Today's economy

What happened to efficient market theory?

By Kevin Press,

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Market watchers have long marvelled at the ability of some to move markets. Mario Draghi, president of the European Central Bank (ECB) is clearly one of those with the ability to change people’s minds about what a security is worth. When he told reporters “the ECB is ready to do whatever it takes to preserve the euro” on Thursday, investors around the world dialled their brokers in excitement. “[B]elieve me,” Draghi promised. “It will be enough.”

What makes the stock market move?It was certainly enough to give the Toronto Stock Exchange a boost. The S&P/TSX composite index rose 2.4% on the last two days of the week alone. Similar results were reported around the world.

But the broader question of saving the euro remains very much open. How Draghi plans to put the eurozone back on track remains a mystery.

There is speculation, of course. Benjamin Reitzes, vice-president, senior economist and foreign exchange strategist at BMO Capital Markets noted on Friday that Draghi’s comment is reminiscent of former ECB president Jean-Claude Trichet’s remarks before he implemented the successful Securities Markets Program in 2010.

“Indeed, markets now fully expect that the ECB will relaunch the program by next Thursday’s monetary policy meeting,” wrote Reitzes in a note to investors.

Talk about great expectations.

This isn’t how capital markets are supposed to work. Efficient market theory tells us that investors buy and sell based on the information available to them. In other words, the price of an investment reflects all the information that contributes to its valuation.

It would be reasonable to decide that a more optimistic outlook for the eurozone makes the stock of a global business active in the region more valuable. But that’s not what happened last week. Investors inflated the value of global business stocks (and other investments) because Draghi promised to save the euro. He may have been convincing, but he was hardly specific.

There are high hopes for Thursday’s meeting of the ECB’s governing council. Anything short of a major move is likely to prompt a sell-off. What’s clear in the meantime, though, is that to the extent the ECB is driving their decisions, investors are making bets based on rumour and speculation.

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[…] This week Brighter Life wants to know, What Happened to Efficient Market Theory? […]

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