Stock Market Efficiency: A football industry analogy

A textbook definition of market efficiency would describe it along the lines of:

An efficient market is one where the undervaluing and overvaluing of shares does not occur and therefore, abnormal profits cannot be achieved. This is because current and past information is immediately reflected in share prices, resulting in the efficient pricing of all shares on the market. This does not necessarily mean that all share prices are equal to their true value. It simply means that errors made in pricing shares are unbiased and that price deviations from the true value are random. Another factor to consider is the efficient market hypothesis (EMH) which explains how in an efficient market, when new information becomes available, it is incorporated into the share price rapidly and rationally.  

However for the purposes of this blog, we are going to explore this concept using the analogy of football with players as assets instead of shares. So:

An efficient market would be one where the undervaluing and overvaluing of players does not occur. For example in an inefficient market, Ipswich Town may value their centre midfielder Luke Hyam at £2 million. However Alex Ferguson may spot potential talent in the player that Ipswich and other clubs have not seen and sign him for Manchester United at this price to only discover he is actually a £10 million player profiting abnormally from this purchase. However in an efficient market his value would be £10 million as every piece of current information (including potential future growth) is included in the price. When applying the efficient market hypothesis to this example, in the situation of a match, if Luke Hyam makes a good tackle his value may increase rapidly and rationally to £10.1 million (rapidly as it occurs as soon as the tackle is made and rationally as it is a relatively small factor providing only a 1% increase), however if he incurred a potentially career threatening injury his value may decrease to £2.5 million (with the significant price drop reflecting the potential severity of the information).

An efficient market compared to an inefficient market does have its advantages. Firstly it encourages share buying as individuals can be confident that they will get a fair value for their shares when buying and selling them. In our example, managers may be reluctant to buy players if they feel they may be paying an unfair price for them, or if they feel that when it comes to selling the player, the price they receive may not represent their true value. The second advantage of an efficient market is that it provides company managers with the correct signals. Therefore managers can see exactly the impact that the market places on their decisions. Again using our example, the Ipswich Town management may decide to invest in a new training facility, meaning that players can improve their skills and maximise their potential. In an efficient market, if the market views this as positive, it may be reflected by an increase in player values, giving signals to the management that they have performed well. A final advantage is that efficient markets help to allocate resources. Under allocative efficiency, ways are found to ensure that resources are allocated where they can be most productive. If shares are priced efficiently more funds should be allocated to those industries with the potential for higher growth to ensure that the economy as a whole is as efficient as possible. Linking this back to the football example, this suggests that in an efficient market, young players with high potential should be valued higher than those who are soon to retire, to ensure resources are allocated efficiently across the board.

Successful analysts and investors such as Warren Buffet (whose fund management company, Berkshire Hathaway, returned an average annual gain of almost 20% from 1965 to date) would argue that market efficiency does not and will never exist in reality, allowing people such as himself to continue achieving abnormal returns. However does the concept of market efficiency have any disadvantages for investors? I suppose the main disadvantage on the buying side would be that it does not allow investors to exploit inefficiencies which would significantly benefit them. For example if Ipswich Town wanted to improve their team, they could send out their scouting network around the world to find undervalued players and sign them, either to then sell them on for a higher value to make a profit, or to improve their team at a lower cost as a result of market inefficiency. In this situation, Ipswich Town would have benefitted from the market inefficiency. However this would have come at a cost for the exploited teams that have lost players, who in an efficient market would have been valued correctly and therefore valued at a higher price. Linking this back to the stock market, whilst undervalued shares in an inefficient market benefit the buying party, they come at a cost for the selling party who is not achieving a fair value from their sale, suggesting that efficient market provide fairness for all.

To analyse the extent to which markets are efficient, American economist Eugene Fama (1970) devised a three tier grading system based on different types of investment approaches which produce abnormal returns. These are described in further detail and linked to the footballing example below:

1) Weak Form Efficiency. This type of efficiency claims that all past price movements of a stock are contained in the current share price and therefore abnormal returns cannot be achieved from such technical analysis. When applying this to the example within this blog, weak form efficiency would suggest that a player’s current value is based upon all previous movements of his value and therefore analysing how his value has changed over time to predict his future value will not achieve abnormal profit.

2) Semi-strong Form Efficiency. This type of efficiency claims that share prices incorporate all of the relevant publically available information. Therefore fundamental analysis such as analysing the economic climate nor technical analysis such as analysing past price movement can achieve an abnormal profit as all of these factors are incorporated into the current share price. When applied to the example this would suggest that a player’s value fully reflects all publically available information such as training facilities available, the coaching team and potential future improvement, therefore suggesting that a player’s value will be efficient and that no advantage can be gained from analysing such factors.

3) Strong Form Efficiency. This type of efficiency claims that all information, privately and publically held is incorporated into share prices. Therefore all of the people know all of the information and no abnormal returns can be made, not even from insider trading. In an efficient market a director may purchase (illegally) shares in their company if they know positive news is to be released which will result in the share price rocketing up. However in a strong form efficient economy, everybody would have this same information about the future price rise. When applying this to the footballing analogy, Mick McCarthy (Ipswich Town Manager) may discover in training that a player is actually not as good as the public believes he is as he loses the ball every time he is in possession. In an inefficient market he may try to sell this player for his higher perceived value, however in a strong from efficient economy, all information about this player’s ability will be available to the public and no abnormal returns can be achieved.