Chasing the Same Signals: How Black-Box Trading Influences Stock Markets from Wall Street to Shanghai

Chapter 4. Finding the Footprint

What Coke and Pepsi Do Not Have in Common

The efficient market hypothesis has been one of the most widely accepted theories in finance for the better part of three decades. It asserts that stock prices trade based on all known information and they adjust instantaneously to new information. Stock prices trade along a "random walk" and fund managers cannot make excess returns when trading on news, earnings announcements, or technical indicators.

Efficient stock markets are best characterized by how they react to new information. Stock prices should react instantaneously to the new information—the distribution of their returns should reflect a normal distribution (i.e. the standard bell curve) around the release of information—some stocks go up and some down.

Similarly, in efficient markets, stock prices should not demonstrate serial correlation, the relationship between one period and the subsequent one. Yesterday's prices are not indicative of today's prices. If stocks were up one day, there should be no correlation to predict a positive movement on the next. The fluctuations day to day in stock prices should be randomly distributed.

There are many published academic studies that highlight periodic anomalies. Most research, however, indicates that few investors could act on the anomaly because of frictional effects (commissions, clearing fees, taxes) and market restrictions (short-sell constraints). Academics often suggest that anomalies are rarely stable ...