The Sloppier Reality

Some thoughts toward what will eventually become chapter 10 of my book, ECMH, The Much Sloppier Practice.

Though there is much to be said for the ECMH, it has its limits as an explanatory tool. There are certain respects in which certain asset price moves are not random, and in which accordingly those properly placed to take advantage of the moves can make a good deal of low-risk money.

Let us note before going further that the great paradox of the ECMH is that it only works to the extent a lot of sophisticated people disbelieve it.

A market can be what ECMH posits that it is, an efficient machine quickly processing all available information, only because there are lots of wily traders looking for inefficiencies and exploiting them. A market is a bit like a river with pirahnas. We can say, as observers, that the river is almost certainly void of large chunks of fresh meat. Why? because if fresh meat were there, it would not be there long! That is in quick form the ECMH argument, where "fresh meat" is an inefficiency and thus a non-random price move. Yet the piranhas are still there, and something is keeping them alive! If there isn't any fresh meat, how do the piranhas continue working to keep the river clean of fresh meat?

One could hypothesize a lot of "sucker piranhas," who wrongly believe that they will find fresh meat and who are in time washed out to sea in their emaciated condition. Would these unhappy piranhas, during their brief life, be sufficient to underwrite the theory: to guarantee the meatfree character of the river?

That won't work. After all, the value of the piranhas in keeping the river free of meat depends upon their being sophisticated enough to know where the profit opportunities are. It seems unsatisfactory that our theory requires that certain fish be both emaciated suckers and sophisticated feeders. If the piranhas stop believing in the presence of fresh meat, they'll stop being piranhas -- they'll find another line of work in which they won't starve -- and the theory will lose its enforcers. Inefficiencies will then prevail, according to the reasoning of the ECMH itself.

What is really going on here? I submit that the reality is sloppier than the theory, and it is the sloppiness at the edges that makes the theory (for the most part) a valuable one.

How might sophisticated traders make money and stay alive? Four examples will do:

1) Distressed debt/assets, reorganization proceedings (intra-national)
2) Distressed sovereign debt (international)
3) Regulatory arbitrage
4) Currency disparities/ the carry trade.