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Inefficient Market Hypothesis

By James H. Nolt

Last week we considered how the ubiquitous initial public offering process for raising funds systematically biases underwriters and brokers toward disequilibrium pricing. Another vast arena of disequilibrium pricing is insider speculation. Like IPOs, speculation is virtually ignored in textbook economics. If it is mentioned at all, it is only as outsider speculation, a force competition driving prices toward equilibrium.

Even students of finance suffer from systematic ignorance about the forces of speculation because modern textbook finance theory is largely based on an impossibly unrealistic starting point: the efficient market hypothesis (EMH). EMH is the finance theory analog of the microeconomic assumption of perfect markets. It includes many of the same precepts, such as ignoring private power, but it adds other unrealistic assumptions as well. Once the real power of insider speculation is recognized, EMH is exposed as an element of the Myth of the Market. Financial markets must be more or less inefficient, but efficiency in the EMH sense is impossible in the context of the private power that the financial system itself generates.

Insider speculation includes a variety of investment strategies that combine pricing power with inside information. Fans of financial regulation will immediately protest that insider trading is illegal in the U.S. today (though it has not been in most countries for most of history). Speeding is illegal, too, but it is still the rule rather than the exception because laws are one thing and effective enforcement is another. Even leaving aside this massive caveat, the most important inside information that is never illegal to trade on is knowledge of what you, yourself, are doing and intending to do. If you are a large enough trader to have power to move the market price of a security, then your intent to move it is necessarily insider information that others cannot know, unless you inform them or they have a spy in your organization.

Insider manipulation of securities prices is so common that there is Wall Street slang to refer to it. If the price of a security is being moved by powerful traders, it is said to be “in play.” There are various reasons a security may be in play. One of the most common is simply that some powerful investor or ring of investors has decided to profit from moving its price. Another common reason is that the company that issued the securities is a takeover target. Those wanting to acquire it may wish to lower the value of its securities before the takeover to make it cheaper, then raise prices afterward to increase their profits. Another reason that securities may be in play is to influence the policy of the issuing entity. For example, government-issued bonds may be forced down in value in an effort to pressure the government to change policies unfavorable to the players involved. Influence over prices is often leveraged using borrowed funds, which connects these pricing power issues with debtor-creditor and bull-bear polarization.

Analogous to the perfect market assumption of microeconomics that all buyers and sellers are too small for their own choices to affect the price of a good or service, the EMH assumes that all investors are too small to affect the value of any security they might trade. This is not only unlikely; it is impossible. Any issuer of any security (stock or bond) must be large enough to affect the value of its own securities, at least. Far beyond that, large corporations and rich investors always have the power to put into play nearly any specific security at their whim. If a security is not in play, modern financial theory may be adequate to describe some of the issues involved in securities and derivatives prices, but whenever a security is in play, EMH-based finance theory is hopelessly inept at predicting the result. This is when my strategic method is needed.

During a general financial crisis, such as in 2008, broad swathes of financial instruments come into play, rendering conventional finance theory and textbook economics useless. What matters at such culminating points is the interacting power and strategy of contending bears and bulls.

Inside players may aim to push prices far out of equilibrium, but outsiders, duped perhaps by the EMH, do not recognize them as artificial. This sort of manipulation can be applied to commodity prices, not just financial contracts, so it might directly impact prices outside the financial sector, but for now I will offer financial examples. Just as in military strategy, several factors influence the success of such operations: pricing power, capital reserves, surprise, and deception. If all of these favor the players, quick profits will result. Incidentally, the Greek debt crisis of 2010 has all the hallmarks of such an insider power play, yet few in the media recognize the obvious.

A classic sort of insider speculative operation is called “pump and dump.” An investor or group of investors pick a security that their capital (including any borrowed funds) is sufficient to move. Note that the total value of the security issued is less important than the “float,” that is, the quantity available for sale. Some might be held off the market by the issuer, investment banks, or investors with a long time horizon and thus little interest in selling. A simple pump-and-dump scheme involves buying the security, encouraging others to buy with good “news” or a convincing sales pitch, and then, as the price rises from the new demand, selling the security as it peaks and trapping the unwitting buyers who are too slow to sell as its price collapses from the sales pressure. This can be done even by bit players in obscure markets like so-called “penny stocks,” usually small companies with uncertain prospects and stock prices less than a dollar a share. Big capitalists can play “pump and dump” with the largest securities, commodities, and even government debt.

More sophisticated pump and dump, practiced at least since the 17th century, uses derivatives to profit far more using less capital and with a greater assurance of success.  Start with a target security that has seen little action recently. Since its price is fairly stable, derivatives betting on wide movements of that price will be cheap, since few people expect such movements in the normal course of things. Out-of-the-money call options (a right to buy in the future at a strike price above the current one) sell for maybe a penny on the dollar. In other words, it takes only $10,000 to buy calls on securities with a market value of $1 million at some future price higher than the current one. Once the calls are purchased, then start the traditional pump and dump. When the price reaches a high level above the strike price of your options, exercise them and buy even more. As the price spikes upward, buy out-of-the-money put options cheaply. Put options give you a right to sell at a price below the current inflated bubble price but still above the old “normal” or equilibrium price. Then start selling everything you own. As the price tumbles below the strike price of your put options, you sell the rest at the price you have locked in with these. Bear and bull positions established using derivatives are rarely visible to the public. If your timing is good and nobody is the wiser, profits roll in.

Free market purists might argue that supply and demand still determines the equilibrium price in my example. This is true in a very literal sense, but it is more accurate and certainly more enlightening to contend that the strategic action of the players determines the price, and to call it an “equilibrium” ignores the ongoing strategic action. Part of the demand, that reserved for the future in call options, has committed capital bullishly, but without yet moving the price because it does not yet involve buying the security itself. Future bearish selling pressure is also fossilized in the put options that will drive the future price down further, but this selling pressure has not yet impacted the current or “spot” price. The spot price therefore does not register, as EMH contends, all of the current information about supply and demand, since it does not reflect the strategic intent of insiders. This is why big players can make big money reliably on the margin between what they know about their own strategic intent and what public markets “know” based only on current buying and selling.

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James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.

[Photo courtesy of geralt]

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