On Tesla and the efficient market hypothesis

Featured image is licensed under the Creative Commons Attribution-Share Alike 2.0 Generic license. Author: einstraus

Recently, one of the big stories in the world of finance has been Elon Musk and Tesla. Following a declaration from the Tesla CEO that he was willing to take Tesla private at $420 a share, Tesla’s share price soared and then fell almost as quickly following a lack of substantial evidence that he could, indeed, secure the funding to actually put this plan into action. However, this is not the main focus of the article; my main focus is instead the market reaction to Elon Musk appearing to smoke marijuana during a discussion with popular podcast host Joe Rogan on The Joe Rogan Experience. My argument, in a nutshell, is that such reaction to Musk’s activities in itself disproves the efficient market hypothesis, and moreover that other readily obtainable evidence cements this point of view as correct. Before I start, I’ll explain the efficient market hypothesis as an idea that states market prices readily reflect any publicly available information in the market, so any movement in the price of a security is the result of changing market information regarding a particular security, or securities.

According to this model of market behaviour, when Musk smoked marijuana there should have theoretically been no effect on Tesla’s share price, given that marijuana has been proven to actually be less harmful to the body than alcohol. This is because you would expect less of a negative movement in Tesla’s stock price due to Musk doing this than if he drank alcohol, which he has admitted to doing in the past with no noticeable impact on Tesla’s share price. However, on the day that Musk admitted smoking marijuana Tesla shares fell by as much as 9 percent, with the only other notable news on the day being the resignation of two C-level executives in the company. This very event shows that the effect of investor psychology (i.e. animal spirits) on security prices can indeed be substantial, and a company’s share price is not always solely a reflection of all available information about it. In addition to this, if the efficient markets hypothesis is so correct, how have numerous investors consistently made significant profits by “beating the market”?

For example, the well-known investor Warren Buffett has amassed a fortune of almost $90 billion dollars value investing (essentially believing that in the short term the market underprices certain stocks relative to their fair value, and that substantial profits can be realised by investing in these stocks and waiting for them to return to their fair value in the long run). Over a career spanning over half a century, the probability that all Buffett’s amassed fortune is down to luck or chance is infinitesimally small, meaning that even Warren Buffett’s huge wealth is a strong counterargument to the efficient markets hypothesis. Expounding on this further, according to the efficient markets hypothesis it is impossible for any investor to generate alpha (or market-beating returns) in the long run due to stocks never being underpriced relative to fair value. This is in direct contradiction to the reality of the fund management industry, where many fund managers (such as Kenneth Griffin) can generate consistent alpha through, for example, extensive prior due diligence or another type of edge. If securities were indeed priced so efficiently, the opportunity for these investors to make their millions and billions would not arise in the first place.

Moreso, there are more examples than just Tesla of how security prices rising or falling can be more a result of fear and greed than any sort of fundamental shift. The dotcom bubble is another example of how businesses like Pets.com had their market capitalisations rise (and then fall even quicker) despite any significant change in their balance sheet, suggesting the initial rise was due to irrational exuberance. Again, with efficient markets these same sorts of market bubbles would not exist and the only time stock prices would rise and fall with such ferocity is if something about a company actually changed that quickly (for example if their CEO or CFO left). To conclude then, over the course of this article we’ve taken a look at why, to me, the efficient market hypothesis is flawed using three key examples. The first is recent, explaining that under the efficient market hypothesis the response to the Tesla CEO smoking marijuana in their share price would not be so severe. The second explores the idea that with efficient markets investors such as the famous Buffett would not have been able to amass such large fortunes at all, and the third explains that financial market bubbles as we know them today would not exist in a world of efficient markets. These proofs by contradiction illustrate why, for me, why the efficient market hypothesis is heavily flawed and does not provide an accurate indicator of financial market behaviour.

By Shrey Srivastava

A finance and economics enthusiast, and someone who wants to share his views with the world.

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