Inverting the Efficient Market Hypothesis

The efficient market hypothesis does not hold, but approximately it does. (I let the two positions fight it out in an earlier two-act play.)

We can phrase it like this: The world exists, and is at a point in time in a given state in its available state space. The stock markets exist and assign a value to each tradable asset which spans a vector space whose dimensionality is the number of assets that exist.

Economic activity is a function (which is injective except for world states in which humanity is dead) that maps the world state to the market state. If the emh holds precisely, this is a deterministic function.

Let’s describe the ideal function as this mapping function if the emh were perfect.

People generally care about evaluating this function and finding a residual between it and the ideal function, as this induces arbitrage opportunities.

But the ideal function is invertible: The market contains a complete description of the world, if we assume stock prices to be continuous. In practice the inversion only provides access to principal components of the world latent.

The market function should not have access to hidden information but in practice it does. It can also to a reasonable extent disregard irrelevant information.

If we assume the market function to be close to the ideal function, observing market trends indicates trends in the world.

Prediction errors in market activity can stem from the residual between the market function and the ideal function, thus inducing a residual in the implied and true world state. Mostly pointing out principal components in the world state our market function misses (because current economic theory fails to model it).

This residual is a proxy for the current zeitgeist. For societal delusions. For what humanity is currently having a ‘discussion’ on.