A new study brings powerful evidence to bear on a very old debate. The debate has been running for half a century or so, and never seems to end because… because… well, to be honest, because one side simply refuses to accept defeat even in the face of mountains of overwhelming evidence. The debate I’m referring to centers on the famous (or infamous) Efficient Markets Hypothesis — which I’ve written about at length too many times to recall — and a very basic question in finance: why do prices in financial markets fluctuate so much?
Two possibilities. If you believe that markets pool information from investors very effectively, and give accurate assessments of the true values of stocks and other assets — the efficient markets religion — then you might think that asset prices fluctuate so much because the true values of assets just bounce up and down quite a lot as the future unfolds and people learn more. Markets work perfectly, and the fluctuations simply show them at work. Alternatively, if you’re not so committed to a prior belief in the wonders of markets, you might think that people and firms buy and sell for all kinds of reasons and often run in speculative herds, behavior which drives prices strongly up or down often for no sound reason at all.
I’m of the opinion that any reasonable person would conclude from a wide range of evidence that the answer is most definitely B — markets are not efficient, and speculative herding drives lots of movements within them. Indeed, there’s strong evidence from surveys that real investors frequently act on the basis of speculative views about how markets are trending, and they expect trends to continue. Ask them about how they trade, and investors say they try to spot trends. Faced with this evidence, efficient markets defenders, mostly from the University of Chicago, go so far as to claim — I’m not making this up — that you can’t believe what people say in surveys!!
Anyway, on the matter of trend following, a new mathematical study shows that one of the strongest predictable patterns in market movements is persistent trends in one direction or another. Investors can exploit these trends by buying assets as they begin to rise in value, or selling as they begin to fall. As the authors of the paper note, this simple strategy in fact forms the core of a huge industry in finance:
“Simple as it may be , this strategy is at the heart of the activity of CTAs (Commodity Trading Advisors ), an industry that now manages (as of Q4, 2013) no less than 325 B$, representing around 16% of the total amount of assets of the hedge fund industry, and accounting for several percent of the daily activity of futures markets.  These numbers are by no means small, and make it hard for efficient market enthusiasts to dismiss this anomaly as economically irrelevant. The strategy is furthermore deployed over a wide range of instruments (indices, bonds, commodities, currencies…) with positive reported performance over long periods, suggesting that the anomaly is to a large extent universal, both across epochs and asset classes. This reveals an extremely persistent, universal bias in the behaviour of investors who appear to hold “extrapolative expectations”…”
What the current study does is document with historical data that these trends have been present for as long as 200 years, which is about as far as it is possible to go with available data. This builds on a number of earlier studies, in particular this one by the hedge fund AQR Capital Management, which looked at the success of trend following strategies over the last century.
Of course, no one should expect this evidence to convince efficient markets purists that markets are not, in fact, efficient. Nothing will do that. But, really, who cares?
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