The Stock Market Might Be Right, Sort Of – Bloomberg

The idea that prices in financial markets reflect all available information — also known as the efficient markets hypothesis — has many variations: Some adherents think the process is immediate and precise, while others think it’s much messier, with prices often missing true value by a significant margin.

New research suggests that the latter version fits the data better — and that the financial mathematician Fischer Black, who posited that prices tend to be off by no more than a factor of two or so, might have been just about right.

This debate isn’t as esoteric as it might seem. If you believe in the hard version of efficient markets, you shouldn’t be concerned that the currently buoyant U.S. stock market is headed for a fall. That risk should already be included in prices, because smart investors enforce efficiency through arbitrage, identifying and profiting from imbalances and thereby wiping them out.

Of course, this purist view is unrealistic. Arbitrage has inherent limits, because traders would need access to an infinite amount of capital to outlast irrational market swings. Investors aren’t as rational as finance theorists often assume. They have biases, such as using past market movements as a guide to the future. Social moods, herding, panic and irrational exuberance all undermine the wisdom of crowds.

So Black’s looser interpretation of market efficiency makes sense. Even so, his “factor of two” was only a guess, based on intuition and experience rather than hard quantitative analysis. Do prices really tend to stay between double and half of true value? Does this differ across markets? And when prices are farther off, how long do they take to come back?

Physicist Jean Philippe Bouchaud, together with colleagues at Capital Fund Management devised a way to get some rough answers. Looking at the prices of stocks, bonds, currencies and commodities going back as far as the year 1800, they analyzed fluctuations around the long-term trend and assessed how well past price movements predicted future movements. Importantly, they did this on many different timescales, from days up to years.

The results show a surprisingly common pattern across markets. Over short periods of time, from days up to a few months, prices demonstrate momentum, meaning that movements up or down predict further movement in the same direction. Over longer periods of time, around two years or so, this pattern vanishes and longer-term reversion dominates: Movements up or down predict reversals to come. This two-year threshold, the authors argue, offers a natural measure of how long it takes the market to correct itself after getting out of balance.

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