It’s long been held that “all of the information in the world is embedded into the price of stocks”- it’s the definition of the Efficient Market Hypothesis (EMH). Developed primarily in the 1950’s and 1960’s, EMH called into question the ability to beat the market, while encouraging the holding of the market itself and the subsequent development of index funds. EMH maintains stocks trade at their fair, fundamental value.
While all the information in the world may generally be baked into market pricing, it is difficult for EMH to quantify things like human emotion, market misinformation, investor time horizons, or even those who are just unaware. As such, volatility can increase, even during times when earnings are generally rising.
It is also important to factor the amount of money flowing into investments with mandates, such as many ETFs, passive funds mirroring an index or benchmark, those that restrict turnover, or those committed to a certain equity/bond ratio. According to the Boston Fed, passive funds account for more than 40% of combined mutual fund and ETF assets under management as of March 2020, up from 3% in 1995 and 14% in 2005; this is money that gets invested no matter the news. These investments also create inelastic market traits, which tend to increase the effect of active traders.
The attached Booth report observes, “What we’re suggesting is that a large fraction of the market is restricted by mandates, therefore not necessarily reacting to new information.” Put another way, no new information necessarily affects mandate-restricted investments. The amount of money invested automatically through workplace savings accounts, like 401k plans, has also increased vastly. While good in general, automatic investing is not money affected by the news of the day and tends to create more market inelasticity.
All of this leads to a point in the report that suggests that stock returns are more than twice as volatile as fundamental (read Efficient Market Hypothesis) information implies. Have a read and let me know your thoughts on the research findings and what makes the market tick!
~ Brian Kasal- The Leadership Matrix
Click here- Why Are Financial Markets So Volatile?
P.S.- Did you see my last Leadership Matrix post- The Case of the Incredibly Shrinking Big Oil Industry
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