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Efficient What?

Suppose we start with the premise that markets are efficient. That every investor is able to look forward and quickly calculate their expected return and potential risk of their trade, take in all available information, and then place a trade to execute on their beliefs. A belief in a given trade must exist if the investor is to even initiate the trade in the first place. Unfortunately for efficient markets, every belief encompasses the 2 biggest behavioral enemies of all investors: fear and greed. No matter what anyone tells you, completely eliminating both emotions from your investment decisions is impossible. The only way to control the risk of these emotions ruining a trade is by having an investment framework that is based on rules to control your conduct in the market.


The Miller-Modigliani Theorem, co-authored by U of C Nobel Laureate Merton Miller (and Carnegie Mellon great Franco Modigliani), forms the framework of modern thought about how a firm chooses its capital structure. The 5 assumptions of the MM proposition argue that “the total value of the securities issued by a firm is independent of the firm’s choice of capital structure. The firm’s value is determined by its real assets and growth opportunities, not by the types of securities it issues.” The beauty of the MM framework is that at least 1 of the 5 assumptions is always false and by understanding why an assumption doesn’t hold is the key to understanding why a capital structure is behaving as it is. The theory of efficient markets should be viewed in the same context. One or more assumptions is always broken, which should lead to further research into why an assumption doesn’t hold.


The truth is that the market speaks a language of its own and that language can be interpreted to lead an investor to superior investment returns. The academic problem is that interpreting the market requires using the language of the market, which is never black and white and is completely foreign to 99% of market participants. The market always speaks in varying shades of gray which makes its interpretation more of an art than a true science and frustrates the academic who wants to make the market all about cash flows and discount rates.


For example, President of MarketSmith and CNBC contributor, Scott O’Neil, correctly interpreted the language of the market on June 15, 2011 (Is the Bull Market Over?) when he noted that the market appeared to be getting ready to roll over. Notice that Scott did not talk in terms of black and white. Scott talked in terms of the market’s language, which is spoken in shades of gray. There was no way Scott could have known that the debt crisis was going to put the market in a barrel and send it over Niagara Falls in early August 2011. But by correctly listening to what the market was saying, he was able to avoid the 20% plunge that was about to happen a month and a half after he gave the interview.


This brings me to my final point: We cannot impose our will on the market. Doing so only leads to frustration and a pile of losses. Much like the women in our lives, the market is allowed to change its mind whenever it sees fit. Since we cannot control the market, the only thing we can do is to listen what it says and act on its message. If you listen closely enough, the market will always lead you down the profitable path. How’s that for efficiency?

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