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1 May 12 2011 @ 10:58am by Matt Smith in Crude Oil, Economy, Global Energy, Natural Gas, Random, Risk Strategy

Scooby, Scrappy, Velma, and Efficient Market Hypothesis

Last week’s crazy moves across Commodityland™ left me needing a stiff drink brought me back to thinking about financial market theory (apologies…despite the presence of Scooby I am going to geek out a little bit) and how sometimes it gets thrown out the window.

From a 17% sell-off in crude, to a 31% sell-off in silver last week, commodities were put through the wringer. When extremities like this happen, it makes us question the underlying assumptions that we make about markets, and whether these assumptions hold true.

Irrationality in markets and emotional responses (= behavioral finance) are two key elements that form the basis of my beliefs around markets. You’ll be glad to know I’m not going to talk about these two points (I’ll save them for another juncture). For today I want to touch on a much-debated financial theory defined in the swinging sixties by Eugene Fama, called efficient market hypothesis, to see what it can tell us about the recent move in commodities. And to ease the pain, we’re going to do this through Scooby, Scrappy, and Velma.

Despite efficient market hypothesis (EMH) being considered one of the cornerstones of financial market theory, it is much disputed to say the least. The theory is based on three forms, which define that markets are both random and efficient.

Scooby represents the weak form of EMH. And not just because he is weak-minded and weak-kneed (but he kind of is). Unless there is food involved, Scooby follows a ‘random walk’. The same is considered true of the weak form of EMH; it considers past movement or direction cannot be used to predict the future movement of a commodity – it considers them random, unpredictable, and that they cannot be forecast. From an analyst’s perspective, this form of EMH has as much credence as Scooby has courage. Pretty much none. Scrappy, on deck please:

Chomping at the bit is Scrappy ‘lemme at ‘em’ Doo. He represents the semi-strong form of EMH. He believes he is super-strong and invincible, but is ultimately lacking in some departments, just like this form of EMH. This form believes that commodity markets rapidly incorporate all publicly available information, meaning prices are usually near ‘fair value’. This makes some sense, although there are always likely to be exceptions. Finally, this leaves Velma.

Velma represents the strong form of EMH (and ironically, her middle name is Eugenia, similar to EMH founding father Mr Fama), a picture of ultimate ghost-hunting efficiency. This form suggests that commodity markets fully reflect all available information, be it public or private, at all times. Which initially seems reasonable, but given last week’s gigantic 17% move lower, cannot be entirely valid (…unless you believe that some truly massive market-moving information was released last week – but it wasn’t).

Where does this leave us? EMH defines that markets are both random and efficient, and that these two factors are intertwined. It is therefore prudent to place some faith in the validity of EMH, accepting that financial markets are usually somewhat efficient. However, based on moves like we saw last week for crude……clearly sometimes they are not.

1 Comment on this post:

  1. Brzezinski says:

    I don’t know the cartoons, but I heard that even Eugene Fama himself did not believe EMH; it is only theory. It is much debated just like whether CL price was manipulated by speculation or justified by emerging market demand.

    Randomness is assumed only for exact science to be applied to. So it’s
    {Ω, F, P }. Soros just denied it, in that random experiment cannot be repeated, in non-academic books and with money.

    when EMH and test thereof dominated phD thesis, My point is that the more credible and [I]ususal[/I] EMH is, the more profitable rejection of it can be.

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