'Magical' Efficient-Market Theory Rebuked in Era of Passive Investing

An anonymous reader shares a report: At first blush, stock trading this week is hardly a paragon of the market-efficiency theory, an oft-romanticized idea in Economics 101. After all, big equity gauges plunged on Monday, spurred by fears of an AI model released a week earlier, before swiftly rebounding. A fresh academic paper suggests the rise of passive investing may be fueling these kind of fragile market moves.

According to a study to be published in the prestigious American Economic Review, evidence is building that active managers are slow to scoop up stocks en masse when prices move away from their intrinsic worth. Thanks to this lethargic trading behavior and the relentless boom in benchmark-tracking index funds, the impact of each trade on prices gets amplified, explaining how sell orders, like on Monday perhaps, can induce broader equity gyrations. As a result, the financial landscape is proving less dynamic and more volatile in the era of Big Passive, according to authors at the UCLA Anderson School of Management, the Stockholm School of Economics and the University of Minnesota Carlson School of Management.

Passive investing dont move markets that quickly

[BeepBoopBeep]

If you think of passively investing in large ETFs (SPY/QQQ/ or any other large passive investmenting instrument), they dont rebalance on a daily basis to move markets like this. Its the rise of levered plays in derivatives thats likely causing these dramatic but short term swings as the traders book their profits on the swing.

Re:Passive investing dont move markets that quickl

[RobinH]

I think the point was that passive investors don't watch the market relentlessly for good deals. If you had your eye on a stock, and you were very knowledgeable about the industry it's in, the people who run it, and the fundamentals, then you'd have a pretty good idea of what the net present value of all its future income is worth, and you'd be able to move swiftly if the price dropped low enough to make that price a "no-brainer." This is how Warren Buffet, e.g., claims to invest. He and his team do tons of research, and then wait for good deals to come along, and scoop them up quickly when they do, with the intent of just holding them indefinitely. Active fund managers *should* be doing that, but they clearly aren't. And index funds only rebalance periodically so they don't react quickly enough.

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[Samantha Wright]

Perhaps "berkcoin" was already taken.

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[Samantha Wright]

(Amendment: it is [bitquery.io].)

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[Anonymous Coward]

It'd be hard to find almost any stock that has any intrinsic worth even vaguely close to where the current market is. Even low-growth consumer crap like Costco is running at a PE of like 56.

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[ClickOnThis]

It'd be hard to find almost any stock that has any intrinsic worth even vaguely close to where the current market is. Even low-growth consumer crap like Costco is running at a PE of like 56.

Stock prices reflect expected future growth of a business. That's why they are affected so much by news that alters perception of a company's future.

The stock market

[JamesTRexx]

A poker game on which the audience gambles on the bribed players while being whispered advice into their ears by marketers and sammers.

No wonder it stumbles at the slightest disturbance.

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[gweihir]

No wonder it stumbles at the slightest disturbance.

Indeed. Stability does not mix with a combination of hot air and mindless belief.

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[Baron_Yam]

It's not supposed to be like that. It's supposed to be shared risk for shared reward, pooling capital so larger endeavors are possible. There's an inherent gambling risk to a venture of course, but that's it.

All this extra stuff is more layers of gambling that are unnecessary for anything other than giving more opportunities to skim and game the system.

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[martin-boundary]

That's just what the Chicago school academics write that it's supposed to be. Anyone who actually works in that space daily knows it's bullshit.

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[Baron_Yam]

So... you just posted exactly what I did. Why?

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[ClickOnThis]

No, the stock market is not a poker game. There's certainly some risk, but it's not at all the same as gambling.

For one thing, there's only one winner in a hand of poker. Everyone else loses everything they bet on the hand. That's not true for companies in an industry or the people who invest in them. Sure, you can have losses, but you only lose everything if a company goes bankrupt, and if you see even a hint of that coming you can get out early and live to "play" another day.

Second, the stock market grows

"The Market" is crap

[gweihir]

What else is new? But I guess as it has been used as the gospel so long in economics (which barely qualifies as a Science due to the lack of good theory), it takes time for people to come round.

Thank you John Bogle

[OffTheLip]

No related comment, just thanks Jack.

That's not the Efficient Market Theory

[tphb]

EMT does not mean the market is always "rational". It states, roughly, that there is no consistently risk-adjusted _profitable_ way to predict market movements. Within EMT, there are strong forms (never possible) and weak forms (possible with insider information).

But this weeks movements in the stock market in no way disproves market efficiency or the wisdom of passive/index investing. To the contrary, I haven't seen any geniuses pop up saying "I told you last week that this was going to happen, and I made a ton of money shorting NVDA".

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[gardyloo]

But this weeks movements in the stock market in no way disproves market efficiency or the wisdom of passive/index investing. To the contrary, I haven't seen any geniuses pop up saying "I told you last week that this was going to happen, and I made a ton of money shorting NVDA".

That's good. You apparently haven't followed the insanity of Fibonacci trading on, e.g., SeekingAlpha.

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[blue trane]

If prices are just noise as Fischer Black theorized in "Noise", would the EMH hold because no one could predict the noise better than the noise?

Is economic efficiency at odds with common-sense and engineering efficiency, hence planned obsolescence and waste externalization onto nature?

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[MikeBabcock]

Index investing ftw. That's all. Good rant.

Re:That's not the Efficient Market Theory

[XXongo]

To the contrary, I haven't seen any geniuses pop up saying "I told you last week that this was going to happen, and I made a ton of money shorting NVDA".

They will pop up. There are always people popping up saying that they made a ton of money shorting whatever it is.

The ones who bet the other way stay silent, of course.

To paraphrase the Batman

[whitroth]

Stock traders are a superstitious and cowardly lot.

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[retchdog]

Having something to lose will do that to a person. But don't worry, you will own nothing and be happy anyway. :)

Costs to much to watch that closely

[FeelGood314]

I was dating someone who ran a mutual fund with a couple billion in assets. Just keeping up with everything takes over 100 hours of work per week. If a stock or even an entire segment of the market is miss priced by the market it would take tens of hours to convince her that she could take advantage of this. She had a team of analysts so for her to react she needed an analyst to recognize the miss pricing, figure out how long the market might take to correct itself, figure out the risk/reward and then be convinced to take an action. The information to make a decision has a cost in terms of her time and the time of her analysts. As a result her fund will likely miss a miss price or if they do notice it, they will be slow to react. The nimble, smaller players who are concentrating on small segments of the market though might see a price miss match but they are likely to starve to death just watching the market before that opportunity arrives.

PS - never date anyone who measures their free time in hours per month.

Re:Costs to much to watch that closely

[UMichEE]

That sounds like the story that someone running a mutual fund would tell. Statistically, mutual fund managers underperform the index in good years and in bad years, which is kind of crazy given that they're supposedly spending tons of time (and your money) so that they can do better than someone just randomly picking stocks. Nowadays, the only people recommending mutual funds instead of index ETFs are people making a commission on selling you mutual funds.

Inflows to mutual funds fell behind ETFs 10 years ago. Nowadays, mutual funds lose money each year because it's so well documented that actively managed mutual funds underperform much cheaper index funds. Every year, we heard some famous mutual fund manager say, "I know mutual funds have been losers for the past couple decades, but this next decade is going to be different..." Honestly, I'm surprised that there's still so much money in actively managed funds.

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[FeelGood314]

Agreed that index funds are better for investors individually but that doesn't change the facts. Active funds are slow to react and they are the only ones with lots of managed money. Active funds are the ones that will change the stock prices. The index funds only follow price changes.

Algorithms

[alternative_right]

Or the obvious, it's algorithms betting against other algorithms.

quantitative easing?

[prof_robinson]

Surely, the govt directly injecting billions into the market over the last 18yrs was included in these calculations?

More like the market influencers

[hwstar]

are trading in patterns which increase the probability that a large swath of those who are passively invested and panic during downturns will lose their shirt.

These folks make their profit off of market volatility and they're hoping that the passive retail investors panic and sell on the dips.

If there was some way to game the market to " L crash" and cause a significant paper loss say (negative 30-60% and stay that way for 5-10 yesrs) to passive index fund investors and it was in their favor, they'd make i