We can summarize the market efficiency concept with the following epigram: “Prices reflect all available information.”
A market is efficient if all investors know the same information and if the information are relevant to determine the value of a company.
Efficiency Definition
Fama, the same of the previous post, in 1965 defines 3 forms of market efficiency:
- Weak efficiency
- Public information about past prices is reflected in current prices
- Semi strong efficiency:
- Public information about past prices is reflected in current prices
- All relevant and publicly available information is reflected in current price
- Strong efficiency:
- Public information about past prices is reflected in current prices
- All relevant and publicly available information is reflected in current prices
- Private information (held by insiders) is reflected in current prices
In a weak efficient market we can estimate future prices only watching at financial statements or fundamental analysis (we should be all rich in this way 😁). More probably we are in a Semi strong efficient market, because we don’t estimate the prices of stocks only with actual financial statements, but also with public forecasts of future economy trends. In this way only insider traders can achieve a better result than the market and you understand why insider tradings is banned from the market. The strong hypothesis is utopian because also the insiders cannot beat the market.
The downside sudden and single price drop it can happen only in an semi strong efficient market above, because the news modify the value of the stock immediately, as we can see everyday on the market.
Testing for the strong form of market efficiency is very hard to do because private informations are… private!
Financial Crisis
Ok, so we can pass to financial crisis, they are particular and tremendous moments in the stock market.
Recall the definition: Stock prices reflect the value of the expected cash flows (dividends) they should provide.
This leads to two possible origins for financial crisis:
- A shock that affects (expected) future dividends
- An overly optimistic perception of (expected) future dividends (i.e. a “bubble”)
Rising commodities, inflation, recession and scandals are all factors that can undermine the earnings of companies in a sector, economy or nation.
So far so good (🤔), we have new information and therefore the market is discounting the stock prices again. Those who invested first lose money and those who invest later find different companies.
Where is the problem? Well, there are situations where the market believes that some companies will grow forever. They forget rationality and above all the fundamentals are not respected. These are bubbles. It is not difficult to tell if we are in a bubble, but it is difficult to know when it will burst.
Fed Indicator
The Fed Indicator is a good model to practice. The “earnings yield” of a stock market and the long-term government bond yield should be equal: 𝐸/𝑃=𝑌 10
Where:
- E is the aggregate earnings of firms in the equity index
- P is the price level of the equity index
- 𝑌10 is the yield of 10-year Government bonds
The model over-simplifies the reality of equity markets on 3 grounds:
- It assumes that the dividend payout ratio is 100% i.e. all earnings are distributed to shareholders in the form of dividends (we know it is not true)
- It assumes that there is no risk premium for holding equity with respect to long-term government bonds.
- It further assumes that we can directly compare the stream of income from equities, defined in real terms: E/P and the stream of income for bonds, measured in nominal terms: 𝑌10
Despite the simplification, if we see absurd numbers like >50% there is something wrong.
Let’s see an example: the Dotcom bubble
Y10 = 6.7%
E/P = 4.2%
So in this case stocks are overvalued of 6.7/4.2 = ~60%
In 2000, we saw the collapse of overrated tech companies, maybe the Fed indicator he could have helped us.
Okay, but 2000 was a valuation bubble, there are also leverage bubbles. They typically arise from:
- Global macroeconomic imbalances
- Policy errors (typically: monetary policy)
- Lax regulation (2008 crisis)
We leave two graphs below to understand together how developed nations (and especially the United States), despite being the first nations in the world by GDP, have serious problems with debt.
Bonus link: