Markets are getting more efficient, or are they?

The rise of communication and information technology has clearly been a great boon for investors. In the days of Ben Graham data about stocks had to be copied by hand from newspapers and company financial statements. Today, a plethora of websites provide millions of data points for free to everyone. And professional investors can access even more data through Bloomberg, Eikon, Factset, and other data providers. In short, data has become ubiquitous. 

Add to that the immediacy of financial media and its rising impact on market movements, and one can only conclude that markets have become more efficient over time, and the news is included in the price of an asset at ever-increasing speeds.

The problem just is that this is not the full story. Today, we live in a world where we are bombarded with so much information and data that we can’t process it anymore. Instead, investors have to focus on the most prominent companies that are discussed most frequently in the media, such as Amazon, Novartis, and BP. There are thousands, if not millions of investors who follow these companies closely and immediately react to every bit of news. 

Meanwhile, fewer and fewer investors have time to cover companies like Cerillion or Cake Box – small-cap companies interesting to a small specialist group of investors. The result of this divergence is that large-cap stocks incorporate information more and more efficiently while smaller companies fall off the wayside and their prices effectively become less efficient over time. Maryam Farboodi and colleagues looked at how well future earnings prospects of companies are incorporated in the share price and found that for large-cap stocks the market has steadily become more efficient since 1960. 

Price efficiency of US stocks

Source: Farboodi et al. (2020). Note: Large = top 500 US stocks by market value, small = everything else. Growth = 30% large cap stocks with highest P/B-ratio, Value = 30% large cap stocks with lowest P/B-ratio.

Meanwhile, US stocks that are outside the top 500 stocks by market value have seen their share prices become less efficient over time. And when looking at the large caps directly, then they even found that the efficiency of market prices has increased for growth stocks but declined for value stocks. In other words, large glamour stocks get all the attention while unloved value stocks and small- and mid-cap stocks are ignored more and more. And that should – at least in theory – make it easier for managers of small- and mid-cap funds and value funds to outperform the index. At least theoretically, there is more and more alpha available in these markets and less alpha in large caps and growth stocks. It is up to investors to capture this alpha.