The return of MEH?

Academic interest in financial markets is ubiquitous these days. The news of mathematicians, physicists and engineers, and other professions going into financial markets are not unusual in our time. But it was not always like this, there was a time when financial markets were seen with disrespect in academia, they were compared to a bargain market in some small village in a third world country, and the players of this market were regarded with the same respect as vegetable dealers in such markets.


To be fair, financial markets have changed substantially in the last century, the scholars of the time were not that far from the reality. Take stock dilution for example, nowadays when people speak of stock dilution they refer to the fact that issuing new shares to the public means that any stake in the company’s ownership is reduced. To put it in simple terms, if you own 20 million shares of a company who has 100 million shares outstanding you control 20% of the equity, however, in the event that the company issues another 100 million shares your interest will be reduced to 10%. However, if the information is public you may act accordingly to protect your interest, either by buying new equity, preventing the new issue or otherwise. However, something that is not on current shareholders mind is: What if the company issues equity that I don’t know of?

This sound a little weird to a modern investor, nowadays we have a centralized deposit that has the information about the ownership of every security. But it used to be different a century ago, to prove the ownership of a share you had a share certificate, and now it becomes relevant the question, what if the company issues certificates that I do not know of? In this setting this was an actual fear. One famous example of this was the USD 7 million (2.3 billion as of today using conservative inflation figures) that railway magnate Cornelius Vanderbilt lost in the 1860s due to stock dilution. Vanderbilt was trying to get control of Erie Railroads and was tricked into buying more and more stock to achieve this without knowing that there was people literally printing stock certificates for him to buy. He spend tons of money, and he never obtain a controlling stake in the company simply because the stock he was buying (at market price) were diluting his own position.


There are many examples like this, in fact, almost all modern stock market regulations have some spectacular story in their past, when there is money in the way people always find a way around the rules. However, things improved substantially over the decades which allowed the advent of modern portfolio theory in the form of Harry Markowitz article: Portfolio Selection (click here for the full article). Markowitz revolutionized the view of the stock market with his probabilistic approach to it. The old theories of investing like the approach of the value approach of Graham & Dodd (click here for Security Analysis one of the main books in this line), were obsolete now, you had to invest in the whole market to achieve the best risk adjusted returns. A decade later, Eugene Fama published his article The Behavior of Stock Market Prices (click here for the full article), crafting the wildly popular Market Efficiency Hypothesis (MEH). In simple terms MEH says that no one can beat the stock market, selecting stocks or any other financial asset traded in a competitive market is pointless since all public information is already incorporated in the price (this refers to the semi strong form of MEH).

Therefore, now it existed a framework for understanding the stock market, what is so great about it? Well, for classical scholars in economics, the answer is: WE FOUND IT!

What did they found? They finally found the frictionless market they have been proposing for centuries. As early as 1776 with the publication of Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations or just The Wealth of Nations (for interest readers click here), political economists have been proposing that free market and laissez faire were the best way of achieving economic welfare with the market being the ultimate resource allocator. And now they had a market in which to test all their theorems, financial markets moved so quickly and erratically that resembled the automatically adapting entities that these classical economist had postulated for decades.

'Adam Smith Institute? Just follow the invisible hand and it'll lead you to where you need to go.'

Hence, it is no wonder that since then, economic theory is kind of governed by a comparison of all other areas to the stock market. Perhaps the biggest example of this behavior is the use of the Capital Asset Pricing Model (CAPM) in Corporate Finance. The main result in the CAPM (linked to MEH) dictates that investors care only about the market risk of an investment, which is translated to its required return. Therefore, investors should price every risk using the price of the stock market risk as a benchmark. This means that the risk of every investment should be treated as if it was a traded asset, even if it’s not the case.

This is not to say that the idea is not appealing, it basically means that when facing an investment decision the investor can always turn back to the stock market, therefore, any other investment should give a better return than that. However, if shows the kind of faith that economist have in the stock markets, in one sentence: The market is always right. But, does it?


There are copious evidences against MEH (for a detailed example click here), they fall into two main categories: behavioral finance biases and “frictions”. Behavioral finance refers to our human nature, we are not perfectly calibrated machines dedicated at processing information for investing. Therefore, our choices when it comes to the stock market might differ from what the rational investor postulated by economists (sometimes the term homo economicus is also used) would do in the same situation. On the other hand, we have the so called “frictions” which is economic jargon for: “evidence that my theory has limitations but I won’t admit it” (to read more on this behavior click here). These frictions include transaction costs, trading barriers and other limits to investing activity that preclude investors from arbitraging price imbalances prevailing in the market.

Therefore, we can update our original statement from The market is always right to: It is really difficult to beat the market. Which explains why we can have financial “rock stars” like George Soros or Warren Buffet in the same market where most newly investors loss money and a typical hedge funds goes bust after three years of operations.


But things might be changing now. On January this year, Barclays sold its market maker position an Ney York Stock Exchange (NYSE) to a high frequency trading firm called GTS, being the last investment bank to do so (click here to read the article on Financial Times). Now the trading floor at NYSE is dominated by high frequency trading firms. These firms implement computerized trading strategies that run so fast than not even the screens can keep up with them, furthermore, they do not succumb to euphoria like human beings, these trading algorithmic trading robots are much closer to the homo economicus than us. It is important to note that this “perfection” of algorithms is in terms of execution, if the strategy implies they have to sell they will sell, no question ask, and this has created fears among old style professionals that algorithmic trading can deepen financial crisis. In fact, they have been blamed for several of them even as early as 1987, in an episode called Black Monday.


We observe that high frequency trading firms are less prone to behavioral finance biases, but what about “frictions”? Well, as we saw most of them are seating currently in the stock exchange meaning that they can react faster than anyone to any perceived (real or not) price imbalance. Additionally, their trading volume makes them by far the biggest clients of the stock exchanges themselves, which explains why the exchanges have granted many of these firms wishes included the infamous phantom orders.


These orders basically delude investors (real or robotic) to think the liquidity profile of a given security or market is materially different than it actually is. The mechanism consists in placing and eliminating price quotes in a speed so high than no one outside the exchange can even trade them, but appear to change the order book that every investors sees (although he could never trade any of these orders). But not only have the high frequency trading firms replaced investment banks in the exchanges, now they have been recipients of one of the biggest cash outflows on record from traditional actively managed funds (for evidence click here, here or here), with the other recipient being passive investing. Retail investors don’t believe in traditional money managers anymore, they are shifting towards high frequency firms where quants do the job, or simply index their money to the market.

If this trend continues at this pace, the actively managed world and the high frequency trading world would be basically the same thing in a couple of years, and unlike hedge funds or mutual funds, high frequency trading firms are closely linked to the exchanges themselves. Furthermore, high frequency trading firms have been repeatedly accused of front running that is, figuring out the trade that some institutional investor is going to make and buy low and sell to him using its ability to place orders at the speed of light. This practice has been labeled as an extra tax or transaction cost into the investors outside the exchanges.

Thus we observe that in this setting, players in the stock market will be either passive investors (as MEH suggest we should all be) or high frequency trading firms which are so close partners with the exchanges that basically are one sole entity to the remaining investors. This is in my opinion, the closest that we can get to MEH actually being true, but does it sound like an appealing future to you?


We have traveled a long way from the days of printing stock certificates in a basement to sell them to some magnate. But we are still humans and some people suggest (although they are in general active managers, they payroll depends on it) that the current environment of low yields make high frequency trading much more appealing than what it might be under “normal” market conditions. Only time will tell if these statements are true or not, yet there are several signs that we might be facing a change of regime right now.

As Quantitative Easing approaches a new era in the US (read article), the OPEC reaches an agreement against all forecasts (read article) and the US are embarking on a new era of policies (read article); we can definitely say that winds of change are blowing. We might be moving to a less open world, both financially and in other more worrying areas, is almost an oxymoron that these conditions might coincide with MEH approaching its asymptotic line to reality. However, it might lead economists to rethink their link between the stock market and the rest of their work, because as the market becomes more “efficient” the rest of the economy might go the other way.


Lucas Buenahora







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