Markets Are Efficient

19 January 2021
Market Insights

Markets are efficient. At least that is what professors of finance have been teaching students in their classrooms for decades. The Efficient Market Hypothesis (EMH) has theoretical roots over 100 years old, but it became mainstream after a 1970 review by world renowned economist, Eugene Fama. EMH is based on the idea that there are thousands and thousands of intelligent, motivated investors participating in the market, who are continuously looking to buy undervalued assets (stocks, bonds ETFs etc.) and sell overvalued assets based on the endless flow of news and information. As a result, the price of financial assets at any one time is accurate and reflective of all available information. Based on this theory, it is essentially impossible to outperform other investors based on an information advantage. Put another way, you cannot “beat the market.” This belief, which is deeply rooted in the investment philosophy of many institutional and retail investors, has led to the explosive growth in index fund investing over the last decade. In 2010, actively managed funds enjoyed an advantage of roughly $3 to every $1 invested in passively managed index funds. However, by late 2019 that advantage had been completely wiped out with more assets under management (AUM) in passive funds for the first time in history.

2020 was unprecedented in many ways. We thought it would be interesting to review a handful of the key financial / market headlines from 2020 from an EMH perspective and weigh-in on the benefits of passive investing in this environment. Here are a few examples that we believe are worth considering:

Tesla (TSLA)

TSLA stock was up 743% in 2020.
As of close of business on January 8th, TSLA stock was valued at $843B.

That is more than Home Depot ($292B), Disney ($342B) & Pepsi ($196B) combined.

Home Depot, Disney and Pepsi made approximately 30x more net income than TSLA in 2020 ($16.7B vs. $556M).

TSLA delivered 499,000 cars in 2020.

Based on TLSA’s market cap of $843B, that equates to $1,600,000 of stock value per car.
Comparatively, General Motors stock value per car sold was roughly $9,750 based on 6.75M cars sold and a market cap of $65.77B.

Does that sound efficient?

Hertz (HTZGQ)

The rental car company’s stock plummeted from a pre-lockdown high of $20.85 in late February to close at a low of $0.82 on June 3rd after declaring chapter 11 bankruptcy.
An army of day traders then rushed in over the next 3 trading days, pushing the price up over 550% to $5.53 on June 8th.

The number of accounts holding Hertz stock tripled on the popular trading app Robinhood over those 3 days.

At the same time, bond investors were less optimistic about the future for Hertz as several of the company’s bonds were trading at less than 50 cents on the dollar.

It is well documented that stock owners will not receive a single cent in a bankruptcy proceeding until bond holders and other lenders are paid 100% of what they are owed.

Hertz management even filed a prospectus to sell upward of $500M of new stock to investors as a result of the stock move.

The prospectus acknowledged in plain English that anyone buying the shares would likely lose 100% of their investment.
Fortunately for the enthusiastic day traders, the SEC shut down the stock offering before it could come to market.

Hertz stock continued to be very volatile since June 8th, experiencing moves of at least 20% in a day (negative or positive) on 11 occasions including a positive 142% move on October 16th and a decline of 60.67% on October 30th.

Does that sound efficient?

Explosive Growth of Special Purpose Acquisition Companies (SPACs)

SPACs are formed through an initial public offering (IPO) of stock for the purpose of raising capital (typically $200 million to $400 million) to acquire another company at some point in the future.
SPACs are known as “blank check companies” because at the time of the IPO, a SPAC is simply a shell company with no operations.

SPACs can exist in this form for upward of 2 years before acquiring a company with actual operations.

SPACs provide a “back-door” for some private companies to go public (become publicly traded) without the same degree of due-diligence and scrutiny that companies would go through with a typical IPO.
While SPACs have been around for decades, funding raised by SPACs in 2020 ballooned to over $80 billion, which is a 6-fold increase from 2019.

SPACs accounted for almost 50% of the total IPO market in 2020, compared to less than 5% in 2014.

Does that sound efficient?

These are just a few examples of the extreme market behavior that we witnessed in 2020. While it is true that the buyer of a traditional index fund today doesn’t need to be concerned with a heavy concentration in Hertz stock or exposure to high priced shell companies, we believe the symptoms of irrationality and speculation are currently pervasive in most financial markets, including broader markets for stocks and bonds. With that said, we do not completely discount the EMH and the belief that markets are generally efficient. Considering the continued development of high-speed computer trading programs and algorithms that instantly adjust to everything from satellite images to tweets, it is clear that markets are as efficient as they’ve ever been in processing new information and incorporating it into the prices of securities. However, the more things change, the more they stay the same. The one critical element of investment markets that is not efficient and has shown the same consistent patterns over hundreds of years is the human element. The extreme examples listed above, and many others that we have seen, would not exist, in our otherwise efficient markets, without the herd-like nature that has always dominated investor behavior. Therefore, we believe that markets ARE efficient, but human emotions are not.

Investment Decisions