If that coupling gets diluted to higher simulacrum levels, such that prices only reflect a free-floating consensus of what traders think that traders think that traders, &c., then a market that is efficient in a narrow technical sense, may not be performing the kind of information processing that some naïve EMH proponents might think it is.
I think this is an important point. And also that there is a time horizon component to it. As Benjamin Graham (mentor to Warren Buffett) put it:
In the short run, the market is a voting machine, but in the long run, it is a weighing machine.
I have a pet theory that part of the way that the market reacts to news is analogous to the blue-eyed islanders, where everyone is trying to do induction on what everyone else thinks.
Suppose I learn some new information (or do some analysis) that suggests that stock prices should fall (e.g. because a new epidemic will be worse than generally thought). But stock prices aren't falling yet. Is that because the rest of the market participants don't know what I know, or is it because they also know some countervailing fact?
After some time, prices still aren't falling. Surely other people would have figured it out by now. What's going on? Is there something obvious I'm missing?
(And how many other people are in the exact same epistemic state, and also asking the same question?)
Finally, prices start to fall. Maybe someone got brave, and decided to bet on the same inside view that I had. Or maybe some other random event caused them to fall. But they're falling now.
Normally, you might think that if you have an inside view of where prices should be, and then prices fall, things that looked expensive to you before should look cheap, and so you should want to buy. But if you're in the epistemic state I describe above, prices falling is validation of your belief that prices should fall, and evidence against the hypothesis that there's some important countervailing fact that you're missing. So as prices fall, your own "fair" price for assets falls too.
So all the islanders leave on the same day. And all the traders sell at the same time. And market moves happen more sharply than they would if they were purely the result of updating on external information.
I'm not sure if this view is correct, but it's my impression. (For a related idea, see Soros's notion of reflexivity.)
One example that caused me to think about these things was when in Feb or so of 2015, Elon tweeted out that there was going to be a new product announcement in March (I think this ended up being for the PowerWall -- don't remember exactly). The stock price jumped something like 1% in one minute. And it was the same minute as the tweet. So it seemed clear that the market had reacted to the news.
Except it wasn't news. Elon had said basically the same thing on the earnings call a couple of weeks before.
You might argue that the fact that he also twee... (read more)
The efficient markets hypothesis (or EMH for short) is the idea "that asset prices reflect all available information". Price changes in a liquid market are understood to be unpredictable—anti-inductive. Suppose some stock has the ticker symbol LW. If you want to buy a hundred shares of LW at $10 per share because you think their price is going to go way up, you need to buy them from someone who's willing to sell at that price—who presumably does not agree that the price is going to go way up. If people know that a share of LW is "really" worth $20 even though the current price is $10, then they should expect to profit by continuing to buy shares from anyone willing to sell them for less than $20, until the market price really is $20. In this way, the market construed as an intelligent system aggregates and processes the information implied by traders' behavior in accordance with the fourth virtue of evenness: "if you knew your destination, you would already be there."
What does it mean for a share of LW to "really" be worth $20? According to the subjective theory of value, there isn't really a fact of the matter over and above what people are willing to pay for it, but we expect there to be some sort of correspondence between the subjective economic value of a thing, and objective facts about the thing in the real physical universe. If I pay $3 for an iced-coffee, it would be circular to say that this is simply because I value an iced-coffee at $3—that doesn't explain anything! Rather, I paid because I expected to enjoy the experience of drinking it, the psychoactive effects of the caffiene, &c., and these actual properties of the coffee were worth more to me than a marginal $3.
The same goes for a share of LW, albeit at a somewhat higher level of abstraction. A fractional "share" of ownership in a business endeavor is valuable not just because we circularly value it, but because the business produces things that are valued (like iced-coffees), and a share of ownership entitles one to a share of that value, in the form of dividend payments, or a claim on the business's assets should it fold, &c. The "randomness" of unpredictable market movements is that of not knowing future information that hasn't already been taken into account, rather than the randomness of a pure random walk, unpredictable but ultimately signifying nothing.
That's why we have conversations like one on 16 February, when Robin Hanson said, "In few months, China is likely to be a basket case, having crashed their economy in failed attempt to stop COVID-19 spreading", and Eliezer Yudkowsky replied, "It seems to me like the markets don't look like they believe this."
The efficient markets hypothesis is what makes "It looks like the markets don't believe this" seem like a germane reply. In contrast, if someone were to reply, "I asked my friend Kevin, and he doesn't believe it," that would prompt the obvious question, "Who is Kevin, and why should I care what he thinks about China's economy?" If one's answer to that question were, "Kevin is a smart guy and I trust him a lot," that would seem much less compelling than "If China was likely to be a basket case in a few months, then you would expect Chinese assets to be priced lower by this competitive market of lots of smart guys who I don't need to personally trust because the ones who are wrong will lose money; what do you know that none of them do?" As it is written: "If you're so smart, why aren't you rich?"
A smart person who saw the COVID-19 pandemic coming earlier than the consensus had the opportunity to become richer, either by shorting the market as a whole, or by buying assets that would become more valuable during a pandemic. For example, with many more white-collar employees working from home in order to comply with shelter-in-place orders and not die horrible suffocation deaths, owning a piece of companies providing videoconferencing software should become much more attractive, which is why the price of ZOOM surged by 6600% (from $2.75 to $20.90 per share) between 24 Feburary and 20 March ...
Wait, sorry—wrong ticker symbol! Zoom Video Communications, makers of the eponymous videoconferencing software, has the ticker symbol ZM. They also did pretty well.
ZOOM, however, is Zoom Technologies, Inc., a "penny stock" of a Chinese company that makes ... um, technologies, presumably? The U.S. Securities and Exchange Commission halted trading of ZOOM on 25 March, citing the potential for confusion with ZM, and "concerns about the adequacy and accuracy of publicly available information concerning ZOOM, including its financial condition and its operations, if any, in light of the absence of any public disclosure by the company since 2015" (!!!—emphasis mine). (Trading of Zoom Technologies seems to have since resumed under the ticker symbol ZTNO.)
I am not learned in the science of economics. But ... this is nuts, right? It makes sense that a pandemic would make a videoconferencing company more valuable. It doesn't make sense for a completely unrelated company that may not have actually existed since 2015 to become more valuable because it happens to have a similar name as a videoconferencing company. It's understandable for an individual investor to get confused by the ZOOM ticker symbol ... but what happened to markets aggregating information, being "as strong as the strongest traders, not as strong as the average traders"? Increased demand for Thai food doesn't make the price of neckties go up.
"Asset prices reflect all available information" would seem to be underspecified. Information about what? The "You shouldn't be able to predict price changes, because predictable price changes correspond to a profit opportunity that many agents are already trying to exploit" argument only shows that prices reflect information about future prices. In order to usefully speak of the market "believing" something, there needs to be some kind of coupling between prices, and things in the real world outside the market. If that coupling gets diluted to higher simulacrum levels, such that prices only reflect a free-floating consensus of what traders think that traders think that traders, &c., then a market that is efficient in a narrow technical sense, may not be performing the kind of information processing that some naïve EMH proponents might think it is.