The Inefficient Capital Markets Hypothesis

The Efficient Capital Markets Hypothesis (sometimes just called the Efficient Markets Hypothesis) states that liquid markets quickly absorb information, so that it is essentially impossible for an average investor to make excess profits trading on public information. Share prices are thus the best indication of the value of a company, because they reflect the consensus view of all available information.

If there ever was a market that might live up to the theory, you'd think it would be the New York Stock Exchange, especially with regard to trading in blue chip stocks like General Motors.  After all, this is a very big company traded on a very liquid market.

Yet a few days ago I observed -- in the pages of the Wall Street Journal -- that GM shares appeared to be overpriced by a factor of 30. Did that effect share prices? Don't be silly. I'm just a bankruptcy professor; what do I know about chapter 11?

And again there was a good deal of befuddlement today when GM's share price started going up after the announcement that the company had reached something of a truce with a large group of bondholders. The new announcement didn't change the reality that the shareholders will likely receive nothing in the GM chapter 11 case.

How much would you pay for something that will have no value in a few months? As of the close of the market today, the surprising answer was apparently $1.12.

By talking with my non-lawyer friends (all 2 of them), I've come to the conclusion that there are a variety of factors at work here. First, sophisticated investors are essentially unable to engage in significant shorting of GM shares right now because the cost of borrowing the shares is quite high. Second, some retail holders might be resistant to selling their shares if the commission on the sale will exceed the sale proceeds. Not an entirely rational, but plausible.

In addition, trading by people who don't understand the Bankruptcy Code is probably all going in one direction (i.e., toward buying GM) -- the ECMH presumes that such noise is random and cancels out. There also may be some buying happening to close out whatever short positions do exist. All these factors could conspire to prop up GM's share price.

On the other hand, shouldn't most investors -- especially retail investors -- be selling GM to lock in their tax losses?  If there ceases to be a market in GM stock, these shareholders might not be able to realize their loss until the conclusion of GM's chapter 11 case -- which could be a long time after the §363 sale. The present value of a tax loss today (or this year) is higher than the same tax loss two or three years from now.

In short, the market in GM's stock is rather clearly not efficient.

Comments

[John Thomas]

I agree with your conclusion. I suspect there are still people with money that rely on option value. You could think of a share of GM as a call option on the value of the company with a strike price as the value of the debt. For example, let's pretend the company is worth $100 and the debt is $125. The stock might trade for $2 on the potential that the company is suddenly worth $140. The government has recently been giving away a lot of money (particularly to the unsecured creditors of large financial institutions) so the bet may not be totally nuts.

[Joe]

Because GM is a member of the Dow, quite a few index funds are obligated to hold it. http://finance.yahoo.com/q/mh?s=GM It looks like over 5% of GM shares are held by index funds. Another large portion is probably hedging other DJIA exposure. The cost of shorting a company everyone knows is going to die, yet that index funds have to hold, probably prevents that last bit from being evaporated.

[Stephen Lubben]

The index fund point is a good one.

[Kurt]

Another possibility is that people are not selling because they want it to take a long time for the losses. They have already taken enough losses for the year and don't fully understand how to carry forward losses. This provides an easy way for them to carry losses forward to offset future gains (and also save on transaction costs).

[Lawrence D. Loeb]

The closing out of short positions, the index portfolio issue, reluctance to take losses, and a general lack of understanding of the bankruptcy process are all good reasons for what is happening.

The concept of a call option is valid too, although I'm not sure what the assumed volatility needs to be to price an option that's so far out of the money (and unlikely to increase substantially).

Professor, you bring up an excellent overall point. The Efficient Market Theory is more of a theory than a reality.

Unfortunately, pretty much all of finance theory (CAPM,Black-Scholes, etc.) assumes that markets are efficient (and that people behave in a manner consistent with a normal distribution curve).

The people who support Efficient Market Theory tend to be fanatical about it.

Warren Buffett and Charlie Munger (along with most of the Ben Graham acolytes) disagree with the theory, but are happy to take any advantage that it gives them.

The market for distressed securities (speculating on companies in, or near to, bankruptcy) has historically been very inefficient. This has primarily been due to a lack of funding and the specialized knowledge necessary to succeed in such investing. Given the large amounts of capital that have been deployed into this market, it will be interesting to see, ultimately, how the returns during this period compare to the returns realized in past periods.

[Legal Vulture]

The most important factors is that you can't short the stock. So speculative buyers exist (for no good reason) but no speculative sellers exist. (Although one can still buy puts which price the stock at about 30 cents).

It would be nice to understand why one can't short this stock? I believe someone is manipulating the process: the government, State Street.

[John from Concord]

Is it seriously news to anyone (other than Gene Fama, who will presumably continue shouting down and insulting those who opt for reality over his pet theory until he dies of apoplexy) at this point that the Efficient Markets Viewpoint (I can't bring myself to call it a Hypothesis) is patently absurd?

[AMC]

My guess is that the price is based on short covering and - if there is any rational basis to the price - a weird speculation strategy on how high short covering can drive up the price before it falls to zero. The percentage moves for a "penny stock" like GM can be pretty large.

Or maybe people are buying shares to they can get stock certificates to frame as GM memorabilia - the price of shares going up sort of like when an artist dies and the supply becomes fixed.

But for anyone holding GM stock - the absolute priority rule and the Supreme Court's 203 North LaSalle Partnership decision means: You get nothing in a Chapter 11.

http://supreme.vlex.com/vid/nat-sav-assn-lasalle-street-partnership-19960575

[Gregman2]

Good points, but underlying asset and earnings qualia are not always grasped and conveyed by analysts. Also, stand alone assets are basically at book, so it's people, synergies and consumer appetites that really drive both value and valuations. Right now, there's little future value for anyone to get excited about.
And why would they...especially if they have no money (and with banks that have no money to lend) to buy?

[investorette]

What do you think of this theory based on the value of their tax losses?
GM Common Stock Is Worth More Than You Think
http://seekingalpha.com/article/140361-gm-common-stock-is-worth-more-than-you-think

[Stephen Lubben]

The article from "seekingalpha" suggests that Microsoft should buy GM to utilize its tax losses. This completely ignores a basic fact of tax law -- a "change in control" would destroy the NOLs.

[investorette]

Stephen,
Thanks for responding to the NOL question. Is there some possible loophole though or is there a common confusion among investors on this point? I just ran across analysis with similar language from a very well known (and respected?) service on a totally different stock (proprietary details hidden):

"With more than $XXX million in net operating losses able to offset future tax liabilities, we think COMPANY could be worth as much as $Y per share for a profitable acquirer."