A V Rajwade: Financial market efficiency

WORLD MONEY

To quote Keynes, it is safe to predict levels, so long one does not simultaneously also predict the timing!

Believers in the totality of the efficient market theory would have surely had their faith shaken by recent happenings in the currency, commodity and equity markets. On the other hand, those who do not believe that man always acts rationally, that emotions, fashions, trends and the herd instinct play a major role in financial markets, as the proponents of behavioural finance argue, would have found much to confirm their views.

But first, the question of market efficiency. The efficient market theory argues that markets react to news (and news alone); and that, therefore, market determined prices of assets (equities, currencies, commodities and so on) reflect their fundamental values, based on all-known information. Market efficiency also requires liquidity, low transaction costs, the availability of the same information to all participants (in other words, no insider trading), and the absence of monopoly power with any player to set prices. A corollary flowing from market efficiency is the so-called "random walk" model, in other words, equal probability of the price moving up or down from the current level. In turn, this means that there is no way to predict future prices.

I have, for a long time, been a half believer in market efficiency: I do not believe that market prices always reflect fundamental values of the assets. Over-shooting in either direction is quite common and, in a cynical mood, one might argue that markets' pricing assets at their intrinsic values is like a non-working watch showing the time absolutely accurately, at least two times during the day! As Keynes famously remarked, the markets can remain irrational for a much longer time than the investor betting on the reversion to intrinsic values, can remain solvent. However, I do believe in the corollary of the theory, namely that markets are inherently unpredictable. I cannot avoid the temptation to quote Keynes once again: that it is safe to predict levels, so long one does not simultaneously also predict the timing!

But leaving such speculation apart, consider what has happened in the exchange market, since mid-April. After months of stability and low volatility, the dollar slipped against all the major currencies over the next four weeks, almost in a straight line. It has been relatively stable last week, when attention shifted to commodity and equity markets, but has already fallen about 4 per cent on trade-weighted basis, and even more against the major currencies, namely the euro, the yen and the pound. Even the Chinese yuan has appreciated, if only marginally, falling below the yuan 8 level (it has fallen all of 3 per cent since July 2005, when the Chinese authorities signaled the end of the dollar peg). Arguably, the gargantuan US deficit on current account has had something to do with the fall "" but the deficit number has increased but marginally from the time when the dollar was appreciating during much of the last year and in Q1 2006. As regular readers of the column might recall, while I have been a dollar bear for many years, as an admirer of Keynes, I had carefully refrained from predicting when the fall would begin!

Let us turn to the commodity and equity market behaviour, and see what it has to tell us about market efficiency. First, the commodity prices dropped. Was this really a surprise "" had they not gone too high anyway, thanks partly to speculation by hedge funds and trend followers? Again, while it may be understandable that a fall in commodity prices would adversely affect the share prices of companies producing them, surely the lower commodity prices mean that the cost of production for the rest of the economy comes down ""should this not be a bullish influence on share prices of the rest of the manufacturing sector? The markets obviously do not think so: equity prices fell across the board, albeit the fall was more for commodity companies than the other sectors.

The other interesting feature in respect of equity market behaviour was that equity prices fell all over the globe, the US, Europe, Japan and indeed the developing/emerging markets. (Have fundamentals turned adverse in every market?) The fall of the Indian market last Thursday, however, has been sharper than in most other markets. Indeed, the herd instinct of investors across the globe, only serves to strengthen one's faith in behavioural finance. Man is not a very rational animal in terms of his economic decision making processes. Too often, sentiment, fear, greed and the safety in numbers outweigh rational analysis and decisions.

Tailpiece: In the context of the medicos strike, there are reports of patients suffering. While one sympathises with the patients, a strike in public services that hurts nobody is an oxymoron: the objective is to generate pressure on those in authority, and this cannot be done without the public feeling the pinch.

Email: avrco@vsnl.com