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SP500

Efficient Markets?

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The efficient market hypothesis holds that the market prices of securities accurately reflect the fundamental value of those securities.  This implies that if no new fundamental arrives, prices should remain relatively constant.  It turns out this is not true, even in the case of the overall market, let alone for individual stocks.  Research by Summers and Poterba published in the Journal of Portfolio Managment in 1988 and a follow up article by Cornell (yes the Cornell of Cornell Capital) published in the same journal in 2012 looked at the 50 largest moves in the S&P 500 index of periods of 25 years.  Both papers found that the majority of the large moves were not associated with the release of any news related to valuation fundamentals.  That brings us to the current experience.  First, the S&P 500 dropped nearly 20% in close to record time only to be followed by one of the largest one day price increases (in points, not percent) in history.  And then the next day, the index dropped sharply erasing more than half of the previous day’s gain by midday before reversing again and finishing up on the day.  In all of this there has been basically no new fundamental news.  The only possible candidate is a 25 basis point increase in the Fed’s target interest rate, but that hardly qualifies as new news.  To begin, the action the Fed took was largely anticipated.  What’s more it is far from clear why changes in the Fed’s targets for very short-term interest, even if coming as a total surprise to the market, should have much impact on stock prices.  At best the relationship is complicated.  Among other things it depends on why the Fed is changing its target.  (For a detailed discussion of this issue see Damodaran.)

So why has the market been moving up and down so much?  The honest answer is we don’t know.  Markets can move dramatically on the basis of scant fundamental news leaving financial economists scratching their heads.  But in this regard, we financial economists have one step up on the financial media in that we know what we don’t know.  Whenever there is a sharp move in the market, the media feels the need to explain it somehow.  When there has not been the release of any fundamental news, those explanations are little more than speculation, often based on unverifiable guesss about market “psychology.”  It is best to pay them no mind.