The Institute for Financial Analysts polled its members and found that they no longer believe in efficient markets, or at least that prices reflect all information (see hedged.biz article). So, is stock investing based on fundamentals a waste of time? After all, information is more prevalent now than every before, and new information (for the most part) is suppose to be shared equally. If prices are not reflecting fundamentals, then surely, efficient market theory is lacking. As a kind of compromise, some will argue that while the markets are efficient, the participants are not, each analyzing the news, information, and data differently. It is felt that this is where some of academia has gone wrong - assuming that all participants interpret new news in the same way (although those in behavior finance might beg-to-differ).

Unfortunately, this view usually creates more confusion given that for many the participants are the market, such that as long as there are human traders, there will be fear, greed, and pricing anomalies. This is why it is often felt that being a fund manager is as much about understanding historical patterns and psychology, as it is about knowing the fundamentals. The irony is that as the flow of information has become more efficient, given the Internet and the 24-hour new cycle, one could speculate that the market may have actually become less efficient. Now freshly armed with new information, you have even more traders and investors trying to figure it all out, each with their own biases, over-reactions, and in some cases, somewhat predictable herd behavior. Such inconsistencies will no doubt keep market participants looking for alpha, all the while allowing fund managers and technical analysts to continue to thumb their noses at those in the ivory tower.

There is an interesting article over at the All About Alpha site regarding the impact of the short selling bans on 130/30 funds. While the article discusses the obvious challenge of maintaining a 30 percent short position when many stocks cannot be shorted, it brings up an interesting point about data and quantitative modeling. As quants go forward with model development, they will need to be careful when back testing their models given the periods of time in the market when short selling was either restricted or tightened for various equities. As one expert was quoted as saying:

"Managers with quant models for generating trades will probably have their heads in their hands. Not only will the quant models have to be redeveloped, but the managers will lose months if not years worth of model evolution, back-testing and intellectual investment. I can predict a few horror scenarios where code and expertise in these models may have been lost.”

There is no doubt that many non-quants or retail investors will say "big deal, isn't it just a bunch of traders taking the hit? Why should I care?" Yet, they should. Besides attempting to make a profit and generate abnormal return, quant funds, like many other strategy based funds, seek to profit from inefficiencies in the market, which ironically helps to keep the market more efficient. When this ability is hampered, as it is when short sale rules are not only changed, but selectively changed, you just add more inefficiency and market volatility (have you seen the VIX lately?).

Sure, naked short selling is wrong, and bans need to be enforced, but interfering with the normal market checks and balances could take months to sort out, even after short selling rules are returned to normal (or at least consistent for more than two weeks at a time). Until then, risk management, arbitrage, and finding someone to take the other side of the trade will be more difficult. All the while, day traders will continue to enjoy the volatility, while retail investors will continue to get nauseous, wondering if things will ever calm down.