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The four sources of inefficiencies.

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Anyone who wants to actively profit from inefficiencies in the market must understand exactly what these result from and who is taking the opposite side in each case. This article provides an overview of the four basic dimensions from which inefficiencies can arise and shows two examples.

In February 2019, Blue Mountain Capital published an interesting overview study by respected analyst Michael J. Mauboussin. 1] It deals with the fundamental issue of market efficiency, possible sources of inefficiencies and the crucial question of who takes the other side of the trades in each position. The latter is an important question that active investors should answer as precisely as possible for their trading strategies in order to truly understand and substantiate their own advantage and the source of the associated excess returns.

Efficiently inefficient

The paper takes as its starting point the often-discussed fact that markets cannot be fully efficient because of the information paradox - since no one would take the trouble (and cost) of pricing in new information if there were no profit opportunities. Therefore, markets are ultimately only "efficiently inefficient". Mauboussin compares them to a machine whose input is information and whose output is the fairest possible price. But like any other machine, markets do not have an efficiency of 100 percent.

However, the mere fact that (temporarily) inefficient prices exist is by no means a guarantee that actual excess returns will be achieved. After all, the corresponding premiums are only actually realized when the mispricing is reduced again. In other words:

To achieve excess returns, both are needed:

firstly, inefficiencies that create trading opportunities
and then efficiency to actually achieve the expected returns through the resulting price adjustment.

This is why it is so difficult to speculate against an inefficient price bubble. Because even if you get it right in the long term, the short to medium-term book losses due to the ongoing positive feedback trading can be immense for the mass of market participants. For fund managers, this means a considerable career risk, which few are prepared to take. At some point, however, the increasingly parallel behaviour of the players in such phases leads to a liquidity bottleneck, at which point the movement can quickly collapse.

For a closer look at how market inefficiencies can manifest themselves, Mauboussin distinguishes the following four categories:

behavioural inefficiencies
analytical inefficiencies
information-based inefficiencies
technical inefficiencies

Behavioural inefficiencies

In certain market phases, collective behavioral effects occur which lead to temporary over- or under-valuation and so to profitable trading opportunities. If, on the other hand, only individual market participants act irrationally, these effects can cancel each other out, so that a fair valuation or efficiency is given. Ultimately, it is therefore a matter of recognising when the phase of diverging opinions in the market (wisdom of crowds) turns into increasingly unidirectional behaviour and hence inefficient prices (madness of crowds). A possible indicator for individual stocks can be positive or negative media reports that indicate an end to strong upward, and conversely, downward movements. The author argues that behaviour-based inefficiencies are likely to be the longest lasting effects, as human nature hardly changes over time. However, they are also difficult to exploit, since it is also a challenge for each individual to act against the masses. For institutional investors, there is also the problem of not being able to underperform over a long period of time without risking their own career.

Analytical inefficiencies

Active investors can identify advantageous opportunities if they have better analytical skills than other market participants, weight information differently or update their assessments more quickly and effectively. Typically, institutional investors have the resources to achieve analytical advantages in the market. An exception may be so-called time arbitrage: These are situations in which the market misinterprets short-term random movements as a long-term signal. Here, investors can position themselves in the opposite direction - for example, in a phase of falling prices as a result of fears of recession, but this does not turn out to be a real signal.

inefficiencies_time arbitrage
Figure 1) Time arbitrage
An opportunity for time arbitrage exists in relation to a coin flip experiment when the market misprices a fair coin in the short term - for example, on the basis of an assumed probability distribution of 70 to 30 after seven tails and three heads (see marker).
Source: Mauboussin, M. J. (2019), Who Is On The Other Side?, You Need Good BAIT to Land a Winner, Blue Mountain Capital Management, p. 16

Another example is a realistic assessment of how a fundamental change in the "story" of a company can have an impact. If a story is perceived sufficiently strongly in the market, this can have a significant impact on the fundamental development, for example through associated reputation effects.

Information-based inefficiencies

Market participants who have legal access to better information have an advantage. In addition, inefficiencies can also be detected by paying more attention to apparent details that are easily overlooked in the flood of information.

Real life example:

On 3 May 1998, the New York Times published an article on its front page about a possible breakthrough in cancer research by administering drugs to stop the blood supply to tumours. The article mentioned the company EntreMed (now CASI Pharmaceuticals), which held the licensing rights for this technology. Within one day, the share price jumped several hundred percent under massive volume. However, it was particularly interesting that both the science journal Nature and the New York Times reported on the core ideas as early as the end of November 1997 (27th and 28th November 1997)! Investors who paid attention to the important but less obvious contributions early on were able to achieve an enormous information advantage. However, since our attention is limited, there is always information that is not adequately taken into account in the pricing.

inefficiencies_news
Figure 2) New old news
Sources: www.tradingview.com; Kolata, G. (1998), Hope in the Lab, A Cautious Awe Greets Drugs That Eradicate Tumors in Mice, New York Times; Huberman, G. / Regev, T. (2001), Contagious Speculation and a Cure for Cancer, A Nonevent that Made Stock Prices Soar, Journal of Finance, Vol. 56, No. 1, pp. 387-396

Another possibility is to anticipate, in a well-founded manner, the expected impact of important information if it is delayed due to its complexity. In principle, the less obvious the expected impact on the profits of the company concerned, the longer it takes the market to price in new information. The opposite effect, which is particularly true for private investors, is the focus on stocks that are currently attracting particular attention - for example, due to an exclusive report on television: Here, prices often rise sharply in the short term, but this rarely proves to be sustainable.

Anyone who wants to actively profit from inefficiencies in the market must understand exactly where these are originating from and who is taking the opposite side in each case.

Technical inefficiencies

These effects occur above all when large players are forced to act. This can happen, for example, if capital flows or regulatory restrictions make it necessary to buy or sell - and a situation arises in which the available capital for risk arbitrage is limited due to the size of the triggering capital flows. A classic example is that insurance companies may only hold investment-grade bonds. The portfolios of different companies therefore look similar. If bonds are downgraded, they must be sold, which can lead to fundamentally unjustified price losses - a technical inefficiency that can be exploited in the short term. It is also possible that individual market segments or even the market as a whole could crash because (overly) optimistic buyers have pushed prices up far with a lot of borrowed capital and then suddenly have to make emergency sales in a stress situation. In this way, prices can fall far below their fair value and it is worth taking the other side of these trades.

Summary

According to Michael Mauboussin, markets are an "efficiently inefficient" machine. Over the course of time, this repeatedly generates short-term inefficiencies, which can be systematically exploited by means of appropriate trading strategies. The decisive factor here is, on the one hand, understanding the source of the respective inefficiency as well as the motivation of the opposite side of the trade why this position is or must be taken.

At the end of the paper, the author summarizes the evidence that fundamentally points to possible inefficiencies. Some of them are:

few analysts for single stocks
complex information
unidirectional investor behaviour
strongly one-sided sentiment (fear or greed)
exaggerated extrapolation of short-term results
Forced purchases or forced sales

Conclusion

Anyone who wants to actively profit from inefficiencies in the market must understand exactly where these are originating from and who is taking the opposite side in each case.

Credits

[1] Mauboussin, M. J. (2019), Who Is On The Other Side?, You Need Good BAIT to Land a Winner, Blue Mountain Capital Management
[2] Kolata, G. (1998), Hope in the Lab, A Cautious Awe Greets Drugs That Eradicate Tumours in Mice, New York Times, 3 May 1998
[3] Huberman, G. / Regev, T. (2001), Contagious Speculation and a Cure for Cancer, A Nonevent that Made Stock Prices Soar, Journal of Finance, Vol. 56, No. 1, pp. 387-396

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