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Asset Allocation, Risk Management, Trend following

A Possible Revenge of the Efficient Market Hypothesis

A virtually flat S&P 500 for 133 days this year may be an indication that the efficient market hypothesis is taking its revenge.

If the EMH is correct, then it is impossible to generate high risk-adjusted returns by timing the stock market without assuming higher risk in the form of riskier investments or leverage. However, this theory has been challenged but the basis for it may have been special circumstances that may not appear again.

Trend-followers hope to generate high risk-adjusted returns by timing market moves and by avoiding large drawdown levels, such as those that were caused after the dot com bubble burst and the financial crisis. So far they were able to do that with fairly simple models, such as a 50/200 moving average crossover.

Relative momentum investors hope that there will be enough market crashes so that value will be left on the table by panicked investors who sell at the bottom. They also achieve this by using trivial models, such as the rate of change of price.

However, both trend-followers and relative momentum investors cannot generate excess alpha when markets stay flat for extended periods of time. This is the case this year with the S&P 500 virtually flat for 133 days:


It is quite possible that we have entered a long-period of efficient prices in stocks due to the following:

  • Rapid growth in information technology including social media
  • Transition to a high frequency market microstructure
  • Better educated investors and traders
  • Direct stock market intervention by central banks

One way that can change that is unexpected events of the unknown unknowns type, i.e., events that we do not know that we do not know. It is entirely possible that known unknowns cannot cause market corrections any longer because they are discounted fast. At a certain period a few months ago we had Grexit, Ukraine, Russian sanctions, Middle East and a host of other economic and geopolitical adverse situations but the markets did not care. The reason I think for that is that these situations were discounted fully due to being known. Only a totally unexpected situation could move the markets so that trend-followers and momentum investors can benefit.

It is entirely possible that the EMH is taking a revenge. Ways to generate alpha if that is the case is by riskier strategies, including high frequency trading, low frequency short-term trading and assumption of leverage. I have a suspicion that the times of making good money using trivial models may be coming to an end.

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  1. Gary Phillips

    …back in early April, the Fed's Dudley's made comments that implied he did not want stocks to decline a lot, but also wanted to avoid meaningful increases. In other words, for the coming rate hiking cycle Dudley wanted a “Yellen collar”, not a “Yellen put”. While prior to the financial crisis it was a fed put, given the policy mistake represented by the 2004 rate hiking cycle, where financial market conditions did not tighten, and in fact they loosened significantly, contributing to the housing bubble and the financial crisis; Dudley now argued for a fed collar. Dudley also wanted bond prices to go down – not a lot but clearly down. It appears, that for the most part, Dudley got what he wanted, and much to the consternation of traders, continues to do so. -g

  2. Jim

    This is one of the best blogs in the quantosphere.

  3. Brian Haverty

    A virtually flat S P 500 for 133 days this year may be an indication that the efficient market hypothesis is taking its revenge. If the EMH is correct, then it is impossible to generate high risk-adjusted returns by timing the stock market.

    • Hello Brian,

      Long period of flat market followed by quick rises or falls due to fundamental news is the worst scenario for market timing methods.


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