Posted By I have stood here before inside the pouring rain
With the world turning circles running ’round my brain
I guess I’m always hoping that you’ll end this reign
But it’s my destiny to be the king of pain
– King of Pain by The Police
By Noah Solomon
Special to Financial Independence Hub
This may seem strange coming from a me: a quant geek who uses data, technology, and machine learning to develop and manage investment strategies, but here it is:
I believe that technology has made markets less efficient.
The efficient-market hypothesis (EMH) was developed in the 1960s at the Chicago Graduate School of Business. It states that asset prices reflect all available information, causing securities to always be priced correctly, thereby making markets efficient.
In my view, perfect efficiency is like the tooth fairy: it would be nice if it really existed, but in reality, it is purely fictional. This divide between the ivory tower and the “real world” was epitomized by the legendary Fisher Black, co-architect of the Black Scholes option pricing formula. After moving from M.I.T. to Wall Street, Black remarked, “Markets look a lot less efficient from the banks of the Hudson than the banks of the Charles.”
Bubbles: The Archnemesis of the EMH
Over the past several decades, markets have borne witness to two extreme bubbles:
- In 1989, the Japanese stock market was trading at 65 times earnings. The aggregate value of Japanese stocks exceeded that of U.S. stocks despite the fact that the U.S. economy was three times the size of Japan’s. Soon after, things went from sensational to miserable, with Japanese stocks suffering a particularly prolonged and steep decline.
- Little more than a decade later, the S&P 500 Index, aided and abetted by a tremendous bubble in technology, media, and telecom stocks, reached the highest multiple in its history. Not long thereafter, the index suffered a peak trough decline of roughly 50% over the next few years.
Clearly, to quote palace guard Marcellus in Shakespeare’s Hamlet, “Something is rotten in the state of Denmark.” How is it that markets experienced such extreme aberrations? I’m not sure that “crazy” is the right word, but I’m darn sure that it’s not “efficient.”
Without a doubt, periodic bubbles can be attributed to recency bias, a common behavioural quirk where investors overweigh recent information and events at the expense of considering objective facts and probabilities. This can cause people to chase recent winners and push their prices to unsustainable levels. According to famed economist John Kenneth Galbraith:
“There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.”
Recency bias notwithstanding, I believe that there are other factors at play that are contributing to irrational behaviour and resulting in decreased market efficiency.
The Rise of Passive Investing & Market Efficiency: Nobody Knows
A persistent feature of markets over the past 20 years has been a secular shift in assets from active managers to passive, index-tracking funds. I do have some sympathy for the argument that this has led to less efficient stock prices. Granted, if the entire world shifted to indexing, then by definition markets would become inefficient for the simple reason that nobody would be analyzing companies.
However, this is clearly not the case, which begs the question of what percentage of investable assets need to be in passive vs. active strategies to engender a meaningful decline in market efficiency. I don’t believe that anyone can answer this question with any degree of certainty.
The Paradoxical Effect of Technology: The Wise Crowd vs. the Foolish Herd
Market manias and the related mispricing of assets seems paradoxical given the amount and speed of information that has become widely available over the past 20 years, not to mention the precipitous declines in commissions and other trading costs. However, speed and availability of information is a proverbial double-edged sword, especially as it pertains to the efficiency of markets over the medium to long term.
In theory, technological advancements, and specifically the ability to obtain and process greater amounts of information at an increasingly rapid rate, should make markets more efficient. However, these developments are not a significant factor for investment strategies with medium or longer-term horizons, for which the speed and availability of information are not particularly important.
On the other hand, technology has had a deleterious effect on the proverbial “wisdom of the crowd,” which is defined as “the notion that the collective opinion of a diverse and independent group of individuals (rather than that of a single expert) yields the best judgement.”
The catch here lies in the word “independent.” While I agree that security prices should be “correct” when investors think and act independently, this is clearly not the case when they act with a herd mentality and all run off the lemming cliff in unison. Under such circumstances, the crowd’s “wisdom” becomes anything but, which leads to manic behaviour and market inefficiencies. In a world where social media personalities such as Keith Gill (Roaring Kitty) can incite their millions of followers into frenzied bouts of groupthink, crazy things are bound to happen.
At the end of 2020, GameStop’s stock stood at $4.71. Based on Gill’s posts, his horde of followers proceeded to push up its price to $86.88 (a gain of 1,745%) within less than a month. Less than one month after that, the stock lost nearly a quarter of its value. Since then, GameStop’s shares have continued their wild gyrations, repeatedly doubling and halving. Importantly, Roaring Kitty’s frolics encompass many other stocks (Chewy, AMC, etc.), which also experienced similarly ridiculous volatility. Moreover, Gill is not the only widely followed social media pundit whose comments cause mayhem.
The ascendance of social media, the availability of information, and the widespread tendency of people to trade their own accounts online, combined with a prolonged bull market, has created a Pavlovian feedback loop in which crazy behaviour has been rewarded, which has spawned even crazier behaviour.
According to (Warren) Buffett:
“For whatever reasons, markets now exhibit far more casino-like behavior than they did when I was young. The casino now resides in many homes and daily tempts the occupants.”
The Pain Trade: It’s about Magnitude AND Duration
Most people can endure being on the wrong side of markets to a limited degree, but even the most steadfast investors have a threshold for pain beyond which capitulation is inevitable. Almost everyone has some level at which they succumb to their primary instincts and jump on the momentum train, thereby exacerbating the very dislocations they had previously believed would revert.
Even when it comes to investment managers with tremendous fortitude, their clients may lack the same resolve and force them to abandon their convictions. This brings to mind a well-known quote from legendary investor Howard Marks, who stated, “Being too far ahead of your time is indistinguishable from being wrong.”
Investment Implications: The Machine keeps calm & carries on
If markets are becoming less efficient, leading to more frequent and more extreme dislocations, this should create more and larger opportunities for active managers to outperform. However, even rational investors are unlikely to possess perfect timing. As such, they will inevitably experience prolonged periods of underperformance at times when crazy leads to extreme inefficiencies that can persist for extended periods.
Over the near term, momentum tends to dominate markets, but over the medium to long-term, mean reversion rules the day. In essence, the size of the prize has gotten bigger, but the potential pain one must endure to get it has also increased. This seems like a fair deal to me.
Secular shifts in market dynamics aside, security prices have recently been exhibiting some of the largest day-to-day market gyrations in recent memory, driven in large part by comments emanating from the new Trump administration. It is likely that such headline-induced volatility will be a permanent feature of markets for the foreseeable future.
Our rules-based, algorithmically driven investment models do not react to headlines, nor do they care what social media influencers think or say (or anyone else for that matter). They lack greed or fear, nor do they get angry or upset. Rather, they simply stick to the very machine-learning based process that has led to higher returns and lower volatility over the long-term.
Noah Solomon is Chief Investment Officer for Outcome Metric Asset Management Limited Partnership. From 2008 to 2016, Noah was CEO and CIO of GenFund Management Inc. (formerly Genuity Fund Management), where he designed and managed data-driven, statistically-based equity funds. Between 2002 and 2008, Noah was a proprietary trader in the equities division of Goldman Sachs, where he deployed the firm’s capital in several quantitatively-driven investment strategies.
Prior to joining Goldman, Noah worked at Citibank and Lehman Brothers. Noah holds an MBA from the Wharton School of Business at the University of Pennsylvania, where he graduated as a Palmer Scholar (top 5% of graduating class). He also holds a BA from McGill University (magna cum laude).
Noah is frequently featured in the media including a regular column in the Financial Post and appearances on BNN. This blog originally appeared in the February 2025 issue of the Outcome newsletter and is republished here with permission
