Does short-selling make a difference?

Short-selling refers to the practice of selling securities like stocks without owning them in the first place. The seller just borrows the stock eg. from a broker to be able sell it, then tries to buy the stock back cheaper in order to give it back and make money out of the process. In so called "naked shorting" the seller doesn't even make that the security can be borrowed. Needless to say, it is a risky process especially considering the potentially limitless losses a short-seller may have to endure. But it can result in significant profits as well.

The thing that makes this a timely topic is the fact that Italy, France, Spain and Belgium set a ban on short-selling two weeks ago to calm the plummeting stock markets . A couple of days ago, they decided to extend the ban for probably at least till the end of September (see Reuters). Were the bans a good decision? An average person usually finds short selling a crazy, speculative and detrimental practice that should be banned not only for a limited period of time but permanently. Many people working in the field of economics on the other hand think that short-selling makes the market work more efficiently and should never be banned. But does short-selling actually make a difference? And if it does, why, how and when? Let's have a look.

An equal selling offer and a buying bid - this should result in a transaction, right?

Starting with the facts, both the people against shorting and supporting shorting can be seen as having legit points. Firstly, like the layman sees it, trying to make money out of falling stocks is not productive for the society in general. On the other hand neither is regular trading. Secondly, like those who support short-selling assert, shorting does support market efficiency. To have a transactions you need someone who is willing to buy and someone who is willing to sell at that price. Anyone can buy shares even if he or she didn't own any, but to be able to sell, you have to own shares of that certain stock. In other words, without short-selling there is much more potential to make a bet that a stock will rise than to bet that a stock will fall.

This partially unilateral nature of a market without the possibility to sell short has a couple of implications. For one, it means that there will be less people willing to sell. This means that the spread between the buying and selling bids increases, which can be seen as making transactions more expensive - in other words the stocks become less liquid. What's more important is that without short-selling, bubbles could easily become bigger, as many of those who would want to bet on falling prices simply wouldn't be able to do so. On the other hand in the case of falling stocks, selling short can make the prices fall unnecessarily deep. Accordingly selling short can make a difference in terms of how stock prices behave. That on the other hand might affect how tempting it is to start trading on the stock market or how the wealth gets redistributed eg. in times of crises.

But does that matter much to the layman who doesn't have a dime invested in the stock market? It might. Stock market doesn't exist in a vacuum, but rather reflects the confidence in economy in general. The bigger the bubble the stock market experiences the bigger the general downfall may be, and the more dramatic effects it may have on the real economy - thus also affecting the life of the layman. In that sense, short-selling can be good for everyone. On the other hand, in a bearish market it might make the overreactions at the lower end more deep and thus cause unnecessary damage to the real economy, which would make short-selling bad in that situation - even though studies haven't found many signs of this.

Short-selling does make a difference for all of us. Especially thinking about overheated markets (like in 2007), I think it's better to always allow short-selling than have it permanently banned. Still, I'm not sure if bans are always a bad idea either. If imposing a ban on short-selling ever makes sense, it should probably be at times when the stock markets are being hit particularly hard - like it now has been.

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The myth of an efficient market, part 3/3: Actual markets

In the previous part I described the preconditions for perfect market efficiency. In principle even with all its shortcomings, a market could get close to perfect efficiency even if none of the preconditions are really met. But has it been like this in the real-life markets? How have the markets acted in every day situations or under special circumstances? How would this manifest itself as a percentage? And will the market of the future be different from the market of today?

Examples from the last decade

Let's have a look at the recent history. Even though it's an extreme example, it's hard not to mention the dot-com bubble. Normally when a company has a 10% possibility of being worth 100 billion in the long run, and 90% possibility of failing miserably and being worth nothing, its value should be about 10 billion. However in the dot-com bubble the value in a case like this was often closer to that best-case scenario. Thus, during the dot-com bubble many companies were overvalued with a percentage of thousands or even tens of thousands. This could be seen not only in the valuations of single stocks but also very strongly on the index level. Less technology-driven indices had much less of a bubble, but for example NASDAQ was overvalued by hundreds of percent.

Then there's the current crisis that started from the U.S. housing market. Before the crisis stock prices rose to ungroundedly high levels, from which they dove to levels so low that they were even less founded on reality. One of the reasons for the gravity of the dip must have partially been in the efficiency factor number 4: external economical factors. Due to these special circumstances also many small investors saw an excellent opportunity buy shares at very low prices.

Moreover, the way this crisis has affected the European economy with all its troubled national economies starting from Greece, is also largely caused by market inefficiency. Had the debt market functioned efficiently, Greece would have had to pay higher interest for its loans many years earlier. But this never happened until it really had to happen. Greece was deceitful when joining the EMU and as a euro country it got cheaper loans than it should have received based on its economy. Since it took much longer to get to the point of rising interest rates, the economical fall is now of course a lot worse.

Everyday situations

In addition to the aforementioned episodic examples there are many more customary situations, where inefficiency is evident. The human restrictions related to time become obvious, when companies announce their quarterly reports. It's not uncommon that the first reaction will be disappointment eg. from too low quarterly earnings, due to which the stock price will plummet, but after the report is analyzed properly, the more essential factors start looking good, and the price will rise. Or the whole thing the other way around. Of course this is extremely short-term deviation, but what makes it interesting is that a quarterly report can set the price course for a significantly longer period of time. The price may slowly change in one direction, even if no new concrete information is brought to attention, and before the next quarterly report is announced, a plummet of 5% may have changed to a rise of 30%. Of course one could argue that the knowledge of absence of news is also knowledge. This is true, but it rarely justifies any significant price changes. All this can be seen as shortcomings in the efficiency preconditions 1-3 and 5.

In addition to these there are other generally recognized phenomena such as the May phenomenon - which can be summarized by the sentence "sell in may and go away", which somewhat applied to this year as well. Stocks with cheap key figures (which are commonly called value stocks) have also usually given better results than "growth stocks". If the markets truly were efficient, this couldn't be true.

Stock prices also more or less constantly vary without any clear reason. Of course given the extremely complex world and web of knowledge around us, this could be justified by new small pieces of knowledge. In practice the situation of the company or the market still shouldn't change significantly by minute.

A special case are stocks that are particularly involatile and may have very large spreads between their sell and buy assignments. Here's a graph of a small cap OMX-H stock that suddenly rocketed 20% on 24.11.2010 from 17 euro to over 21 without any apparent reason. From the perspective of a regular private investor the change was also significant with a worth of over 30 000 euro. After that the spread was also that huge. Next day the price almost plummeted back to its earlier level, which means that the seller did a good deal there. Of course this is just a small stock in a somewhat peripheric market, but still shows an example of how unefficient the market can be.

The percentual efficiency of the market

So what do we get, when we look at all the practical data we have and try to put it into the the formula given in the first part? It's fair to assume that under full efficiency a stock market index should have a quite steady and balanced progress - not a straight line but not that far from it either. Still, also in an efficient market the stocks of individual companies would of course vary more than the entire index. Thinking like this, the efficiency of many stock market indices would have gone down to something like 30-40% during the dot-com bubble. By using some kind of more merciful weighting methods the efficiency could have been a bit more, around 50%, but that's still very inefficient.

The more recent bubble and recession don't seem much more efficient either. Even though the market started to be more aware of all the problems and risks related to the subprime loans, the market still continued its bullish trend for a while. In the end, most major indices, like DAX, NASDAQ and Dow Jones had gone down over 50% percent from their peaks reaching a bottom from which they have afterwards recovered close to 100% in two years reaching almost the level before the crisis! Of course unlike with the dotcom-bubble there are now more real issues instead of just extreme speculation about huge future profits. Still, even as the western economies are still facing severe problems, the course of events is extremely hard to consider as being even close to efficient. From overvaluation the situation progressed to a clear undervaluation, and once again, depending on the weighting method and other factors the efficiency levels might have been just a bit over 50 percent in many markets.

When thinking about efficiency on a more general level, we should of course consider a longer period of time. Between overvaluation and undervaluation there needs to be a moment when the stock market index momentarily "fully reflects all information". When the index is close to this level, the misvaluations of individual stocks take a bigger role in the overall efficiency. The stocks that are most actively bought and sold are usually of course relatively more efficiently priced as well, and when defining overall effectiveness these could actually have a bigger weight in it. Still, even if this would make the stock selection efficiency (in other words the relative price of different stocks, when comparing them with each other) have an efficiency of let's say 90 percent, the overreactions in the turns of economic trends seem so big that this would still make the overall efficiency much lower to about 70 percent.

When you consider Fama's efficiency forms more like layers as I suggested in the definition part, there is the possibility that efficiency on the information layer would in fact be stronger than efficiency on the psychologic-speculative layer. If the market pricing is divided into macro and micro level efficiencies (in other words the efficiency to detect the business cycle correctly and the efficiency to detect the price of a single stock correctly respectively), the psychologic-speculative layer can be considered as taking a bigger role as a cause for inefficiency on the macro level than it does on the micro level. Still, in practice the layers cannot be fully separated: even if the role of psychology and speculation grows, information efficiency always has a significant part in all of it. Nevertheless, if security pricing inefficiency on the macro level is enough to lower the efficiency to a level of 70 percent, one cannot neglect the non-informational causes for inefficiency.

True efficiency or just human efficiency?

It's probably clear by now that I don't find the market particularly efficient. Still, the level of efficiency is largely a matter of how you define "full reflection of all information". For a full reflection just having a large group of people isn't enough: all information will never be fully reflected in all prices. Still, the information could in principle be reflected to the extent that no individual could ever outperform the market. In practice, as long as the investment decisions are done by humans instead of machines, not even this can be possible. The reason for this is that then there would be no motivation to explore investment possibilities, and that in itself would already lower the overall efficiency from this level that would be humanly efficient.

I suppose when people talk about market efficiency, they are in fact talking about this human efficiency, even though in my opinion "the full reflection of all information" would require a lot more. In principle we can distinguish three different levels of efficiency. From the weakest to the strongest they are as follows:

The actual current market efficiency

< Theoretical full human efficiency

< Theoretical real full efficiency

Even the full human efficiency would already require a huge and extremely efficient organization without any personal goals to evaluate the prices of even the smallest of stocks. In addition the efficiency prerequisites 4 and 5 should always apply, since an individual investor can block these factors. If human efficiency would be for example 75% and the actual market efficiency 65% of the theoretical real full efficiency, the actual market efficiency compared to the human efficiency would be 87%. At good times this efficiency could reach even the 95% that was mentioned in the introduction.

Are the markets getting more efficient?

In practice the market is always wrong - it's only a matter of how wrong it is and how easy it is to pinpoint this error. There may be even big efficiency differences between different indices or markets and in somewhat peripheric indices like the Helsinki OMX-H the efficiency is probably lower than in bigger indices. As time passes efficiency might also grow. For example as the awareness of the January and May phenomena has grown, their effect may have become lower - or on the other hand sometimes these can be seen as self-fulfilling prophecies which would actually result in the opposite. What's more important, however, is that internet with all its information, interaction and the ease of trade should create a certain kind of intelligence of the masses. On the other hand as the amount of players on the playground grows, so might the amount of fools and lemming behaviour.

The dynamics of efficiency will probably still experience many changes. Information efficiency will still probably grow at least in terms of information available. However, as the world economy has become more and more connected, there is always a need for even more information and a possibility for more unexpected emotional bursts. Whereas movie critics for example evaluate a static fully finished product, the different parties in the stock market need to evaluate a constantly living, massive and hugely dynamic web of securities. And what's more, these stock market "critics" - investors, analysts and media - all live in interaction with the market, which in turn may cause self-fulfilling speculation and chain reactions.

All "critic parties" influence the market movement not only in the price formation of securities but also in the real economy. Thus, even absurd and originally inefficient psychologic-speculative reactions may through their own influence result in those reactions being partially sound and even expressing efficiency in a way. When you end up in a market that's been hit by a overreaction, even the tiniest straw can then break the back of that psychological camel, and once again the the entire market will turn from bull to bear or vice versa, and all this affects the real economy as well.

In a way, in addition to business cycles, one could define efficiency cycles. When efficiency gets too low, the motivational precondition for efficiency will get higher, and efficiency will grow. And when efficiency gets too high, the motivation gets lost and inefficiency takes over. By evaluating how efficient the market at a given time is, an investor might get clues on how worthwhile it is to investigate various investment possibilities. When efficiency gets low, it's time to strike.

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The myth of an efficient market, part 2/3: Preconditions for efficiency

In the previous part I described how market efficiency has been generally defined, and how it in my opinion should be understood in practice. I also defined an example formula for calculating market efficiency as a percentage. But what would it require in practice to actually achieve perfect efficiency? For each security there should at all times be enough willing buyers and sellers with adequate purchasing power and an exactly correct and adequately strong view about the correct price of the particular security. In principle one party interested in selling and one party interested in buying may suffice. However in order to form that exactly correct view and to actually follow that view to an adequate extent several preconditions should be met.

1. Perfect information

In order for the market to function fully efficiently, there needs to be perfect information. At its narrowest, the public information mentioned in the depiction of Fama's semi-strong efficiency could be understood as including merely the economical figures of the stock. However the future and thus the price of the company can under no circumstances be deducted from just these figures. A company has a specific business branch and a specific position in its field. The clients also have certain economic power and motivation to buy the products or services of the company, and in addition the whole economical atmosphere in general needs to be taken into account. Thus it is clear that proper price formation demands extremely broad information about all these matters.

Since most of this data is actually not strictly numerical, I think there is no point in making any other artificial restrictions to what the needed information actually consists of either. Instead, all information that anyone with an access to the market anywhere around the world possesses, should be included in the price-forming process. Especially in the global market the amount of this kind of information is extremely vast. Part of this information is relatively easily available for anyone. Part of it on the other hand is knowledge that cannot directly be accessed even by company insiders, but which may be accessed by some party interested in investing, who can thus benefit from this information. This kind of information would be the economical or consumer atmosphere in a certain market area, or knowledge about some kind of a potential scientific breakthrough for example.

When information is thought on a large scale like this, also the so-called insider information is just a small summary of sorts or a peek into an ocean of information. In principle it hardly brings any extra information, but in practice it may be a conclusive factor in the humanly restricted decision making.

2. Perfect interpretation

Information in itself does not reflect any price, so also interpretation is needed for price formation. Thus, in order for the market to be fully efficient, the price has to be based on perfect interpretation as well. Just like the perfect information, also the perfect interpretation should be based on the best know-how that can be found in the world. This analysis would of course be an irrationally complicated process, which would include everything from microeconomy to macroeconomy, from predicting changes in the technological as well as the natural environment to predicting changes in the political decision making, population growth and social culture - along with of course assessing alternative investment possibilities and their relative profitability.

3. Sufficient time and motivation for collecting and interpreting the information

According to the efficient-market hypothesis, the efficiency should be there all the time no matter what the circumstances. Thus, when new information comes up, this should be instantly reflected in the price. This would mean that for example changes in currencies or raw materials prices should instantly be reflected to the whole market network through even the most indirect connections. In practice, even the collective intelligence of the world analysing such humongous networks of cause-and-effect might only succeed in a timespan of months or even years - and even then always imperfectly.

In addition to time, those who have the power to affect price formation should have enough motivation to study and analyse all relevant information. There is of course an inherent paradox related to this: there would never be adequate motivation, if the market would already price the security perfectly.

4. No affecting external economical factors

In addition to the abovementioned factors describing informational efficiency, there are also factors which should not disturb efficient price formation. There should under no circumstances be such external economical agents that would influence the core price formation. To elaborate, private investors in the core of the price formation should not have such strong and irrelevant motives that are based on economical pressure (eg. unemployment, disease, divorce) or need (eg. vacation, buying an appartment), or taxational factors, that they would make the price of the security sway from its true value.

The same of course applies to institutional investors, who actually have even stronger potential to shake up the price formation of securities. In a fully efficient market institutional investors would for example never make allocation changes in a way that would include ill-proportioned trades compared to the normal trading volumes of a specific stock. There should also be no asymmetrical bonus systems that give bonuses for extra profit but do not punish for losses to the same extent, since these kinds of moral hazards might cause an emphasis on the more risky securities.

5. No affecting psychological / speculative factors

Since the market basically consists of just people, one significant factor is market psychology, which directly affects the lowest level of efficiency, namely technical analysis or in other words predicting from past prices. This psychology has a few special features. In addition to the fact that people may predict the future of a company emotionally, people also speculate, what the others think about the future of a company. Moreover, people may also speculate, what the others might speculate. In the end some market movements may momentarily be based on mere speculation of speculation: no one believes that the real economy factor behind a movement would be as significant as the market reactions, but enough people believe that others believe in its adequate significance.

Another special feature is that even if a market reaction was not originally based on anything real, the psychology on the market may create a chain reaction that may have consequences in the real economy as well: once trust gets weaker, companies may invest less, which causes the trust to get even lower - and vice versa. As a result there may be strong overreactions in both directions, when fear or greed take over. However, true efficiency should be able to keep these feelings and overreactions at bay.

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The myth of an efficient market, part 1/3 - Definition of efficiency

According to the efficient-market hypothesis the prices of all traded assets always "fully reflect" all information related to them. The most essential direct implication of this is that no one can continuously outperform the market. However, hardly any one suggests that the market would be entirely efficient, although on the other hand utter ineffectiveness would be an even more impossible idea. It is also clear that not all markets or submarkets function with the same degree of effectiveness.

Nevertheless, I'm surprised how strong the belief in market effectiveness appears to be in the economic field. For example according to the view of a Finnish doctor in Science and economics, the market would be 95 per cent efficient (Meklari 1 / 2010 in Finnish). No matter how you define this percentage and regardless of whether you look at the market through the obvious theoretical preconditions of perfect effectiveness or through practical experience in history, I find it very hard to believe in an efficiency of this magnitude.

This is the first part in a three-part series of blog entries. In this part I will have a look at the definition of effectiveness, whereas the latter parts will concentrate on the theoretical preconditions of perfect effectiveness and the level of effectiveness encountered in actual stock markets.

The definition of an efficient market

Eugene Fama is perhaps the most well-known spokesman for market efficiency. In 1970 he defined three forms of efficiency. The weak form only suggests that you cannot predict future prices for a traded asset based on past prices - and thus technical analysis is a futility. According to the semi-strong form all public knowledge is reflected in the price, so there's no point performing fundamental analysis. The strong form asserts that even insider information is fully reflected in the price.

In my opinion it's misleading to even define the weak form as efficiency. In practice, it only tells whether investors groundlessly base their choices on something that others have done earlier. The fact is that the price history of a stock has nothing to do with how sensible or valuable a specific company is right now. Ignoring the historical prices is certainly a part of the efficiency as a whole, but in itself it only measures how common irrational decision making actually is - in other words it's more like a measure of ineffectiveness rather than effectiveness.

The strong form on the other hand is rather absurd to begin with: how could insider information be included in the price if the holders of that information cannot even utilize the information without breaking the law? And if the insider information would be thoroughly reflected in the market, it wouldn't be insider information any more, now would it? Thus it could be stated that the semi-strong form is most open to debate on actual efficiency. However, rather than looking at three different forms of efficiency, I think it is more sensible to think of these three forms as different layers of the overall efficiency - layers which can be evaluated separately from each other. For instance, one practical implication of this is that in principle the efficiency on the "semi-strong / fundamental layer" could actually be higher than the efficiency on the "weak / technical layer". The fundamental and insider layers could also be considered as one single layer of informational efficiency, whereas the weak/technical layer could also be seen as a psychological and speculative layer.

Whether efficiency is viewed as a whole or through its layers, it seems to me that there is a common fallacy in its definition. It is true that as a consequence of perfect efficiency no one could ever outperform the market without good luck. However, since people are deficient, this reasoning doesn't work the other way around. In other words I find it rather peculiar, if someone tries to prove market efficiency by showing how no-one or merely few can actually beat the market. It's peculiar because already those few are a sign of inefficiency. But more than that, it's peculiar, because prices that fully reflect all information can only mean that the price of a traded asset is always truly "right", and that this price would include all possible information about the state of the company and its future prospects in a perfectly interpreted fashion. It's no wonder that not even the most talented investors can fully define this price in order to benefit from it - not even if they would have a limitless amount of time and resources at their disposal.

In the introduction an efficiency percentage was mentioned, so a definition for calculating one is in order. So let's say there is a "correct/true" price for each stock. Let's also think of a stock exchange and assume that we would have the information about the "correct/true price" of all shares. Since we're talking about the efficiency of the market as a whole rather than just the index, every single share needs to be taken into account separately. The preciseness of the price of a stock could be defined directly as a ratio between its "true value" and its market value. In order to get this value between 0 and 100%, this ratio should be calculated comparing the smaller value to the bigger one. The overall efficiency of the market could then be for example a weighted average (eg. based on company market values) of all stocks. As a formula this would look like as follows:

, where E is the Effectiveness as a whole, n is the number of stocks, w the entire market value of a company, and the letters v represent the "true" (t) and market-based (m) values of a single share.

The true value required here is in practice of course not explicitly definable. However, compared to the time when the market value was defined on the stock exchange, it still should be easier years afterwards. In this case there might of course be a tendency to hindsight bias, where this true value was based on something that could never have been predictable earlier. However, there are still many things that can be fairly judged in retrospect as something that could have been predicted, as long as those who were in the market would have just looked close enough and interpreted the information in the right manner.

In my opinion, when one considers a subject as theoretical as market efficiency, it cannot be justified by just assessing the performance of invidual people. Otherwise you could as easily state that no mammal can run 100 km/h, since no man is capable of that; or that a neighbouring galaxy does not exist, since man can't reach that. In other words, even though a person was not able to define the true price of a share let alone do that in adequate time to actually benefit from it, it does not mean that this true price didn't exist. After all, practical markets are only a manifestation of the inefficient decision-making of people who work under economical and even social restrictions, affected by irrational emotions, with limited information, limited time and limited comprehension in terms of actually interpreting the data at hand. Accordingly it is only natural that the stock prices are also defined at least somewhat inefficiently.

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