The Efficient Market Hypothesis is Dead

Posted by kid dynamite

on December 9th, 2013

Barnes and Noble’s ($BKS: long) Friday price/”news” action officially killed the Efficient Market Hypothesis for me.

If you’re unfamiliar with the efficient market hypothesis (EMH), the layman’s cliff notes are that the EMH says that information is quickly priced into stocks. You think you know something? Some special information that will give you an edge? Guess what – The Market knows it too. Now, there are different “technical” versions of the EMH that you can argue about if you want to (weak, semi-strong, strong), but that’s not my desire here.

Most traders hate the efficient markets hypothesis because it basically says to a trader: you can’t beat The Market. If you believe that markets are efficient, you can’t beat them by trading on the edge you think you have, because it’s not an edge: the market already knows what you know* (quick caveat: you can still make what you think are positive expected value trades if you can quantify exactly what The Market’s expectations are, and if you disagree with them). Now I made my career as a trader, but a lot of what I did was profit from flow-related inefficiencies that our clients created. In the second half of my career, on the buy side, there were no such inefficiencies to trade around. This, incidentally, is one of the reasons I quit Wall Street: I never really thought I was “smarter” than The Market. Another way of saying this is something I’ve said on these pages many times:

I believe that markets are efficient enough.

When I say that, what I mean is that if you read a piece of news, and say “hey man, did you hear about that Tesla that lit on fire? We should short the stock,” odds are that The Market already knows what you know and has priced it in, or at the very least is in the process of pricing it in. Then, the “game” becomes a 2nd level evaluation of what exactly The Market has priced in or is expecting.

You read that the Fed might taper their Q.E. activities, and you want to buy/sell stocks/gold/bonds/seashells? Dude – it’s priced in.

You heard that Carl Icahn likes $NFLX – or that he sold half his $NFLX? Dude – it’s priced in.

You want to short $BKS because you read the little note in the 10q that said they were subject to an SEC investigation into some accounting methods? Dude – it’s priced in.

But it wasn’t!

Friday’s action in Barnes and Noble ($BKS: long) put a bullet in the heart of the efficient markets hypothesis, and also in my “efficient enough” maxim. On Thursday evening, BKS filed their 10-q, which contained the note:

Securities and Exchange Commission (SEC) Investigation On October 16, 2013, the SEC’s New York Regional office notified the Company that it had commenced an investigation into: (1) the Company’s restatement of earnings announced on July 29, 2013, and (2) a separate matter related to a former non-executive employee’s allegation that the Company improperly allocated certain Information Technology expenses between its NOOK and Retail segments for purposes of segment reporting. The Company is cooperating with the SEC, including responding to requests for documents.

On Friday morning, the stock opened basically flat, and traded that way for *hours*. Suddenly, around 11:15 am, the stock completely fell out of bed. Here’s the intraday chart:

Now, it’s possible that some sell-side firm came out with a big sell recommendation for $BKS and cited the SEC investigation as the reason – if that’s what happened, then the Kid Dynamite “markets are efficient enough” thesis isn’t totally dead. From what I’ve heard, however, what happened was that the “SEC IS INVESTIGATING BARNES AND NOBLE” non-news (from the night before) hit the tape in headline form, and the rest was history.

Of course, I would have expected that the news of the SEC investigation, which had been disclosed in the 10-q the prior evening, had been priced in already. It seems pretty clear that I was wrong, and that my “I believe in the EMH more than I think most other traders do” pillar is clearly cracking.

I would like to note, however, that if I’m going to be guilty of a stock market sin, thinking I’m *NOT* smarter than the market (which is my whole point when discussing my belief in the “efficiency” of markets) is a great “flaw” to have.

-KD

disclosure: long $BKS

postscript: I think there is a philosophical discussion to be had about how traders can get an edge by knowing how their own views differ from the consensus of The Market. In other words, if there was a sign posted that said “The Market has priced in a 63.5% of a December taper,” and you, for whatever reason, thought that the true taper odds were 82%, and you knew what would happen to various asset classes if the Fed tapers, well then you can make some positive EV trades. Of course, we never really know exactly what the market expects, and we never really know what the true odds are/were. Still, the entire art of “trading” is trying to monetize the difference between one’s own expectations, and what one *thinks* the market expectations are. Of course, there’s also the issue of the accuracy of our own odds estimates, which I’ve attempted to address previously, such as in this post.

* Some people get confused by this: it doesn’t mean that markets are always right, or that prices shouldn’t move – it means that you don’t know something that The Market doesn’t know. There are, of course, ways to get information that the market doesn’t know: do proprietary research: but I’m guessing that the vast majority of the people reading this are not out counting the number of customers at the Apple Store ($AAPL: no positions) or employing an army of worker bees to count customers at McDonalds ($MCD: no positions), etc etc etc.

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