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Bankruptcy

: Credit Slips

The Inefficient Capital Markets Hypothesis

By Stephen Lubben

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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.

Full post as published by Credit Slips on May 28, 2009 (boomark / email).