Market Efficiency?

With the stock prices rising so dramatically for many companies on apparently so little news, we academics take a lot of kidding about the efficient market hypothesis which says that the market price of a stock fairly reflects fundamental information about the company. Just what fundamental information is the market reflecting? In our defense, it is important to draw a distinction between informational market efficiency and fundamental market efficiency. As described in our book, The Conceptual Foundations of Investing, a market is said to be informationally efficient if it responds quickly to new information.

Tesla is a poster child for informational efficiency. The stock responds almost instantaneously to slightest hint of news. A tweet by Elon Musk can set the stock moving the instant after he hits the return key. But fast response to information is not the same thing as a fundamentally correct response to information. A market is said to be fundamentally efficient if stock prices fairly reflect fundamental value. That means when the stock price moves in response to information, it moves the right amount.


Testing Informational And Fundamental Market Efficiency

Informational efficiency is easy to test. All a researcher has to do is check the time that a piece of information was released, say an Elon Musk tweet, and see how long it takes the stock price to react. Research shows that most stocks, and certainly Tesla, pass this test with flying colors. But although the stock price responds quickly to information, does it respond by the right amount? That is an entirely different question.

In most situations it very difficult to answer because of the difficulty of measuring fundamental value. As I write this analyst estimates of the fundamental value of Tesla range from $300 to over $2,500. With such a broad range of fundamental values there is no unambiguous way to measure fundamental efficiency except in special circumstances.

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