The Price Knows Everything
On 28 January 1986, at 11.39 a.m. Eastern time, seventy-three seconds after lift-off, the American space shuttle Challenger blew up. Seven people died. The whole country watched it live.
Within a few minutes, people on the New York Stock Exchange started dumping the shares of the companies that had built the shuttle’s parts. They sold all four, but not in the same way. By the end of the day the three big contractors had fallen by two to just over three per cent. But Morton Thiokol, which made the solid-fuel boosters, was falling so fast that by 11.52 trading in its shares had been halted. By the evening it had lost almost twelve per cent.
A government commission investigated the disaster and named the cause only on 9 June: in the cold, the rubber O-rings in a booster had lost their elasticity. Whose booster? Morton Thiokol’s.
The market worked it out in one day. Without a commission. Without engineers. Without a report. None of the sellers knew for sure what had happened. But thousands of people each had a scrap of knowledge—an engineer, a supplier, an analyst, a former employee—and by selling and buying they put the scraps together into one number. The number pointed at the culprit five months before the official finding.
If only commissions worked like that.
The Efficient Market
In 1970 the American economist Eugene Fama gathered everything that was then known about share prices into one big paper. Out of it grew what came to be called the efficient market hypothesis. The idea is simple: the price of a share has already taken in everything there is to know. Everything. In the weak form: you can’t guess future prices from past ones. In the semi-strong form: a published piece of news goes into the price instantly, and you can’t make money by reading the paper. In the strong form: the price has taken in even what isn’t in the papers.
If that’s so, you can’t beat the market: whatever bright idea you come up with has already occurred to thousands of others, and the price has taken it in. It’s worth buying shares not because you’re smarter than the market. But because over long stretches the market as a whole has grown, and you take your share of that growth. With no guarantee it will go on that way.
And now an irony I’m very fond of. In 2013 the Nobel Prize in economics was shared by three men. One was Fama, the chief defender of efficient markets. Another was Robert Shiller, their chief critic: all his life he argued that prices jump about far more than companies’ earnings justify. The Nobel committee rewarded both of them for studying the same thing and let them disagree. You couldn’t put the state of affairs better. The market is excellent at finding out the truth. And every now and then it goes mad.
News Travels Fast
We had our own theory of efficiency too. The counterfeiters came up with it.
In 1909 the Morello gang printed another batch of fake banknotes, and the engraver Comito overheard talk that the selling would be arranged so the whole batch was thrown onto the market across the whole country within one hour, on a day agreed in advance. Dash thinks such a plan is extremely unlikely. Fine. Any financier understands the point of it.
All the notes in a batch were printed from the same plates and looked the same, with the same tell-tale marks. Once the first one is spotted in one bank, a description goes out to all of them, and the rest become paper. A counterfeiter earns only until the news gets around. There’s only one way to make it in time: sell everything before the market finds out. Today’s traders who deal in fractions of a second are running the same race. Just with computers.
The Market You Can’t Buy Over Lunch
And now for why you can trust an honest market.
The American numbers racket fed the Mafia families, but one thing held it back: why should a player believe that the winning number hadn’t been fixed? The answer they found was brilliant. The number was taken from public figures nobody could control. From the last digits of the balance in the Treasury, which was printed in the newspapers. Or from how many shares had changed hands that day on the New York Stock Exchange. No boss could bribe the exchange into trading the number he wanted. The Mafia, notice, built trust in its lottery on a market you can’t buy over lunch.
But in Boston, they say, the number was taken from the total bets on the first few races at the local track. And, as historians drily note, the winner could be controlled by manipulating the total of the bets. A small market is easy to buy. A big one, much harder.
That’s the whole point. The more people make a price, the more expensive it is to shift it with one big trade. A small market with three buyers can be bought over lunch. A deep one can’t be bought like that. But “hard” doesn’t mean “impossible”. In 2020 the bank JPMorgan agreed to pay the American authorities nine hundred and twenty million dollars to settle a case. For years its traders had been moving the prices of precious metals and US Treasury bonds, and you won’t find many markets in the world deeper than those. They put in orders they had no intention of filling, just to nudge the price. The size of a market gets in a crook’s way, but it doesn’t stop him. And a price that picks up news quickly can still be walked on someone else’s leash. Before you trust a price, ask: how many people made it, and which of them could have given it a push?
The Don Reads the Price
Don Vincenzo never read Fama, but he trusted a price more than a letter.
One autumn the mill owner wrote to us: the harvest is good, prices are the same as before. And a week later the Don noticed that on the wholesale market oil had gone up by a tenth, though the new oil hadn’t come in yet. He rang two wholesalers he knew. Neither of them knew anything definite. But the price knew. Somebody somewhere had seen poor groves and started buying in advance.
That same day the Don ordered two months’ more oil than usual, at the old price. Three weeks later a letter came from the mill owner: hail had damaged the olives, the harvest was smaller, prices would have to go up. “A letter is written by one man,” the Don said. “A price is made by everyone who knows something. I listen to everyone.”
The Bottom Line
A price is good at gathering what other people know. But it can be pushed, and sometimes it goes mad all by itself. How that happens—in the next essay.