Market Efficiency & Market Liquidity

Circa 1970 Eugene Fama popularized a body of research known as random walk theory.  Soon after leapfrogging many other efforts he finally published a paper on the Efficient Market Hypothesis (EMH) defining weak, semi-strong and strong efficiencies in markets.  Efficient market theories have often been criticized by academics in the field of behavioral finance.

In essence, what the body of work that came out of Fama and other’s efforts was after was to prove that the average investor was remiss in picking stocks since the US markets were fully efficient therefore indicating that it was impossible to find a “cheap” or undervalued security.  Strong form efficiency is summarized below:

  • Share prices reflect all information, public and private, and no one can earn excess returns.
  • If there are legal barriers to private information becoming public, as with insider trading laws, strong-form efficiency is impossible, except in the case where the laws are universally ignored.
  • To test for strong-form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time. Even if some money managers are consistently observed to beat the market, no refutation even of strong-form efficiency follows: with hundreds of thousands of fund managers worldwide, even a normal distribution of returns (as efficiency predicts) should be expected to produce a few dozen “star” performers.

To me, our recent market crisis has me wondering what role liquidity plays in EMH or behavioral finance.  Efficiency in market pricing is based on the free flow of information and information symmetry where everything is essentially freely know to everybody.  Barring insider trading and with Sarbanes Oxley in place one would think that markets would have become more effiicient.

However, with indexes moving 4, 5 and 6% in either direction on a daily basis our current market has become very innefficient.  My unresearched and untested hypothesis, let’s call it LMH or the Liquid Market Hypothesis is that market liquidity carries a positive correlation to market efficiency.  I have often heard it said recently that this is not an investors market but a traders market.  That could not be more true.  Good traders today know that if they pump liquidity into a security, momentum alone well help boost their profitsm.  In fact managed futures funds have been star performers in this environment, and managed futures are fairly straightforward momentum strategies, following trend trading techniques.

Part of the painful result of massive deleveraging is that a large pool of dollars that used to provide liquidity to the market is now gone, and much of it will never return in the wake of the mega investemnt banking model gone bust.  As a result, we are in a world of higher volatility and even more opacity now.

Lastly, taking my Liquidity Market Hypothesis to the next level, I also wonder if there is a relationship to the amount of information available to market prices.  Said another way the interenet, email, instant messaging, and the proliferation of business news networks have changed the information to investment ratio.  If one could count all the bits and bytes of info over time available to the trading public and create a ratio to the amount of liquidity available I wonder what the result would look like.

My guess is over the last year the amount of “noise” has skyricketed meanwhile liquidity has plumeted.  This will benefit good stock pickers and excellent traders for a time to come.  In the meantime look forward to seeing your 401k (201k) bounce around at depressed levels as a reminder that, as John Stewart alluded to in his interview with Jim Cramer, that you are just a pawn in someone else’s game.

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