The Two Minutes It Takes to Read This Will Shatter Your Efficient Market Beliefs Forever

Let me transport you to the early 1980s, where you find yourself in a classroom, barely holding onto every word of a renowned medical professor. He's imparting the wisdom of the age - peptic ulcers are a plague due to modern stress and a reckless diet. The medically sound remedies: copious amounts of antacids, self-restraint from the temptations of spices, alcohol, and caffeine. If all else failed, the last resort was a scalpel. Simple, right? Yet, it was profoundly, irrevocably wrong. In 1984, a couple of Australian scientists, Marshall and Warren, overthrew conventional wisdom with a bombshell - a tiny bacterium, Helicobacter pylori, was the real culprit. Two decades later, they were rewarded with a Nobel Prize.

At about the same time, I sat in a classroom at the University of Chicago Graduate School of Business, absorbing the efficient market theory from another renowned professor. Like the ulcer theory, it seemed infallible: since markets are efficient, no investor can consistently beat them. I believed every word. Efficient markets became my holy grail, as powerful to me as Moses' Ten Commandments.

Yet, just as with the medical dogma of ulcers, the truth was elusive.

Fast forward to 1992. I hosted a lunch meeting for my fellow University of Chicago GSB alums in Massachusetts, and our guest of honor was the recent Nobel laureate, Merton Miller. I don't recall a single word Miller said, but an encounter with a fellow alum, Arthur, stands out vividly. Arthur was singing praises of a rising star in the investment world, Warren Buffett. He urged me to invest in Buffett's public entity, Berkshire Hathaway.

I looked at Arthur with abject pity, much as I might consider a lost puppy. Poor Arthur, did you not learn anything at all at our alma mater? Have you not heard about efficient markets? Did you sleep through Gene Fama’s lecture on the Capital Asset Pricing Model?!

"Mr. Buffett is a lucky guy, but his luck will eventually run out," I remember saying. How wrong I was, as the price of Berkshire's shares now, a staggering $520,000, would testify. It is safe to say that, in the ensuing 15-20 years, the compound effect of a lecture in 1983 cost me many millions of dollars.

Coming face to face with these grave errors in my education was an excruciating process. I ventured into Wall Street as an analyst and witnessed firsthand the fallacies of the efficient market theory. Markets were riddled with inefficiencies, and those who could spot them were hitting the jackpot.

Stock prices weren't instantaneous reactions to information, and the flow of information was far from equitable. Before Reg FD, I remember a meeting with a VP of Investor Relations from a large corporation, who spelled out precisely what the numbers in my model should be ahead of their official release. Analysts at lesser firms had to endure the consequences of their uninformed guesses.

Paul Marshall, co-founder of the hedge fund Marshall Wace, elegantly sums up the reality in his 2020 book "10 ? Lessons From Experience." He writes, “Fama’s ‘ideal world’ does not exist. Information is only ever partially available, and despite the best efforts of regulators to create a level playing field, that information is available in very varying degrees to different participants.”

This uneven playfield was the genesis of my firm, Farmhouse Equity Research. We thrived on digging up fragments of information ahead of the curve through relentless interviews with everyone who mattered in a business ecosystem.

In the current age of 'expert networks,' this remains daunting. Yet, for those willing to stretch, there are still many opportunities to beat the market.?

Consider the monthly Consumer Price Index (CPI). How much would it be worth to know the CPI numbers before they are published? The Bureau of Labor Statistics conducts surveys to determine it, a process that a well-funded fund manager could mimic. For about ~$100,000 per month, a manager could assemble a similar team of researchers and gather the same data as the BLS but tabulate results days before the official numbers are released.?

I tried selling this idea to a few funds a few years ago but had no takers. Of course, no one cared about the CPI when inflation was consistently and boringly at 2% each month. Now that the CPI is less predictable and has massive implications for market movements, it would not surprise me if at least one or two hedge funds are currently doing this.

Ultimately, it's evident that markets, like medical wisdom, are not infallible. And the real-world lesson here? Many things we believe today as absolute truth will invariably turn out to be completely wrong.

Dispel the notion of ‘strong beliefs, loosely held,’ as that doesn’t work either. Instead, my advice is to question every basic concept, adapt, and, when necessary, unlearn.