The Pyramid Market

What’s known as the “strong” version of efficient-market theory (EMT) holds that the price of a stock at any moment reflects all the available information about that stock. As a result, it’s theoretically impossible to beat the market, because as soon as any new information about a company becomes available, it’s immediately reflected in the company’s stock price.

Now, there are very few adherents of the strong version of EMT left any more. That version can’t account for the volatility of the stock market, nor for the remarkable trading volume–close to a billion shares every day–that’s now characteristic of all the major exchanges. But even if markets are occasionally inefficient, they are efficient much more often than not. And even if the strong version of EMT isn’t true, that still doesn’t mean that stock-price movements are at all predictable, which is why so few mutual-fund managers outperform the broader market.

Still, what’s going on with Internet stocks does seem to represent a fundamental challenge to efficient-market principles (if only in the way that madness always represents a challenge to rationality). In the first week of the year, for instance, rose 49 percent. In the last two days, is up much more than that. And today alone, Yahoo rose more than 90 points (better than 25 percent). Yet these moves have taken place in the absence of any really new information.

Amazon, for instance, did announce that its fourth-quarter sales would beat expectations, but that announcement was not really a surprise, nor was the news that it would be no closer to profitability. Trading in, meanwhile, was actually halted on Thursday while Nasdaq officals asked the company to explain the unusually strong upward movement in the stock, but trading resumed after said that it had no explanation for the movement. And Yahoo apparently soared today in expectation of its earnings report, which comes out tomorrow. But everyone who bought Yahoo today knew on Friday that the company would be reporting on Tuesday. So why did they wait to buy today?

The obvious catchall answer is that this is what “momentum investing” entails, namely, waiting to buy a stock until after it’s started to accelerate upward. But it’s not as if these Internet stocks have not been going upward pretty consistently in the last month (the last year, for many of them). And in any case there’s something unsatisfying about “momentum investing” as an explanation. What starts the momentum going? In the absence of new information, why does a stock suddenly become the cat’s meow?

This, I think, is why so many people see investing in Internet stocks as bubble-like. If you’re buying Yahoo at $400 a share because you think its earnings will be phenomenal, then you should have bought Yahoo at $330 a share, which you could have done last week. Investors are supposed to discount the future. But too many Internet investors don’t seem to be discounting anything. They seem to be jumping on the train not because of where it’s going but just because it’s moving. Now, so much money is being made in these stocks that it’s difficult at this point not to sound like a ridiculously wet blanket. But then that’s the nature of pyramid schemes. As long as you can keep bringing new people in, the people who invested at earlier stages will make a tidy profit. The problem comes when those new people stop arriving. And while efficient-market theory is an excellent guide to the stock market in general, I’m not sure it really equips us to understand why bubbles burst. I’m not sure it helps us understand why one day people wake up and do start discounting the future. What I am sure of is that it will be a very strange day on Wall Street if they finally do.