Never Mind Market Efficiency: Are the Markets Sensible?

So Much for Efficiency

I began this article with the goal of addressing an academic notion, the efficient-market hypothesis, or EMH. My research dissuaded me. In one University of Chicago article, a faculty member questions the EMH by citing Black Monday, 1987, when global equities dropped 20%-plus for no apparent reason. Yet elsewhere on that institution’s website, another professor states that attempting to refute the EHM by bringing up stock market “runs and crashes” reveals “simple ignorance.”

Time to retreat. If the birthplace of the efficient-market hypothesis cannot define the issue consistently, there’s no hope for me. Thus, I will reframe the discussion. Never mind the E word. Let’s discuss instead if the investment markets are sensible. (Once again, I had intended a different word, and once again I withdrew from the field after reading a Stanford professor’s complaint that “Rationality is one of the most overused words in economics.” Sigh.) Although “sensible” does have several scientific meanings, none to my knowledge occurs within investment research.

The Sensibility Standard

The first definition of the Cambridge Dictionary serves our purpose. The adjective “sensible” describes a decision that is “based upon or acting on good judgment or practical ideas or understanding.” We may therefore call an investment sensible if it is priced by sound collective judgment. Some of its buyers and sellers will be loopy. That is immaterial. The issue is whether the group decision is defensible.

That is not a difficult standard, as the consensus need not be correct, or even remotely close to being so. It merely needs to arrive at a valuation that can be justified, given the information that was then available. For example, buying the stocks of companies that soon declare bankruptcy, as with Kodak or Neiman Marcus, doesn’t violate the precept of sensibility. It would if investors knew for certain that the event would occur, but they do not. Sometimes, wonders occur.

For example, Apple AAPL shares sold at a split-adjusted $0.10 in July 1997 because the marketplace widely expected the company to enter Chapter 11. Suddenly, co-founder Steve Jobs returned to the organization and staved off the seemingly inevitable by arranging a shock $150 million investment from rival Microsoft MSFT. Apple’s stock gained 1,100% over the next two and a half years.

A similar principle applies to marketplaces, as opposed to individual securities. It’s easy to claim now that the breathtakingly high valuations accorded to Japanese equities in December 1989, or US technology stocks in February 2000, were manically foolish. Investment tulips! But people made similar arguments about the FAANG stocks a decade ago while being indisputably wrong. As with recessions, bubbles are more often proclaimed than realized.

Exception 1: Treasury Bonds

All that said, sometimes the financial markets do cross the sensibility line. One recent instance involved 30-year Treasury bonds, which briefly in March 2020 yielded less than 1%. As I wrote at the time, no matter what one’s economic forecast, the bond’s prospective gain was too low for a 30-year commitment. That yield could not be defended. Stocks may permit investment miracles, but government bonds do not. Their returns are fully specified in advance.

This is where the distinction between efficiency and sensibility proves useful. Enterprising academics will have no problem arguing that those Treasury bond prices were efficient. Central banks hold Treasury debt; investors with long-term liabilities immunize them with similarly long-term assets; and those who run strategic portfolios prefer to hold the same positions, regardless of their costs. One can tell stories why a 0.99% yield was an “efficient” payout.

Fair enough. But for typical investors, those prices were nevertheless insensible. Aside from sheer speculation—the possibility of fools selling to even greater fools—Treasury bonds accomplished nothing that Treasury bills could not do better. Both securities protected against the stock market’s slide. Unlike Treasury bonds, though, bills did not carry the threat of steep capital losses, should US interest rates follow the very likely path of rebounding from their 200-year lows.

Exception 2: Destiny Tech100

An even more recent example is a publicly traded fund called Destiny Tech100 DXYZ, which owns 23 positions in privately held technology firms. Conventional mutual funds buy and sell their shares at net asset value, which would make DXYZ’s shares worth $5.00, give or take, as the fund launched on March 26, 2024, with a NAV of $4.84. Closed-end funds, however, cost what the market will bear. Which, in the case of DXYZ, has been a weight that Hercules would struggle to shoulder.

That openly fails the sensibility test. Some amount of investment premium may occur because retail investors cannot otherwise own the fund’s businesses. A 2,000% markup, however, cannot be countenanced, nor can the fund’s extreme volatility. After all, DXYZ’s price dropped from $99 to $29 in 6 days, despite a lack of relevant news. Call that behavior efficient or call it not. Either way, it’s absurd.

Exception 3: Carveouts

A third situation concerns stock “carveouts.” Company A has sold a small public stake in one of its subsidiaries, which I imaginatively will call Company B. Company A now announces that it will spin off the rest of its Company B stake. In response, the publicly traded shares of Company B rally so aggressively that the imputed value of Company B stock that Company A still retains—the divestiture having not yet occurred—exceeds the stock market capitalization of Company A.

In other words, Company A now possesses a negative value. Somehow, through its additional sale, Company A has simultaneously boosted the value of Company B while making its own net worth less than zero. If that seems peculiar, that’s because it is. However, such events have occurred on several occasions, some of which are chronicled in this paper. (Sure enough, a subsequent article argued that such events do not contradict the efficient-market hypothesis.)

Where’s the Money?

By now, you may have guessed the catch: These examples offer no profit opportunity for investors establishing long positions. Violations of the sensibility test typically occur with securities that are overpriced, as opposed to those that are open and obvious bargains. They are potential short sales, not long positions. And selling short is perilous because what is already expensive can easily become even more expensive. (For proof, ask those who have shorted Trump Media & Technology Group’s DJT stock, only to watch its price rise 130% in one month.)

The authors of the previously mentioned carveout paper, Owen Lamont and Richard Thaler, explain the situation: “If irrational investors are unwilling to buy [securities] at an unrealistically high price, and rational but risk-averse investors are unwilling or unable to sell enough shares short,” then prices can become distorted. The skeptics are twice sensible—first in recognizing that the security in question costs too much, and second in avoiding the hazard of shorting too aggressively. Twice sensible, however, does not square the market.

This explanation of investment behavior is also consistent with the performance of active portfolio managers. They are well-trained, informed, and disciplined. They can see where danger lies. Unfortunately for their funds’ returns, their acumen provides scant benefit. They may know enough to recognize the markets’ trouble spots, but for the most part, they cannot gain from that knowledge.

Postscript

Despite my frustration with how the term “efficient markets” is used, I recommend this 1991 review of the concept from Eugene Fama, wherein he discusses the literature that initially followed his research. Naturally, Dr. Fama favors accounts that preserve the notion of market efficiency to ones that admit anomalies. That said, he gives his critics their due while clearly explaining their arguments.

Post Postscript

As I file this article for publication, I see that GameStop GME stock is up 80% on the day, on the hope that Keith Gill, who touted the company online in 2020, will be returning to social media. Not only is that news unrelated to the company’s business, but it’s not really even news, since the signal consists of an uncaptioned picture on Gill’s social-media site.

Oh, and AMC Entertainment AMC has also gained 60% on the day because AMC is another dinosaur business that is owned by some of the same investors who hold GameStop, so if there’s a rumor about a web-related sighting for GameStop, that naturally should lead to AMC being worth substantially more.

Is that behavior consistent with the markets being informationally efficient? Indeed it is. Almost instantly after the picture was posted those stocks rallied. Is that behavior consistent with sanity? Not so much.