Where did the idea of efficient markets come from?
Photo: Gerd Altmann. Source: Pixabay.
One of my first jobs in finance was as a bond-market trader for a regional bank. I would buy and sell Treasury bonds, futures, and options all day. My job was to stare at a screen and figure out what the market’s next move would be.
Some people might find this boring. I found it incredibly exciting.
I would call Wall Street or Chicago and talk to other traders, strategists, economists and we would swap stories about our families, our views of the economy, our experience with the markets. I knew that my compatriots were making up at least half of what they told me. I returned the favor. And over time, I got a sense of how the market was pricing risk, return, and the future. It was pretty cool.
One day, everyone was worried about inflation. We were looking at oil prices, and this was the late ‘80s. Oil had just started to climb out of a multi-year low, and everyone worried that it might get into the broad inflation numbers. Financial futures opened lower, and began to drift down. I wondered if I should get “short” the bond market, betting on an inflationary push for higher bond yields.
Then, a funny thing happened.
Grain futures in Chicago opened “limit-down.” Prices on Corn, Oats, Wheat, and especially Soybeans were at the lowest level that they could trade for that day. Folks had been concerned about how drought conditions in the Midwest might affect the harvest and the supply of these staples. Soybeans were especially important; they’re a feedstock for animals and all kinds of manufacturing.
“Get long treasury futures,” I shouted at my trading friends. “It’s raining in Chicago. They’re selling the bean and buying the bonds!”
Photo: Max Bender. Source: Unsplash
At the time, there were no worldwide weather reports, “The Weather Channel” hadn’t even been invented. The best way to find out about weather in the Midwest was to call some friends out there and ask them to look out the window.
We can believe in efficient markets and not believe that the market is always right. Markets incorporate the information they have. They just don’t always have all the information they need all the time.
Eventually, though, they get there.
Efficient markets mean the market never has to be sorry about the prices it prints. It’s not that every price is exactly right all the time. (That would be ridiculous.) It’s that millions of market participants are constantly balancing and weighing the best information they have at the time. That means when it’s raining in Chicago, it may be sunny for the Treasury market. And as many have learned over the years, it can be pretty hard to outrun the sun – or the market’s information.