Are the Markets Inefficient or Irrational? And What Do the Conclusions Mean for Investors?

https://www.ft.com/content/a85d3e6e-4bd0-11e9-8b7f-d49067e0f50d?ftcamp=engage/capi/widget/client/openft/b2b

This FT article explains that the risk of a no deal Brexit is not being built into the Sterling’s exchange rate. This is because barely any fund managers believe that a no deal Brexit will happen. Is this a herd effect suggesting an inefficient market? Perhaps investors are not individually assessing the real risk of a no deal Brexit. Or is it legitimately so unlikely that no price change reflects an efficient market?

The market is not considering yesterday’s news which, assuming there is a significant enough risk, suggests an inefficient stock market. I think it is entirely plausible that whilst information reaches the market quickly, not all that information will be acted upon rationally. Considering the political shocks that have occurred in the recent past I think the likelihood of a no deal Brexit should be accounted for in the Sterling’s exchange rate. Nobody can predict the political world at the moment, have we learnt nothing? This FT article also explains that the likelihood of a no deal Brexit is increasing and yet the pound is not moving.

However, the studies to support the efficient market hypothesis are hard for me to ignore. Studies have suggested that a monkey throwing darts at the FT has been about as effective as trading techniques for predicting the market. The random walk suggests that past performance gives no indication of what will happen next. The idea that the market price accounts for all known information makes sense to me. People are valuing stocks with their money considering news as quickly as they can and assessing it as well as they can. I think with so many different people making their contribution to valuing stock based on their estimation of the value, stock price certainly reflects value well.

We know the markets are not and never will be strong form efficient. However, we know strong form inefficiency is possible through unethical (and illegal) insider trading.  Looking at the fraud triangle it is clear to me that individuals who have insider information could be a) incentivised and b) see the opportunity to use that information to invest in the stock market. Such misconduct could be very lucrative and the complexity of the unethical trader's business could present an opportunity. Insider trading is negative for ordinary investors because such traders would have an unfair advantage. To link back to the article that started this blog, politicians will have information about a Brexit deal before anybody. Therefore, such politicians could use this information to invest in the stock market, but given the metaphorical spotlight the media have have politicians the opportunity to get away with such misconduct is unlikely. Semi-strong efficiency is also deemed by most as unrealistic. However, I think the rise of alt data proposes a future where stock markets could move closer towards such efficiency. Alt data enables companies to receive information from consumer's mobile phones on where they are shopping and what they are buying almost in real time. Even individuals shopping on the high street could be subject to such analysis, as drones take pictures of car parks. Alt data is seen by many as unethical when considering the personal information some mobile apps take from users. We know from Facebook's recent troubles that such activity sparks large scandals, so I believe it is likely that some forms of alt data could be subject to new legislation in the near future. Weak form efficiency is widely considered to be the state of most markets today -- considering yesterday's news. 

Even in a weak form efficient market investors can only make money from the stock market if they have information not published yet, receive published information before anyone else or by luck. I do not believe this is the only way investors can make money from the stock market. I still cannot accept that all investors, even if they are trying to be rational, are making completely rational choices. People are obviously influenced by herds and their own emotions. 50% of trades are conducted on computers which I realise will not be affected by behavioural finance but if they are reading the news then they can still be influenced by herds. The fact the market has crashed several times throughout history also suggests investors can get it completely wrong. I cannot believe that value investors such as Warren Buffett just got lucky. I can believe that value investing was more lucrative in Buffett’s day though. Since the financial crash companies have being trying to reduce their leverage and thus value investing has proved less effective. When it is estimated that it can take up to 30 years for cheap stocks to outperform their value, you will not be turning a profit anytime soon.

Maybe it is still possible to make quick money on the stock market by spotting where people have been irrational. In the modern world intellectual property can make up the most significant value in a company. To value companies now investors will need to look for information outside of the balance sheet such as customer/ fan base, goodwill, brand recognition, copyrights and patents. There are minimum fact-based figures attached to these assets which makes them more subject to opinion. More opinion I think must lead to more irrationality in valuations. Chan et al. (2001)’s research showed that companies with high R&D intangibles tend to have volatile share prices. However, the unpredictability of the potential of certain companies on the market, and to link more into the article that started this blog, the unpredictability of the political world, suggests to me that investors can spot where people have valued such eventualities more irrationally than others.

Therefore, in my opinion, there are still ways to make quick money on the stock market via analysis of current information. The analysis will not be as black and white as in Buffett’s day, when he would look at a company’s financial statements and whip out his calculator. Intangibles are more difficult to value but I think it is possible to identify when they have been over/ under valued significantly – as they regularly are possibly due to an irrational stock market.