Recent news has focused on social media trading platforms aimed at driving up prices on certain “meme stocks”, most notably the contrived “short squeeze” of Gamestop (GME). These activities seem to have no basis in traditional security analysis; indeed the recent volatility in GME appears completely detached from a rational assessment of risk and return. Rather, they bear the hallmarks of pure speculation or even a desire to punish high net worth investors who shorted the stock in expectation that its price would fall.

Some claim the Gamestop episode undermines the notion of market efficiency that underlies our investment approach. The Efficient Market Hypothesis (EMH) after all assumes rational market participants who dispassionately discount information pertaining to risk and future returns.

This claim is likely based on a misunderstanding of the EMH. Fama (1970) asserts that the EMH is simply a statement that prices reflect all available information. This is silent with regard to how investors should use information or how prices should be set. As Marlena Lee explains, “To be testable, EMH needs a companion model: a hypothesis for how markets and investors should behave. This leaves a lot of room for interpretation.”

“Price discovery” in the stock market, the process by which security prices are set, is complex. The investing public is diverse; it encompasses households, professional money managers as well as firms and government investors. On the supply side, securities are offered by firms and governments representing an equally broad spectrum of capital needs. The scope of objectives and methodologies among these market participants is vast.

This diversity defies any simple claim as to how prices should be set, and the EMH is no exception. All that can be certain is that the market is always in equilibrium; for every buyer there is a seller and for every loss there is a gain. To quote Professor Fama “The point is not that markets are efficient. They’re not. It’s just a model.”

Though models are only an approximation of reality, in our estimation EMH is among the most useful models in economics. It is the optimal framework available for informing investors as to how they should pursue their financial objectives. Specifically, wise investors will behave as if the market is efficient, by avoiding speculation, and instead embracing the rules-based allocations and techniques we have long described in these pages.

Also In This Issue

Fed Policy, Price Inflation, and your Portfolio
2021 Contribution Limits: Health Savings Accounts
95 Years of U.S. Stock Market Returns
Free Markets, Sound Money, Property Rights and Investing
The High Yield Dow Strategy
The Dow Jones Industrials Ranked by Yield
Asset Class Investment Vehicles