When teaching efficient markets I like to have fun speculating about the limits of the theory. The third edition of my casebook (Ribstein & Letsou, Business Associations), had a New Yorker cartoon which showed executives looking out their high-rise window at attacking flying saucers and remarking: “Drat! I suppose the market has already discounted this, too.”
I have also used (see Ribstein & Letsou, 4th edition, at 250-51) the following example from Michael Lewis’s Liar’s Poker about a securities analyst he called “Alexander.” Lewis says that right after Chernobyl exploded Alexander called him and told him to buy oil futures:
Minutes after I had persuaded a few clients to buy some oil, Alexander called back. “Buy potatoes,” he said. “Gotta hop.” Then he hung up. Of course, a cloud of fallout would threaten European food and water supplies, including the potato crop, placing a premium on uncontaminated American substitutes. Perhaps a few folks other than potato farmers think of the price of potatoes in America minutes after the explosion of a nuclear reactor in Russia, but I have never met them.
The casebook continues:
Yet if Alexander believed in perfectly efficient markets, he would not have bothered, instead figuring that the market had beaten him to it.
Yesterday’s WSJ provides more recent illustrations from the lives of “macro” traders John Brynjolfsson and Samer Nsouli. The article suggests that things are more complicated than Lewis suggested:
The nuclear accident in Japan suggested to some traders that the prices of oil, natural gas and coal would rise, as Japan and other nations move away from nuclear power, putting new pressure on already stretched energy markets. Some investors have bid up these investments. Other traders countered that the falloff in demand in Japan is quite small, or that the events there would cause a slowdown in overall economic activity, something that should hurt oil prices.* * *Mr. Brynjolfsson has taken to peppering questions at his 84-old father, Ari, who spent 40 years as a nuclear scientist, asking about the potential impact of Japan’s nuclear crisis.
The elder Brynjolfsson “wasn’t panicked”:
“We’re overdoing it,” Mr. Brynjolfsson concluded to a colleague, saying his fund should consider buying uranium. Mr. Brynjolfsson also was tempted to buy Japanese shares. But he worried that even if he didn’t think the nuclear threat was great, others might.
But then again:
“If 90% of experts say don’t buy Toyota it doesn’t matter if they never find radiation on car seats,” he says.
And the traders also need to worry about the yen and Bahrain. Nsouli, who is from Lebanon and has been monitoring Al Jazeera and talking to his cousin in Bahrain, says “there’s a 20% chance that Iran enters the situation, something that could bring the U.S. into military conflict with the nation. Such a scenario would send oil prices surging, he says. So Mr. Nsouli has been buying up oil contracts * * *”
But of course the market might already have discounted that, or it might fail to discount the risk even if it exists until after Nsouli can no longer hold his bet.
So almost 50 years after the efficient capital markets hypothesis, it’s still a hypothesis. We don’t really know what drives securities prices. But one thing we do know: the markets are very hard to beat.