothing but a perception anyway.

It is the fact that the markets perception shifts minute to minute, hour to hour, day to day, that allows us to make money by trading.

BS I know, but EMH is as dodgy as they come, so at least as valid.

</musing>

 

[motorway]

What Is the Problem?
Prices in equity markets are much noisier
than many people expected
Black (1986):
“All estimates of value are noisy, so we can never
know how far away price is from value. However,
we might define an efficient market as one in which
price is within a factor of 2 of value, i.e., the price is
more than half of value and less than twice value…
By this definition, I think almost all markets are
efficient almost all the time. ‘Almost all’ means at
least 90%.”

That is efficiency !

In Short, Value Investing
Has Its Limits:
• Value plays require patience (Frankel and Lee,
1998)
Abnormal returns are realized over 2 to 4 years
• Value plays can be risky (Piotroski, 2001)
The median “value” stock underperforms the market
• Value stocks tend to be negative momentum
stocks
Buying them can be like catching a falling knife
• Often improvements in the valuation technique
contribute only marginally to returns prediction:
When a stock is really over- or under-valued, almost any
valuation model will spot it; when a stock is only marginally
over-valued or under-valued, it’s typically not in a hurry to
correct

"""Inefficiency means there is an arb opportunity in the market and hence a profit motive for those that spot it. The next possible step is the thought that if there are arb opportunities out there that are taking a long time to be resolved, people obviously aren't spotting them."""

But to soon ... or liquidity vanishes
means what is obvious still has risks..
So the opportunity has to become big enough..
Even with closed end funds !

motorway

 

[Viginti]

Interesting conversation and I agree with a lot of the comments.

If some stocks are more efficient/inefficient than others, is there potentially scope for a new form of analysis around "information efficiency". If you could isolate companies that were deemed "inefficient" (i.e. limited coverage by brokers, media, and the like) there would be potential to make gains when (and if) the efficiency of that given share increases. This of course is assuming that the "efficiency rating" of the share will right itself over time - i.e. the share receiving more coverage.

An recent example which may fit the bill is BRM - many posts in the BRM forum here at ASF suggested that people had never heard of the company before the recent ann. Interestingly, all of a sudden the mainstream business press had hold of it and everyone knows about it. What has happened over the last week? The value has come back down - perhaps on the basis of greater informational efficiency??

This is totally unsubstantiated thinking, but perhaps food for thought?? Perhaps someone with more experience (I'm still a relative newbie to the mkt) could either shoot me down or provide supporting comments?

 

[prawn_86]

Interesting idea Viginti.

however the point of mainstream media, is one i was trying to raise. Due to the amount of smaller 'less educated' investors in the market, it does seem to be only stocks that are in the mainstream media that are noticed. This is part of the reason for inefficiency IMO.

However, with regards to making $$ from this information, your idea is a good one.

Wayne, couldnt agree with you more.

The market prices marketing (isnt it funny how those words are the same?) rather than 'value' (whatever that may be)

 

[motorway]

If some stocks are more efficient/inefficient than others, is there potentially scope for a new form of analysis around "information efficiency". If you could isolate companies that were deemed "inefficient" (i.e. limited coverage by brokers, media, and the like) there would be potential to make gains when (and if) the efficiency of that given share increases. This of course is assuming that the "efficiency rating" of the share will right itself over time - i.e. the share receiving more coverage.

This is the direction of the lee's Fusion analysis in the PDF

eg The volume momentum clock.......

Some stocks are efficient but for who

Brokers
or shareholders

A brokers utopia is not the same as a stockholders

motorway

 

[cuttlefish]

there's always opportunity to find and exploit true value because psychology and value are two different things and both drive the market. Value definitely prevails over the long term but all participants apply differing ratio's of subjectivity and objectivity when assessing value and there is always a subjective element no matter how objective one tries to be. (these are the qualitative factors)

Potential and value are also two different things, the more valuations are based on potential (prospect of value down the track) rather than real value (income generation today), the more psychology/subjectivity is involved in the valuation.

The more sizzle and less steak, the more important selling the sizzle. The steak if often boring but it always gets eaten in the end. Sometimes the smell of the steak creates more excitement than the eating of it, but its the eating that provides the real sustainence to live another day.