Supreme Court Has Some Theories on Market Efficiency

This is my second "people discuss whether EMH is true" post this week. In the first one, the people were hedge fund managers. In this one, they're lawyers. So ...
At least Halliburton is a sympathetic defendant. Photographer: Simon Dawson/Bloomberg

The lawsuit argued in front of the Supreme Court today, Halliburton v. Erica P. John Fund, is about whether the Supreme Court should allow stock-drop securities class action lawsuits, or whether it shouldn't. If you spend a lot of time thinking about stock-drop securities class action lawsuits -- say because you are a lawyer at a big law firm -- then you probably think this is the most important Supreme Court case in years and you already know all about it.

If you don't spend a lot of time thinking about securities class action lawsuits, there are people who will endeavor to convince you that this case is worth your time anyway, but they are braver than I am. Here is a good effort that I can mostly endorse. 1 Anyway, right now those lawsuits are mostly allowed, under a 1988 case called Basic v. Levinson, and the smart money seems to think that they'll still be mostly allowed after Halliburton is decided, though maybe with some more limits.

But while Halliburton is really about whether stock-drop securities class actions should be allowed, it is technically about something else. It is about ... whether markets are efficient? That can't be right.

Ugh, but it is, sort of. The basic rule of securities fraud is that if a company is cooking its books and sells you some shares, say in its IPO, and then later the book-cooking is revealed and the shares are worth less than you paid, you can sue the company for fraud: It has deceived you about its financial condition and thereby tricked you into overpaying for your shares.

Similarly, though more oddly, if a company is cooking its books and you buy shares in the open market from a third party, relying on those cooked books, and then later the book-cooking is revealed and the shares are worth less than you paid, you can sue the company for fraud: It has deceived you about its financial condition and thereby tricked you into overpaying for your shares, even though you didn't pay the company for those shares.

The problem is that it's hard to prove that you relied on cooked books. I mean, really, you never looked at the financial statements. And even if you did, you can't prove that thousands of other investors did too. So it's tough to get a class action together. And if you can't get a class action together, it's hard to get a lawyer to care.

But, you say -- or the people in Basic v. Levinson, lo these 26 years ago, said -- come on, that's not how it works. Most people don't buy a stock because they've read all the financials and relied on each line of them. People buy a stock because they think that other people will think that other people will think that other people will think that other people will want to buy that stock. But that doesn't mean the financials don't matter. Somebody does the financial analysis. And everyone else just relies on that guy: All that beauty-contest-ing rests, ultimately, on some view of the present value of future cash flows.

The proof of this is self-evident: When financial fraud is disclosed, the stock goes down. That's why they're called stock-drop cases: If the stock doesn't go down, you have no losses, so you don't sue.

This concept is called "fraud on the market": The idea is that some people rely on the company's financial statements to "set" the market price, and most people just rely on the market price being right, so everyone in effect relies on the company's financial statements, though sometimes at one or two removes. So if those statements are wrong, everyone has relied on them, and everyone can sue.

This strikes me as obviously correct as a description of the world. You don't have to like stock-drop class actions -- I don't! -- to think, well, yes, if a company is hiding accounting fraud, that will tend to prop up its stock price, and if it discloses that fraud, that will tend to make its stock price go down.

Lawyers are easily confused, though, and somehow this "fraud on the market" theory of Basic v. Levinsonhas gotten wrapped up in the question of "is the efficient markets hypothesis correct?" Here you can read the Supreme Court arguments over whether the efficient markets hypothesis is correct, and let's just say that they're not as sophisticated as Cliff Asness's arguments. The questions that finance people worry about are, how rationally do financial markets incorporate all past information? What is the proper pricing model to use in testing market efficiency? How many exploitable anomalies are there, and do those apparent anomalies represent compensation for poorly understood risks or rather truly irrational pricing? Are there predictable behavioral patterns that cause stock price moves, or is everything explainable as incorporation of information?

The question the Supreme Court is concerned with is, when companies disclose massive accounting frauds, do their stocks go down? These are not unrelated questions, but come on. The latter is much easier than the former. Yes! Disclosing massive accounting fraud hurts your stock! We've solved the problem!

But you can try to un-solve it if you want. Here is Halliburton's poor confused lawyer:

[T]he economics have changed. The economic premises of Basic, in particular, the premise that investors rely in common on the integrity of the market price. The government and the fund do not even contend, they don't even contest that that's the case anymore. Many investors, such as hedge fund, rapid fire, volatility traders, index fund investors, sophisticated value investors do not --­ they have investment strategies that do not rely on the integrity of the market price whatsoever. So that sort of reliance is the quintessential individualized issue.

Oh no. No no no. That's the opposite of how it works. You think "index fund investors" don't rely on the integrity of the market price? Index fund investors are the definition of investors who rely on the integrity of the market price: The only thing an index fund knows about a stock is its price. An index fund owns a bunch of companies in proportion to the value that the market places on each company. If those prices are wrong, the index fund has no way to correct them: It just free-rides on the work of others who set the price. That's the easiest possible case of "fraud on the market."

Or "rapid fire" traders -- high frequency traders I guess? -- are essentially in the business of providing liquidity to uninformed traders. That is a business that relies very explicitly on the price being right: If there is information not incorporated into the price, and it is then revealed, HFTs get burned. (Though only very briefly!) High frequency traders rely on market prices like everyone else; they just do it faster.

Or volatility traders. Volatility trading starts with the Black-Scholes formula, which assumes that the future stock price is entirely predicted by the present stock price. 2 Volatility trading is the business of saying "okay, the price of a stock obviously incorporates all available information, I'm not gonna outguess the market there, but maybe I can be smarter than the market about its volatility."

Yes, "sophisticated value investors" do their own research, sure. But they always did. What has changed in the 26 years since Basic is that "sophisticated value investors" -- Warren Buffett, whoever -- make up a much lower percentage of the market than they used to, and index investors and others who implicitly rely on efficient markets have become much more prominent. The efficient markets hypothesis has gained ground in the markets. It would be odd if it lost ground in the Supreme Court.

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  1. He's more evenhanded than I would be. I'm reeeeeeally skeptical of securities class action lawsuits generally, and stock-drop ones specifically. As he puts it, "The illogical thing about a lot of these suits is that they transfer money from one group of innocent investors to another group, with lawyers extracting beaucoup fees along the way."

  2. Oh gosh that's not really true, risk-free worlds and hedging and all that. The point is, though, that Black-Scholes rejects pricing options based on predictions about future stock prices: The only admissible price information is the present price, which is effectively assumed to be efficient/correct.

(Matt Levine writes about Wall Street and the financial world for Bloomberg View.)

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Matthew S Levine at

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