The Efficient-Market Hypothesis states that asset prices reflect all available information. Most real people, as opposed to institutions or insiders (who are legally barred from trading on their information), are “price takers,” meaning that they must trade at prevailing prices, with their transactions being unable to affect the market price. The ordinary person’s buying or selling of an individual stock, mutual fund, or index fund, would not change the price. But if Jeff Bezos were to sell all his holdings of Amazon, that would have a downward effect on the price of the stock. There are endless arguments about whether the Efficient-Market Hypothesis (EMH) is right, including whether some of its variants are better. For nearly all of us, it does not matter.
The case for the public stock market in the United States being an efficient market is very strong. Billions of shares trade daily. Buyers and sellers, indexers, arbitrageurs, speculators and others come together to set the prices of stocks they trade. Often investors have the idea that they can outsmart the market. In the last century much research disproved this idea, but it still persists. On-line brokerage ads make us think we can outmaneuver other traders. It is really a good way to lose money over time.
When new or unexpected information becomes widely known, such as quarterly earnings reports, interest rate changes, guidance changes, this does move a stock, or a whole market, up or down. Sometimes it takes time for the market to adjust to the new information, so there can be wild swings, but it’s not possible to “ride the waves,” either. Outperformance in both cases is no more prevalent than would be predicted by luck. We won’t get into market panics such as crashes in 1929 or 1987 today, but those are examples of such swings.
Every once in a while, a broad re-framing of expectations happens. Recent examples include the surprise attacks of 9/11, or the realization in 2007-8 that the sub-prime lending was not working out the way models projected. These led to the last two significant market declines.
In the last month, Novel Coronavirus (2019-nCov) has become a new epidemic in China. It is spreading rapidly across the People’s Republic and beginning to spread to nearby countries, and around the world. Today, the course of the epidemic is unknown. However, the economic impact of the quarantine in China and now travel limits, will be felt soon. Efficient markets will reprice as new information becomes available.
Here is where there could be a problem: based on its past performance, the Chinese government has been less than transparent about these things. For example, the SARS epidemic of 2002-2003 was virtually unknown until it turned up in Hong Kong. The Chinese had to come clean – and it’s not clear they ever did completely. Nobody knows what will happen this time.
Certainly, the economic effects will be felt across the world, whether or not the disease spreads. China is now “the world’s factory.” Ordinary investors cannot reliably predict the future prices of stocks. This is why we advocate a risk-management approach. At the darkest hour of the last downturn (March 2009) many people sold out and proceeded to wait until 2010 or even 2013 to get back into the market. They missed rebounds of 45% to as much as 95%. Missing just a few up days in a down market can reduce long-term returns significantly; staying uninvested for years can do permanent damage to a portfolio. We’ve had a good run over the last 10 years. It may, or may not, be coming to an end. Regardless, the long-term future still looks bright.
Best funds for Me may not be best funds for Thee