Last Updated on June 19, 2022 by Quantified Trading
Is it possible to find market inefficiencies when trading or investing? Yes, it’s possible to find inefficiencies in the markets. However, if you want to consistently make money in the stock markets, you need to understand how the markets work. Are you the prey or the predator? Are you street smart or academic smart?
Inefficiencies are rare and require backtesting, knowledge, and labor-intensive work. In this article, we discuss what market inefficiency is, how you exploit inefficiencies, and we discuss which markets are most efficient and inefficient. We end the article by suggesting how you go about looking for inefficiencies.
What are the three forms of market efficiency?
The efficient-market theory asserts that there is no way to gain superior performance (that is, extra returns) for a given level of risk. Unfortunately, according to academics, the only way to gain an extra return is to take on more risk.
There are three forms of market inefficiency:
The weak form states that all prices have discounted past data and thus technical analysis is futile. However, fundamental analysis works under a weak form of efficiency.
The semi-strong form states that all public information is reflected in the prices, and thus both technical and fundamental analysis is a waste of time and will not work.
The strong form goes one step further and includes not only public information, but also non-public information. Thus, there is no way anyone can get an edge, not even insiders.
With a strong form of efficiency, no one can get abnormal returns.
Paul Samuelson, the winner of the Nobel Prize in economics, explains market efficiency much better than we do in this paragraph:
If intelligent people are consistently shopping around for good value, selling those stocks they think will turn out to be overvalued and buying those they expect are now undervalued, the result of this action by intelligent investor will be to have existing stock prices already have discounted in them an allowance for their future prospects. Hence, to the passive investor, who does not himself search out for under- and overvalued situations, there will be presented a pattern of stock prices that makes one stock about as good or bad a buy as another. To that passive investor, chance alone would be as good a method of selection as anything else…..
Is the efficient market hypothesis true? Are capital markets efficient?
Let’s start by quoting the greatest investor of all time, Warren Buffett:
I’m convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors have successfully exploited gaps between price and value. When the price of a stock can be influenced by a “herd” on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical………I think it’s fascinating how the ruling orthodoxy can cause a lot of people to think the earth is flat. Investing in a market where people believe in efficiency is like playing bridge with someone who’s been told it doesn’t do any good to look at the cards.
Warren Buffett wrote those words some decades back in an article about his friends from the 1960s and 70s (The Graham Group – renamed after Benjamin Graham).
As a matter of fact, he was so offended by the academics that he kept them on a dartboard on the wall. He and Munger saw these academics as holders of witch doctorates. Their theories offended Buffett’s reverence for rationality and for the profession of teaching.
Buffett is, of course, partly right. As far as we can see, there are opportunities to reap abnormal rewards, but they are not abundant, to say the least. Another proof that it can be done is Jim Simons’ Medallion Fund:
Unfortunately, these are the exceptions. Based on an index the returns are like a zero-sum game. Some win, some lose, but in aggregate, all can’t be winners.
Why are markets inefficient?
The main assumption behind the market efficiency theory is that market players are rational. This is, of course, a useless assumption. Individual investors are prone to do behavioral mistakes over and over, while the market as a whole most likely deviates from intrinsic value for long periods of time.
A market inefficiency example?
Finding an edge is not that difficult, but the problem is that most of them don’t last for a very long time. Some work for years, while others last for a short while – but long enough to drive in “suckers” so the edge stops working.
The best inefficiencies are structural: how the markets operate:
Let’s give you one example: the specialist system on the New York Stock Exchange was such a system that made you have an edge. For example, at the opening, you could put opening only orders over and above the theoretical opening price (calculated by some simple inputs). By using the law of big numbers you had a true edge for many decades (not anymore). Similar structural inefficiencies still exist. We used this method for many years, something we covered in our trading lessons and how I made money day trading.
How do you exploit market inefficiencies? How do you identify market inefficiencies?
We believe some markets are offering better odds of succeeding than others.
Which market(s) is best for traders? That is the stock market.
Why do we believe the stock market offers the best opportunities?
The main reason is the annual tailwind in the form of inflation and increased earnings. Moreover, the stock market is huge and offers thousands of stocks to choose from.
The stock market offers a second advantage: durability. Stock market strategies are more likely to last than in other markets. We generalize, but a strategy in stocks tends to last much longer than in, for example, gasoline or forex.
Why is the stock market more “durable”? Because it has fewer random factors influencing the prices and you are less likely to compete against other traders.
Which markets are most efficient? Which markets are worst for traders?
There is one market we almost stay away from completely: the forex market. Good luck if you dream of striking it rich in forex!
There are millions of people just competing on the EUR/USD spread alone. What do you bring to the party that sets you apart in such a huge market? What do you see that others don’t?
Likewise, commodities are also difficult. There is no problem finding edges based on the past, but the problem is durability (or the lack of it). In these markets, we believe the separation of academic smart and street smart shines through. Commodities are much more prone to erratic and sudden moves than, for example, stocks.
Ways to find and identify market inefficiencies and edges in the markets
Below are a few examples of inefficiencies:
A good start to find market edges is by reading, but you risk ending up “book smart”. In trading, you need to be street smart – you need knowledge, adaptability, and an understanding of how the markets work. No reading will ever make you street smart. Street smarts beat book smarts!
Michael Mauboussin has just released his latest paper titled Who Is On The Other Side?. In the paper, Mauboussin describes a number of inefficiencies that exist in the market, driven mainly by the optimism or pessimism of human beings. Included in the paper is Mauboussin’s checklist for identifying 15 market inefficiencies. Some of them are these:
Exploiting fear and greed:
Sentiment indicators have over many decades proven to be reliable contrarian indicators and work well as trading strategies, like for example the VIX:
The same goes for the put/call ratio, another well-known sentiment indicator.
Why do sentiment indicators work? Most likely because greed and fear are next to impossible to contain and are unlikely to be “arbed” away. We would say this is the “low hanging” fruit in the markets.
When sentiment indicators suggest extreme readings, you better pay attention.
Likewise, we believe seasonal trading strategies still work pretty well. There are often good reasons for these to last many decades. Examples of such strategies are the turn of the month strategy, turnaround Tuesday, and the Santa Claus rally.
Fragility in the markets:
An example of this is the short interest. We guess everyone remembers what happened to Gamestop (GME) in the winter of 2021? This is fragility. Short sellers are fragile because they have to buy back and return the shares to the rightful owners. And as a short seller, you face theoretically unlimited risk:
You can only gain 100% return, and this is often unlikely to happen, while you can lose 500%. The short sellers in Gamestop faced the risk of ruin when the stock went from 10 to 300.
Speculators started buying stocks with high short interest and subsequently, short-sellers were forced to buy back their positions. The result was a vicious cycle of crazy moves in many stocks.
You can do time arbitrage. For example, some long-term buyers and sellers are willing to dispose of their shares or contracts by increasing or lowering their prices. You can act as a market maker:
Take the other side of order flows – act as a market maker:
Forced selling and buying happen frequently. You can act as a market maker.
Do you possess an excellent analytical mindset?
Are you adaptable and pragmatic? Or do you bury yourself in details and theoretical simulations?
Unfortunately, many traders go for complex strategies, while many simple and easy strategies have existed for years, like for example mean-reversion and trend following in the stock market.
Street smart vs. academic smart:
Some traders like to “show-off” very complicated models using for example Monte Carlo simulations. However, the distinction between what we call academic smart and street smart is huge.
A street smart trader is pragmatic and spots opportunities when an academic smart buries himself in complicated models. Likewise, a street smart trader spots when a strategy is bound to fail even though the backtest shows superior returns.
Likewise, models make you underestimate risk. The biggest risk is always the unknown – no model can ever capture that.
Conclusion: Is it possible to find inefficiencies in the markets?
The markets are probably to a certain degree efficient, but we believe you can make good and consistent returns by using the right approach – which is to use empirical and quantified data for short-term strategies and by using common sense. Moreover, we believe the best place to start is in the stock market.
The markets are somewhat inefficient because of human folly. This is unlikely to change, which is good for the rational trader and investor. So the correct answer about inefficiencies is this: Yes, it’s possible to find inefficiencies in the markets.