It’s in the price

In the early 2000s, between graduating university and entering work, I embarked on a ‘world tour’ (of the English-speaking world, given my embarrassing lack of foreign-language abilities), which included a visit to the Chicago Mercantile Exchange (CME or ‘the Merc’). A self-guided tour of the Merc covered its history, its status as one of the few remaining open-outcry securities exchanges, and also included a game where visitors could try their hand at being a day-trader for a few minutes.

I found the trading game fascinating, not least because I was so bad at it. The premise was that some market-moving piece of information would be released (say, relating to an OPEC decision to curtail oil production) and then you, as the trader, would predict the price movement of an underlying security or commodity (e.g., oil). The reason I did so badly at the game is that I assumed that, by the time the news had hit the market, it would already be priced into the underlying securities or commodities, perhaps more so than was justified. Consequently, I was just as inclined (actually, more inclined) to place the opposite bet to what the news release implied. According to the game, however, there was still time for a trader to place a profitable trade by assuming that the price of the relevant asset would continue moving in the direction suggested by the news. In industry jargon, this is called ‘momentum’.

Perhaps this was an early sign of my contrarian streak, or just that I would make a rubbish day-trader. But I guess I had also stumbled across an element of the efficient market hypothesis. In its strongest form, this basically states that all securities at all times price in all publicly disclosed information. Do not get me wrong: over the longer term, we in Ninety One’s Value team absolutely believe that mispricings exist, and have built portfolios and an investment process around the arbitrage opportunity. Time and again, we see stocks oversold (or overbought) in a market that predictably over- or under-reacts to short-term news, and effectively prices short-term developments into a company’s share price as if they were permanent.

But is it possible to consistently outwit the market by reacting to short-term economic and company-specific news, and build a profitable investment process out of it? We would argue that the chances of doing this are slim in all but the most illiquid, remote corners of the market, with any repeatable gains likely to be so miniscule as to be eaten up by trading and other costs. In other words, the premise that the Merc’s trading game was based on is unrepresentative of market reality, and is best confined to museums and tourists. (For an entertaining and revealing account of just how tiny the gains on offer are from short-term trading anomalies, and the efforts that deep-pocketed traders are willing to go to to try and capitalise on them, Michael Lewis’ Flash Boys is a great read).

Given our investment process is built around a company’s long term fundamental earnings and growth prospects, the idea of over-trading for a few tiny, speculative, short-term gains is anathema to us. When some piece of short-term news moves one of our stocks by a few percentage points, our most likely response is – borrowing a quote from one our competitors – to ‘do nothing’. Why? More often than not, by the time anyone can react to the development, it really will be priced in.

Past performance does not predict future returns; losses may be made.