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Sometimes Markets Are Stupid

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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“We can try to understand/the New York Times’ effect on man”

-- The Bee Gees, “Stayin’ Alive”

I’m generally a fan of the efficient markets hypothesis. It’s a good baseline for thinking about financial markets. But there are some important ways in which it fails, and it’s fun when you can see these failures happen in real time. One of these failures happened on Nov. 28, when the New York Times blog the Upshot ran an article about the effect of ride-sharing services on the value of taxi medallions. Josh Barro explains:

If the stock market is efficient, why would a single Upshot article on taxicab medallion prices help push down Medallion Financial’s stock 7 percent in a single day, when most of the information in that article was already public?...

Last Thursday, with the stock market closed for Thanksgiving, my article about falling taxi medallion prices in those cities went up on the web. The next day Medallion Financial’s stock closed more than 7 percent lower, with nearly all that drop coming in the first minute of trading.

According to the so-called semistrong form of the efficient market hypothesis, that shouldn’t have happened. Medallion Financial’s stock price shouldn’t have been affected by the story.

Basically, if you were following Medallion Financial -- often referred to by its ticker symbol TAXI -- on Nov. 27, you wouldn’t need a New York Times story to tell you that Uber and Lyft pose a threat to the stock’s value. You would know it already. Someone out there must have been following TAXI. So why didn’t that someone act on that knowledge and sell the stock, pushing its price down?

The answer is something that finance researchers have been studying for a long time now. It’s called “limits to arbitrage.” It’s the idea that one person has limited resources with which to push around the price of a stock. Even if you see that TAXI is overvalued, you can’t just short-sell huge amounts of TAXI until the price falls to the right level.

Why not? What are the limits to arbitrage? One is that short-selling is expensive and risky. Another is that there is always the risk that irrational people will enter the market, pushing the price the wrong way -- and in the words of successful investor John Maynard Keynes, “the market can stay irrational longer than you can stay solvent.”

If investors have only limited power, then the only way to push the price to its correct level is for them to all push at once -- like getting a car out of the mud. But this can introduce another difficulty. Coordination across a bunch of different investors is difficult, not to mention potentially illegal. Even if a bunch of investors all know that TAXI is overvalued, each one doesn’t necessarily know that the others know. In other words, common knowledge breaks down.

Lack of common knowledge and coordination can prevent prices from adjusting. One investor might try to short TAXI at the same time that another is trying to go long TAXI for the purpose of short-term speculation. The problem is especially bad if the irrational traders in the market have some resistance level that the rational investors have to overcome. Princeton economists Dilip Abreu and Markus Brunnermeier famously showed that this problem can even lead to bubbles and crashes.

In these cases, investors need a so-called coordinating signal to tell them that everyone is on the same page. That could be a big price swing, such as when a bubble starts to pop. It could be an earnings announcement, or some other piece of big public news.

Or it could be a blog post in the New York Times.

In these kinds of situations, market efficiency breaks down, because people have to know too much information in order to push a stock’s price to the right level. Instead of just knowing about a stock’s value, they have to know all kinds of things about what other investors know and what other investors are thinking. In other words, useful information -- such as the information that TAXI is in big trouble -- gets trapped. It’s trapped in people’s heads, because without the extra information that it’s in other people’s heads, it can’t get into the market price.

Of course, experienced traders are laughing as they read this, because it’s obvious to anyone who has ever traded. But it’s still fun to think about it in abstract terms, and to watch the theories play out in the market in real time. 

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net