As a short-selling investor, you hope that when the price does fall, you can repurchase the shares cheaply, return them to the owner, and pocket the difference. However, this trade becomes extremely risky when the share price rises. This is precisely what happened last week, as GameStop’s shares soared 1700 percent driven by a coordinated effort by retail investors to beat Wall Street at its own game. The event caught extensive media attention, not merely because GameStop’s stock price rapidly increased but because the rise did not reflect any change in GameStop’s lackluster performance. According to GME’s most recently filed 10-Q, its gross profit dropped dramatically from $1311.4 million in 2019 to $810.9 million in 2020. The company recorded a net loss of $295.8 million in the first three fiscal quarters of 2020.
This phenomenon has caused further questioning of the long-accepted efficient capital market hypothesis (ECMH). In the article “The Mechanism of Market Efficiency,” Professor RJ Gilson of Stanford Law School posited that the ECMH is “the context in which serious discussion of the regulation of financial markets occurs.” As a classic footnote of ECMH, Eugene Fama, who won the Nobel Memorial Prize in Economic Sciences in 2013, posited that “in a well-functioning market, the prices of… securities will reflect predictions based on all relevant and available information.” Thus, in a “well functioning” market, prices will “fully reflect” all “available information.” The intuition behind this theory is that the value of financial assets is determined by information. Thus, any “good” or “bad” news relevant to security will cause its price to increase or decrease, respectively. Based on how the asset prices reflect “all the available information,” the theory comes up with three different forms of ECMH: the “weak” form, the “semi-strong” form, and the “strong” form.
Under the weak form of ECMH, the current market price reflects all the past information regarding that security. Thus, if the close price of GME is $18.84 on December 31, 2020, this price should reflect all past information (for example, strong revenue growth or huge economic losses) concerning the stock. For the same reason, the weak form indicates that any short-term stock price will move in a “random walk,” given that the price will be only influenced by tomorrow’s information and tomorrow is always uncertain, so too will be the news.
Under the semi-strong form of ECMH, it further incorporates the reality that information about a security can be publicly available (e.g., the filings disclosed to the SEC, CEO’s marriage story published in the newspaper) and non-publicly available (e.g., confidentiality agreement between employer and employees). In light of the semi-strong form of the ECMH, the price of the security will reflect only all the past information plus the current publicly available information. The reason that the price is able to reflect the upcoming publicly available information is that the traders in the market are constantly seeking out value-relevant information, and in a semi-strong market, it was expected that the new publicly available information would be disseminated quickly. Thus, under the semi-strong form of ECMH, when GameStop’s price peaked at $380 per share on January 27, 2021, it resulted from a fast reflection for the surging purchase demand available to the public eyes.
The strong form of ECMH posits that the current price of a security incorporates all the past and current information regardless of whether such information is publicly available. Thus, under this form, even corporate insiders cannot benefit from insider trading. However, there is little evidence to show that the U.S. securities market is a strong form.
The U.S. capital market, such as NYSE, is deemed as either a weak market or a semi-strong market. However, it would be very much an illusion to conclude that NYSE is either a weak-form market or a semi-strong one. As a typical anomaly to illustrate the deviation, it was found that a stock will have positive current returns if it had positive returns within the past twelve months, while a stock will have negative current returns where it had negative returns within the past twelve months. This finding disobeys the rule of the weak form of the ECMH that the current price will not be influenced by historical information.
A deviation of the semi-strong form of the ECMH is the Long Island case. Long Island is a struggling ice tea company listed on Nasdaq. The company disclosed that its name would be changed to “Long Blockchain Corp.” Immediately after the announcement, its stock price soared nearly 300% before returning to the original price three months later. Compared to this over-reaction case, according to an event study of a pharmaceutical company, the company’s stock price dramatically increased after a release of positive news regarding its cancer-curing drug in the New York Times, even though the same information has already been published in Nature.
Back to GameStop, at first glance, it seems like another deviation of the semi-strong form of the ECMH. However, the lesson behind GME is that market efficiency is not a binary concept but a matter of degree. Thus, for any valuation relying entirely on market prices, it must be carefully examined whether the market is sufficiently efficient to account for the price. This is particularly the case in the current post-COVID-19 period with an extremely low-interest rate, which can trigger the “animal spirits” in investment considerations. This is likely what we have seen with GameStop.