HH Alphanomics: The Study Of Security Mispricing

I just finished reading Alphanomics by Charles M. C. Lee and Eric So, published by a small academic press in 2015. The subtitle is The Informational Underpinnings of Market Efficiency, but that doesn’t really give a sense of the book, which essentially summarizes the last five decades of academic research into market pricing mechanisms. I’d like to give readers a summary of what the book accomplishes.

I: Is the Market Efficient?

There are a lot of arguments against the efficient market hypothesis (the belief that the price of a stock reflects all available information and therefore approximates the intrinsic value of a company), and Lee and So seem to marshal practically every one of them. But my favorite is their surfing analogy.

Market efficiency, or so argue its proponents, is “an inevitable outcome of continuous arbitrage,” where arbitrage is defined as “trading aimed at profiting from imperfections in the current price.” Because so much arbitrage is going on, prices rapidly adjust to reflect the information available.

Lee and So point out that this belief “is akin to believing that the ocean is flat, simply because we have observed the forces of gravity at work on a glass of water. No one questions the effect of gravity, or the fact that water is always seeking its own level. But it is a stretch to infer from this observation that oceans should look like millponds on a still summer night. . . . If we are in the business of training surfers, does it make sense to begin by assuming that waves, in theory, do not exist? A more measured, and more descriptive, statement is that the ocean is constantly trying to become flat.”

Because price discovery is an ongoing process, there is always going to be a lot of adjustment as the market searches for some sort of equilibrium, and this adjustment involves lots of mispricing and correction of that mispricing even as new information and signals come in. “In fact,” Lee and So write, “it strikes us as self-evident that arbitrage cannot exist without some amount of mispricing. Therefore, either both mispricing and arbitrage exist in equilibrium, or neither will.” (What Lee and So mean by “mispricing” is essentially the divergence between the market price and the net present value of a security.)

Lee and So then take on the idea that abnormal returns (pricing anomalies) are a compensation for risk factors. This doesn’t fit with empirical observations. There is a great deal of evidence that “healthier and safer firms, as measured by various measures of risk or fundamentals, often earn higher subsequent returns. Firms with lower beta, lower volatility, lower distress risk, lower leverage, and superior measures of profitability and growth, all earn higher returns.” In other words, these companies all appear to be less risky than comparable companies.

Let’s take the opposite assumption (please note that Lee and So don’t go here) for a moment. Let’s hypothesize that the market is fundamentally inefficient and that while arbitrage makes it slightly more efficient, it doesn’t even begin to make it fully efficient. Let’s hypothesize that mispricing is ever-present in part because information is always imperfect. Let’s hypothesize that arbitrage—a industry that costs, in management fees, $600 billion per year, as Lee and So estimate—succeeds only occasionally and is mostly making stabs in the dark. Under this model, investing in less risky assets is more likely to succeed than investing in highly risky assets, and there’s no need to worry about “compensation for risk factors.”

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Disclosure: My top ten holdings right now: MIXT, RMNI, PCTI, SPNS, PALDFF, MGIC, QMCO, PRPL, CO, TTEC.

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