Efficient Market Hypothesis

A short explanation of one of finance's most famous theories and why you don't need to worry about it.
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We have a quick question here from a new subscriber asking whether we are familiar with the efficient market hypothesis, and what we think of it. So thanks for the question as always, and yes, we’re all familiar with it.

But as traders we, don’t really believe the hypothesis to be true. For those of you that’s not aware of it, the hypothesis is the idea that all the information that can make prices move are already freely available to everybody. And thus all the buyers and the sellers in the market simply react to this freely available news, which means that every single security will always be trading at its precise fair market value.

So the hypothesis tries to show that, all market info is already priced, fully priced into the market, and that due to this there’s really no way to consistently make a profit against the market because with this theory, nothing should ever really be undervalued or overvalued, so to speak. Now, of course, if you’ve been trading for a while, well just watch how fundamentals affect prices, then you would know that there is a lot of holes in this theory, if everything that happens is immediately priced in, the theory would be correct, and it would be impossible to extract money from the market consistently.

But if this is true, it would not be possible for some of the most famous trading names in the industry to continuously beat the market year in and year out, based on the methodology.

So you see the theory or the hypothesis, doesn’t really hold up when we consider the way that instruments move after certain sentiment shifts. Let’s just take a recent example with the Euro. If we just quickly open up the Euro chart. Now we got the news about the European Commission’s increased proposal of that 750 billion for the Euro recovery fund on the 27th of May. So this was this little jump to the upside, right?

But the good news in the hopes of the deal, was not really fully priced into the market immediately as the news ran out. We saw the Euro actually continuing to rally on the hopes of that recovery fund deal for the next six days in a row. Continuously printing new highs every day in the anticipation of that bigger deal. We can also take a much longer time frame example. Everybody should remember Brexit, right? So let’s go back to the pound.

Let’s maybe go to the daily timeframe for this. We can go back to the June 2016. Now in June 2016, of course, we had the Brexit Referendum. And even though we had that initial move to the downside, directly after the announcement on the 24th of June 2016, we can see that the pound versus the US dollar continued to trade lower on the back of that outcome, for another three months all the way to October. Only reaching this referendum low so to speak in 2016 October when we revisited that low back again, in January 2017.

So If all the bad expectations of what Brexit would mean for the UK economy was immediately priced in, as the referendum results came out, then why would the pound continue to trade lower? Why was there continuously trading opportunities to take on the downside for the pound?

So, there are plenty of examples and reasons that refute the hypothesis, especially if you have some experience with following fundamental news flow in the market and seeing how it impacts asset prices, and at varying levels and at varying times due to the implications and of course, how it changes or changed the markets expectations.

So I hope that helps with your question, we are aware of it, and but of course as traders we do believe it is possible to extract profits from the market, based on overvalued and undervalued instrument prices.

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