Market Inefficiency

[ForexGuy]

This is a piece I wrote recently. Thought I would share it here.

Market Inefficiency: The Market is Wrong

What follows is my personal view on market dynamics and principles that govern my own trading. It is written as simply as I can muster, in plain English, in the hopes of explaining my process to traders of all education and experience levels. Nothing that you are about to read is ground breaking. It is simply my attempt to put down in plain words my approach to the market.

It has been rightly stated that the current market price for a given security or commodity represents the collective agreement of all market participants at a given point in time. It is the “most perfect” price as determined by the collective. What has been grossly misinterpreted is that this price is the “correct price” that markets are efficient and therefore represent what should be.

Those of you in the world of finance would recognize this principle as EMH or the Efficient Market Hypothesis. For those of you who have not been blessed with an Ivy League education:

The efficient market hypothesis asserts that stock market prices are the best available estimates of the real value of shares since the market has taken account of all available information on an individual stock.

While it is reasonable to suggest that the market has taken into account all available information, (think about it. Every bank, hedge fund, and investment house has a team of numbers crunchers strait out of Harvard Business School working around the clock deciphering every piece of available market data.) What I believe is unreasonable is the idea that the collective takes that information and applies it in a rational way to the market.

A clear indication of this is violent price swings in and around major news events where market participants attempt to reevaluate their previous assumptions with new information. If markets where truly efficient there would be no opportunity to capitalize on such conditions because the market would rationally move from one price point to another as market participants revalued the price relative to the new information. In the real world markets react emotionally, even violently in some cases allowing participants to take advantage of the volatility.

Traders, markets are emotional because its participants are emotional creatures. So I want to present and idea to you that you may not have considered. It is a contrarian way of looking at the market and I hope it will at the very least allow you to question the status quo and think in new directions.

What if, instead of assuming that markets are efficient and the current market price represents the correct price, we assume that the market is wrong and the current price is incorrect? Since markets move from their current price to some future price, it is only rational to assume that the current market price is incorrect, and that not only will the market move in an attempt to reflect a more perfect price, but in turn that price will also be incorrect.

Now, if you think about it we do this every day. We anticipate the market will do one of three things; go up, go down, or move sideways. We anticipate where the market will go based on fundamental and/or technical analysis.

Fundamentalists look into the future by analyzing a variety of factors in an attempt to determine what a company, commodity or currency will be worth tomorrow relative to today. This approach assumes that the current price is incorrect relative to what it should be worth at some point in the future. Your time horizon will determine how you classify “tomorrow” (one hour, one day, one year etc.) But you assume based on all available market data that the current price is either over or undervalued.

Technical traders work roughly the same way. Looking at a variety of indicators and chart patterns to determine what the markets intention is. This again assumes that the current price is incorrect relative to some point in the future.

It would seem then, that approaching the market from a prospective on inefficiency rather than efficiency would allow a trader to more accurately determine future price action. I would also contend that a more rational approach would be to assume that the market has no idea what the price of a give security or commodity should be, and therefore is in a constant state of reevaluation in an attempt to determine what should be.

The trick then is determining the “more perfect” price. If we assume the market is wrong then in my opinion it becomes much easier to view the market objectively. Not only that, but it also makes it much easier to continually reevaluate our own opinions and assumptions. The desire to be right is a dangerous and costly emotion for traders. The ability to see multiple scenarios allows us to stay objective.

We all remember the Choose Your Own Adventure novels from grade school. You would come to the end of a page and you would be presented with two different paths. One path would take you to page 30, while the other would send you to page 56.

The ability to choose the outcome of the story was a fascinating concept to me. I can remember choosing one path and following it to its conclusion only to go back and see how the story might have turned out if I had chosen differently. I have taken this inquisitive nature to the market and it has served me well.

The only certainty in life is that there is no certainty. By approaching the market from a belief that it is an inefficient emotional ameba we leave ourselves open to see multiple scenarios and outcomes. It is my belief that viewing the market from the assumption that the current price is incorrect we not only increase our objectivity but also our likelihood of seeing the direction price will take in its attempt to become more perfect.

As I said at the beginning, I am not attempting to reinvent the wheel. May of you will find objection too much of what I have presented here. But the concepts I have laid out are ones that I have found to be true in my own trading. I hope you enjoyed my thoughts, however backward they may be.

[carefree]

Good Insight.

[MiiJaySung]

Social justification aside, the actions of the market have been anything but rational in the last year. The disconnect from the real economy and the markets is huge, and ever more drifting.

Also, looking at the equities market, if you look at some larger companies in history that have had exploding stock prices they often come crashiung down at some point and it's often due to insider scandals. (Northern rock, Lehman, Enron etc). It's harder to on a larger scale but this does carry through to the currency markets (i.e. last year when the dollar strengthened due to the deleveraging/sell off). These generate a huge about of noise to the general trend.

Further more instrumnents like derivatives further amplify this, couple this with Clinton's removal of the glass stegal act and the sub prime homes that Clinton also authroised we have a had a perfect recipe for the banks to engineer this crash in the interest of consolidation by the cartel running the game.

[darrell]

great just when I thought I figured it out.:)

[musketeer]

Good insight...!
There is so little things that are necessary... and some insight... and trading become like a so easy thing.

Cheers,
Miro

[dannylohra]

Thanks for this post/article.

The market is never wrong, it is efficient.
We are the ones who create the market and the systems in and around it.

The point is that the role and information distribution is not fair.

Let's keep the market a transparent place.

Happy trading to all :)

[inellgilsta]

"The market is never wrong, it is efficient.
We are the ones who create the market and the systems in and around it."

I totally agree that we are the one who create the market so we are all responsible for all our move.