One of the things that a stock market novice would inevitably encounter in his search for knowledge is the discussion about the “efficient market hypothesis” or EMH.
The EMH which was developed by Professor Eugene Fama of the University of Chicago Graduate School of Business in his Ph.D. thesis in the early 1960’s argues that the financial markets are efficient. It maintains that the prices of stocks reflect all known information and that it is impossible to consistently outperform the market by using the information that the market already knows.
To better understand the EMH which actually has three variations, it would be nice to dive into those books again – which I always recommend. At any rate, the hypotheses basically states that practically every single information that anyone can use in determining the proper valuation of the stocks are already reflected in the prices of the stocks at any given moment.
It is one of those contentious issues that I would have loved to leave to the experts to resolve, except, there is something about this discussion that didn’t really sit well with me.
As our regular readers would know by now, I am not one who pretends to be an expert. And I am not. But anybody who deals with information would know that despite all the available channels of communication (print, broadcast and electronics) information is not something that is readily available to everyone at exactly the same time.
Just look at the major broadcast networks, news wire services and dailies whose people are equipped with the latest communication equipment, all of them still get out-scooped every once and a while. These people are not in the habit of keeping information to themselves. It is in their best interest to disseminate to the public whatever relevant information they have.
Yet, the distribution of information is still lopsided at best – favoring those who are tuned-in to the right source at the right time. Now, consider a situation wherein the people who has the information will benefit more by keeping them close to their chest, even for just a little while…
The people with easy access to material information will always have the advantage. Of course, those information will eventually reach the market and those information will be factored in, and the stock prices will reflect them and the stock market can be considered efficient again, but the lag between the time the knowledge first became available to the time that it is finally reflected into the stock prices could spell the difference between money lost and money gained.
This is one of the reasons why “insider trading” is considered illegal. The regulators do not want the people who have access to material information to have undue advantage over other investors who do not have the same information.
And we have not even talked yet about information limited to people who went over the “Chinese Wall”. We are talking about information that are supposed to be in the open, the ones not being kept under the lid.
“Going over the Chinese Wall” is an aphorism that simply means that one is made privy to a confidential negotiation that may lead to a windfall that could affect the price of certain stocks should the confidential information becomes common knowledge. Normally, the negotiation involves mergers and acquisitions.
Remember how the prices of Yahoo! and Microsoft fluctuated at the time when there were stories about the latter taking over the former? Well, imagine if you are the guy whose ears are practically attached to the lips of the person who knows practically every single positive and negative story that will come out of the “deal” and you have tons of money at your disposal…
If insider trading isn’t illegal (not that it stops even some of the supposedly respectable professionals) I would imagine you would be buying like crazy before the positive story comes out in the open, and you would be selling like mad before a negative story goes out to the public. Now, how efficient can a market be with that?
Let’s get out of the “Chinese Wall” and try that theory in the outside world. Without going into the real facts, let us presume that a terrorist group somewhere has decided to disrupt the supply of oil in some godforsaken area. A big supply line is bombed and millions of liters of the, oh so precious, oil are being lost every minute.
When that story comes out, there will be pandemonium in the oil commodities market. People will be buying like there is no heaven or hell, and the price of oil will go up like it is the only thing we need to buy to live. And then, the following day, when it becomes clear that the bombed portion of that supply line has been repaired in less than a second by “Superman” there will be another pandemonium as the price of oil begins to drop.
Now, how efficient do you think can the financial markets be, if even the most dependable sources of information are so inept they cannot provide the same piece of information to every living soul in this planet at the very same instant?
Of course, not every single living soul is an investor, but do you really think every single market player gets his information just as fast as everyone else?
Nope. From where I sit, blessed will be the Indians whose ears are always tuned to the ground – and pity are those who are always hearing a different sound.
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