Markets are not Efficient

Economists don’t like to think about it but, according to conventional theory, events such as the present wild gyrations in financial markets aren’t supposed to happen.

That theory says share prices move only when investors quietly incorporate new information about the prospects of their investments, whereas it’s clear the markets are swinging between blind panic and the thought that maybe it’s just a great buying opportunity. The herd can’t decide which way to run.

How would you feel if you walked into a shoe shop and the manager rushed up and told you to buy extra shoes because prices had skyrocketed? Or if nervous customers warned you not to buy any socks because sock prices had fallen by half? You’d feel that both the manager and his customers had taken leave of their senses. Yet that’s the kind of logic we see in financial markets all the time: people buying shares because their price is rising and selling shares because their price is falling.

We’ve been witnessing sharemarkets around the world doing both those things in recent days – sometimes both on the same day.

The thing to note is that both those reactions fly in the face of the laws of supply and demand. According to them, people buy less when the price rises and more when it falls.

So what on earth is going wrong? Well, according to an article by Robert Prechter and Wayne Parker, published in The Journal of Behavioural Finance, the explanation’s surprisingly simple: economists are mistaken in their assumption that the markets for financial assets such as shares work the same way as the markets for ordinary goods and services.

That’s because ordinary goods markets are subject to the laws of supply and demand, but financial asset markets aren’t. Rather, financial asset markets are subject to “the socionomic law of patterned herding”. In a market for goods and services, you have producers on the supply side and consumers on the demand side. When prices rise, the producers are happy to supply more of the item; when prices fall, they’re willing to supply less.

For consumers, however, it works the other way: they want to buy more when the price falls and less when it rises.

The conflicting desires of producers and consumers create a dynamic balance, arbitrated by price. The price will adjust until the amount producers wish to supply exactly equals the amount consumers are willing to demand. By this mechanism, the market reaches “equilibrium” (balance).

But, Prechter and Parker argue, the markets for shares and other financial assets don’t work that way. That’s because you don’t really have any producers in the market.

The supply of shares is increased when a new company floats on the stock exchange or when an existing company makes a new share issue. But these are comparatively rare events. The vast majority of share trades involve the exchange of existing, second-hand shares.

So, for practical purposes, there’s no supply side in financial asset markets, just a demand side. You’ve got demanders who want to buy and demanders who want to sell. And the same person can be buying one day and selling the next.

“Without the governing influence of the law of supply and demand deriving from the conflicting purposes of producers and consumers, financial prices are free to rise or fall wherever investors’ aggregate impulses take them,” Prechter and Parker say.

The result is not equilibrium but unceasing dynamism. In other words, this is why share prices are so volatile.

The next big difference between goods markets and financial asset markets is uncertainty about current values. When a consumer (or even a producer) is buying an orange, a washing machine or a haircut, it isn’t hard to decide what it’s worth to you and whether you’re prepared to pay the asking price.

When you invest in a share, however, it’s much harder to know whether the price you’re paying is an attractive one and whether you’re likely to be able sell the share for a good profit at some time in the future. When you buy goods or a service, you only have to decide what it’s worth to you, right now. But when you buy a share, you have to decide what it will be worth to someone else some time in the future.

So there’s far more uncertainty associated with sharemarkets and share prices – contrary to the assumption of conventional economics and its “efficient market hypothesis”.

Our proponents of this “socionomic theory of finance” argue that in making decisions about goods and services, where certainty is the norm, people use conscious reasoning. But in financial markets, where uncertainty is pervasive, people resort to herd behaviour.

Herding is an unconscious, impulsive behaviour developed and maintained through evolution. Its purpose is to increase the chance of survival.

When humans don’t know what to do, they are impelled to act as if others know. Because sometimes others actually do know, herding increases the overall probability of survival.

“Unfortunately, when investors in a modern financial setting look to the herd for guidance, they do not realise that most others in the herd are just as uninformed, ignorant and uncertain as they are,” the authors say.

Buyers in a rising market appear unconsciously to think, “the herd must know where the food is – so run with the herd and you’ll prosper”. Sellers in a falling market appear to think, “the herd must know there’s a lion racing towards us, so run with the herd or you’ll die”.

To the individual investor, straying from the group induces feelings of danger and unease, whereas herding induces feelings of safety and wellbeing.

Because herds are ruled by the majority, trends in financial markets appear to be based on little more than investors’ moods.

These moods, which are generated “endogenously” (that is, by factors within the system, not outside developments) and shared via the herding impulse, motivate changes in overall sharemarket prices.

Moods are the basis on which investors judge the way they expect other investors to value shares in the future, so they motivate current buying and selling. Thus in markets for financial assets there’s no tendency to “revert to the mean” of equilibrium.

There are just the ceaseless waves of social mood, fluctuating between optimism and pessimism.

Ross Gittins is the Sydney Morning Herald’s Economics Editor – http://www.smh.com.au

Mr. Perruna,

I have written about the folly of random market ‘theory’ also. I appreciate this post and I will refer my subscribers here to read your views.

In my view, the unaddressed issue with randomness in markets is that markets function and exist because people differ continuously about any single object/issue, in this case, the price of some security. The soft spot in this theory is people. People do not behave randomly do they. If one does behave randomly, society helps them into a hospital for specialized care.

If people were random, we might walk for a minute, then eat for a minute then begin running, then lay down to sleep for a few mintues, then off to some other nonsense. That people possess the ability to reason does not imply to conclusion that they are objective in everything they do and think.

In my view, people behave based on either of two basic classes of subjective motives. The first is what they do what they want, or they do what they need to do – just basic Maslow isn’t it. In any type of marketplace I have studied (securities, retail, manufacturing, etc.), people do what they want first, if they are confident what they need is secure (such as job, providing food, water and shelter).

I assume that all security market participants are doing or behaving according to what they want because they have the money required to participate. Some are on the correct side of the market some of the time, some are rarely on the right side of a market. The Pareto Principle applies here but potentially a heavier weighting toward a 90% versus 10% ratio when in extreme market conditions.

Indeed, the next two weeks will be difficult for most investors and traders.

Studying this behavior closely for many businesses gave me the edge in quantifying for a business as to what products or services they should concentrate their energy and resources. Years later, we quantified it for the financial markets into a normalized sentiment index to show us extremes of the emotion driven traders and investors. The tops and bottoms showed immediately as you would expect.

Sentiment is one of a few important trading tools that gives disciplined investors and traders an edge. As a trader, I believe it is most important to know when excess fear or excess joy has occurred or is occurring. It is the non-random frame for the painting created by the markets each day.