Exposing The Lie Behind “Efficient” Markets

We’ve talked tirelessly about how correlated and interconnected markets have become in the post crisis world.

If you believe in the efficient market hypothesis, you believe - generally speaking - that asset prices always reflect available, relevant information. In other words, you can’t “beat the market.” It’s always going to “beat” you to the mark because it’s supposedly so “efficient.”

Now there are stronger and weaker forms of this argument and there are myriad reasons to believe it’s flawed. For instance, some investors are trading on inside information. They’ll beat the market every single time. But as a kind of broad strokes way of thinking about asset prices, it’s useful to the extent that it helps investors remember what they’re up against. Trying to beat the market is trying to beat every other market participant to the punch when information is readily available to all. The chances you’ll get there first are slim and in fact, the chances you’ll get there pretty close to last are pretty good.

Based on this principle, it should stand to reason that the faster information travels, and the more connected everyone is, the more efficient markets should be, right? After all, efficiency in part depends on timely access to information and at no other point in history has it been easier to access a universe of relevant data with a few clicks of a mouse.

This however, has turned out not to be the case. Information travels too fast. And there are now machines programmed to “interpret” that information based on little more than key words. That’s why you get ignition or collapse in things like crude prices when the words “OPEC” and “freeze” are mentioned in the same Bloomberg headline. It’s why flash crashes happen more frequently. And it’s also why you’re seeing more six sigma and up events:

(Charts: Citi)

The problem is no one is actually interpreting the data anymore. They’re just pulling the trigger. It’s not about what the data actually means on a fundamental level or even about whether any one discrete piece of data is important in the big scheme of things. It’s about the trade.

This magnifies insignificant data and downplays important underlying trends. It contributes mightily to why the Fed has been forced to seesaw between meetings and why their “optionality” (read: confusion) will persist in perpetuity.

It’s impossible to overstate the importance of this dynamic and on Thursday, we got one the clearest explanations of all of what we said above from Bloomberg’s Richard Breslow who we’ll quote at length below. Read it once and if it doesn’t resonate, read it again. Enjoy:

“Every market trading in lockstep is a legacy symptom of the financial crisis that benefits no one but computer algorithms.”

“The transmission mechanism from one piece of localized data to financial conditions all over the globe just doesn’t work that fast. If at all. And it creates false, even ridiculous, narratives purporting to describe how the world has suddenly changed. Until the next economic factlet requires an entirely different interpretation.”

“This phenomenon has been a contributor in a very real sense to the policy and institutional reform paralysis that is globally epidemic. After all, if people want our stocks or yield it must prove that existing policies are paying off. Ignore that youth unemployment rate behind the curtain.”

“One halfway decent number out of China and the effects on the world’s markets and storylines becomes the stuff history textbooks are written about. Or they would be if the use-by date wasn’t today. Interconnectedness has been turned into spurious connections. And of course, extrapolated ad infinitum, while ignoring the bits and pieces that don’t fit the script.”

“This of course is why there’s so much hand-wringing over the prospect of a tiny and cautious U.S. rate hike. It has nothing to do with the real economy, but what it means for some credit trade whacked on in South East Asia, or the like. The Fed may carefully watch the global situation, but this consequence should be utterly ignored.”

“When the G-20 meets, they’d do us all a service if they acknowledged interconnectedness by seeing if they can salvage what’s left of the dying trade pacts rather than agonizing over the next big figure in USDJPY.”

That, folks, is the best commentary you’ll read all week.

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