Refactoring EMH – Thoughts following the latest market crash

I think one of the concrete takeaways from GJP and related classes of things is that it's possible to notice when experts are being stupid [LW(p) · GW(p)] in ways that make sense given the incentives and/or the environment changing from the training data the expert is operating off of and then make *measured* bets against said stupidity, since a lot of money seems to go with expert consensus. Calling this an EMH failure seems sort of like...underestimating the ability of intelligence to generate an information advantage? Like, you can in fact just sit down with a blank sheet of paper and gain an information advantage, that's what inventions are.

I've been thinking about the EMH a lot, since it seemed to me that even after the initial COVID crash the market still was overvaluing everything. This turned out to be correct and now I have a lot more money than I did before (although far less because it takes 4 days to be approved for option trading).

My confusion was about half resolved by the following thought: since actors in the market have finite capital, it can be consistent that the value of an asset is X, everyone knows that it will be Y > X in the far-ish future, but no one buys X until it reaches value Y now because there are other things that you can do that will make you more money, i.e. exploit market volatility, short-term puts/calls, etc. In terms of COVID, everyone can know that a recession is coming, but think that you can make more money through exploiting short term volatility, e.g. panic buying/selling.

What I'm still a little confused about is the fact that recent market movement seems incredibly obvious to me (so obvious that I put literally all my assets into shorting positions), but hedge funds are going out of business and Bridgewater's Pure Alpha lost money. Dalio even thought about COVID significantly before the crash.

I only thought about COVID for like 5 days become becoming extremely confident that the market was going to drop. I wasn't an expert on pandemics. I don't think I'm a nimble generalist. I didn't even make a guesstimate model. I just looked at COVID, read LW comments and read the news. Hedge funds can read both the news and LW, so they should know all the things that I know. They also have more time to think and more incentive to think correctly, so they should be efficient relative to me. But they were not. I notice I am confused.

What do people at hedge funds even do all day? You would at least have a few people working full-time to think about COVID, right? And they can't all get it wrong? Is it really that important to be nimble?

And it didn't just drop once more to correct, it dropped like 3 more times? Something must have gone horribly wrong, but all of my explanations seem way too forced.

I feel like this version of EMH is already a consensus replacement (of the EMH found in textbooks) among the finance people that I know, but it is possible that I am speaking from within a very small bubble. Anyway, I think your formulation is well-stated and useful.

I would suggest that one week -- or even a couple of months in the context of COVID-19 -- of market price behavior really tells us little about EMH. A lot there probably depends on just which version of that theory you want to apply.

Quick follow up regarding your last point about small nibble-large slow. I just saw this bit on CNBC. You might need to wait and see what the quarterly income reported from the investment banking/trading side of the house for these large financial houses.

I'm afraid the argument was a straw man from the start. Only the so-called "strong form" EMH says that prices are always right. Most economists and even more practitioners have long understood that there are inefficiencies in the market--after all, the market is efficient because departures from efficiency are exploited, driving prices toward efficiency. For most of us, the inefficiencies are too small or too fleeting to be exploitable. For a few, those who are either much smarter than everyone else, or got there earlier, or have the most efficient trading algorithms, there do exist exploitable inefficiencies. It's no coincidence that mispricings used to be much, much larger in the past than they are now, as trading costs have declined and computer algorithms of increasing speed and sophistication have been deployed.

An example: some years ago a friend of mine worked for a startup that had the idea of arbitraging between sports betting markets (like Betfair), since they often show different odds and anyone can lay odds.

But only after developing software to do this - which worked - did it dawn on them that the liquidity was too low (e.g. not enough people laying odds). They had no trouble making revenues, but only tens of dollars per hour, not thousands. No possibility of profits.

So they closed the business. And presumably that market remains inefficient.

Relatedly, from Seeing the Smoke [LW · GW]:

The coronavirus was identified on January 7th and spread outside China by the 13th. American media ran some stories about how you should worry more about the seasonal flu. The markets didn’t budge. Rationalist Twitter started tweeting excitedly about R0 and supply chains.

Over the next two weeks, Chinese COVID cases kept climbing at 60%/day reaching 17,000 by February 2nd. Cases were confirmed in Europe and the US. The WHO declared a global emergency. The former FDA commissioner explained why a law technicality made it illegal for US hospitals to test people for coronavirus, implying that we would have no idea how many Americans have contracted the disease. Everyone mostly ignored him including all major media publications, and equity markets hit an all time high. By this point several Rationalists in Silicon Valley and elsewhere started seriously prepping for a pandemic and canceling large social gatherings.

On the 13th, Vox published a story mocking people in Silicon Valley for worrying about COVID-19. The article contained multiple factual mistakes about the virus and the opinions of public health experts.

On February 17th, Eliezer asked how markets should react to an obvious looming pandemic. Most people agreed that the markets should freak out and aren’t. Most people decided to trust the markets over their own judgment. As an avowed efficient marketeerwho hasn’t made an active stock trade in a decade, I started at that Tweet for a long time. I stared at it some more. Then I went ahead and sold 10% of the stocks I owned and started buying respirators and beans.

By the 21st, the pandemic and its concomitant shortages hit everywhere from Iran to Italy while in the US thousands of people were asked to self-quarantine. Most elected officials in the US seemed utterly unaware that anything was happening. CNN ran a front page story about the real enemies being racism and the seasonal flu.

Finally, the narrative couldn't contain the sheer volume of disconfirming evidence. The stock market tumbled 10%. The Washington Post squeezed out one more story about racism before confirming that the virus is spreading among Americans with no links to Wuhan and that’s scary. Trump decided to throw his vice president under the coronavirus bus, finally admitting that it’s a thing that the government is aware of.

And Rationalist Twitter asked: what the fuck is wrong with everyone who is not on Rationalist Twitter?