Fama Market

Eugene Fama, Booth School, Univ of Chicago


Do you know traders could have made 580% in the S&P 500 the past 200 days?

Public companies, your stock need not rise.  I’ll explain.

The S&P 500 is up almost 20% the last six months. The math says 454 of the 500 are up. That also means 46 stocks are down. Including some big ones like Verizon, Lockheed Martin, Procter & Gamble, Kellogg, Zoetis.

But up isn’t the point. It’s up and down. Traders could have made all the returns in the S&P 500 from October 1995 to present – about 600% – in just 200 days on volatility.

By capturing all of it perfectly, which is next to mathematically impossible. But follow me here.

Across the 500 components, average intraday volatility the past 200 days is 2.9%. That is, the typical S&P 500 stock will gyrate almost 3% from lowest to highest intraday prices.

Add that up.  Over 200 days it’s 580%.

And it bugs the bejesus out of Chief Financial Officers. As it should.  The Wall Street Journal highlighted the investor-relations profession and our own Laura Kiernan in a piece (subscription required) last week called CFOs Zero in on Shareholders as Stock Volatility Soars.

But holders aren’t behind volatility.

The University of Chicago’s Eugene Fama won a Nobel Prize on efficient markets and the effects of volatility.  He famously said, “If active managers win, it has to be at the expense of other active managers. And when you add them all up, the returns of active managers have to be literally zero, before costs. Then after costs, it’s a big negative sign.”

Why?  I’m oversimplifying but he showed that volatility risk, size risk and value risk make stock-picking inefficient and ineffectual.

The data prove it.  Most stock-pickers can’t beat the market because they don’t understand why volatility exists.

What is volatility? Changing prices. We’ve written often about it over the years as this search on the word “volatility” at the ModernIR blog shows.  Stock prices constantly change.


Regulations require it.  Think I’m overstating it? Rules for stocks require trades to occur between the best bid and offer. And regulators mandated penny spreads for stocks 20 years ago.  Thus trades can only occur at the best current price, which changes often.

The best price for stocks cannot be established by a single principle. That idea earned a Nobel Prize.  Other factors matter including volatility, size and value.  And I’d argue convenience, time-horizon, purpose. You can probably add more.

The market is only efficient for parties benefiting from constantly changing prices. Who’s that? Traders and stock exchanges. 

Profiting on price-changes is arbitrage. We have the perfect arbitrage market. How? There are almost 50 different places where trades can occur in the National Market System, a cornucopia for changing the price if you’re fast and algorithmic.

And now the market is chock full of things that look like stocks but aren’t stocks. ETFs, options, futures.  They all converge and diverge in price.  The parties feasting on this environment need prices to change all the time.

Enter the exchanges. They sell data. The data is comprised of quotes and trades. The more the price changes, the more data there is.  Heck, they lose money on trades to make it selling data.

Only trades involving different owners will settle. About 95% of my trades – I understand market mechanics and I become my own algorithm to take advantage of how it works – match at my broker’s internalizer.  No measurable ownership-change.

And Fast Traders are 54% of market volume. No ownership-change. And trades tied to derivatives are 18% of volume. Little to no ownership-change. And half the market’s volume reflects borrowed stock. No ownership-change.

Let’s review.  Shareholders don’t create volatility. They try to avoid it.  Most trades don’t result in ownership-change because the market is stuffed with efforts to profit on changing prices. And that is the definition of volatility, which exists because of rules that promote constantly changing prices.

There’s a simple fix.  Put the focus back on stable prices, by emphasizing factors other than price, such as size and value.  Call it the Fama Market.  When my dad sold cattle from our ranch, we wanted an average price for a herd, not a price per steer.

If public companies want to fix volatility, we need a different market. You can’t fix it by telling the story. And that can’t be the heart of the investor-relations job. It’s now understanding the market for shares – just as my dad knew the cattle market.

If we lack the collective verve to lobby for better markets, then we have to adapt to this one, by understanding it. We have the tools and data for both companies and investors.