PERFECTLY EFFICIENT MARKET HYPOTHESIS
“To be a “master of the Market” you need to look past the immediate effects of major upheavals and fluctuations, and look at their secondary and tertiary effects.” The efficient market hypothesis says, as accepted, that the price of an asset always perfectly reflects the value of that asset. The idea is that all the information about an asset–public and private–gets translated into market activity, which is a kind of revelation of the asset’s real value. It’s an elegant, if contentious, theory, that in some way illustrates the intrinsic value and organic nature of the market. The efficient-market hypothesis was developed by Professor Eugene Farma at the University of Chicago Booth School of Business as an academic concept of study through his published Ph.D. thesis in the early 1960s at the same school.
When Lebron James, arguably one of the best basketball players of all times, became a free agent, his next move was one of high anticipation, and one that was obviously reflected in the world markets. It is an amusing story to hear that when it became rumored that Lebron James was going to sign with the New York Knicks, it drove up the stock price of Madison Square Garden (MSG) (New York Knicks stadium) up by 6.4%.
As we can see above it is a clear example of the Efficient Market Hypothesis.When someone finds out a secret (Lebron is signing with the Knicks), realizes the financial consequences (tens, if not hundreds, of millions more in revenue for MSG), realizes MSG stock is under-valued, and buys a bunch; other people see this and jump on the bandwagon. At some point, the stock price levels off at its true value. As we can see in the graph above the price of MSG skyrocketed. However as Lebron signed for the Miami Heat only 3 days after, again the same principle happened, resulting in a drop in the share price of the New York Knicks Stadium.
However there have been some counter-examples:
Remember Chernobyl? When news broke that the Soviet nuclear reactor had exploded, Alexander called. Only minutes before, confirmation of the disaster had blipped across our Quotron machines, yet Alexander had already bought the equivalent of two supertankers of crude oil. The focus of investor attention was on the New York Stock Exchange, he said. In particular it was on any company involved in nuclear power. The stocks of those companies were plummeting. Never mind that, he said. He had just purchased, on behalf of his clients, oil futures. Instantly in his mind less supply of nuclear power equaled more demand for oil, and he was right. His investors made a large killing. Mine made a small killing. Minutes after I had persuaded a few clients to buy some oil, Alexander called back.
“Buy potatoes,” he said. “Gotta hop.” Then he hung up.
Of course. A cloud of fallout would threaten European food and water supplies, including the potato crop, placing a premium on uncontaminated American substitutes. Perhaps a few folks other than potato farmers think of the price of potatoes in America minutes after the explosion of a nuclear reactor in Russia, but I have never met them.
Yet if Alexander believed in perfectly efficient markets, he would not have bothered, instead figuring that the market had beaten him to it. So almost 50 years after the efficient capital markets hypothesis, it’s still a hypothesis. We don’t really know what drives securities prices. But one thing we do know: the markets are very hard to beat and as John Maynard Keynes once commented, “Markets can remain irrational far longer than you or I can remain solvent.