The long memory of the efficient market

TL;DR

This paper shows that order signs on the London Stock Exchange follow a long-memory process, indicating potential predictability, but market efficiency is maintained through compensating fluctuations in transaction size and liquidity.

Contribution

It reveals the long-memory nature of order signs and how market efficiency is preserved through counteracting long-memory processes in transaction size and liquidity.

Findings

Order signs exhibit long-memory with autocorrelation decay ~τ^(-0.6).

Market returns remain uncorrelated due to compensating fluctuations.

Some institutions show long-memory, others do not.

Abstract

For the London Stock Exchange we demonstrate that the signs of orders obey a long-memory process. The autocorrelation function decays roughly as $\tau^{-\alpha}$ with $\alpha \approx 0.6$, corresponding to a Hurst exponent $H \approx 0.7$. This implies that the signs of future orders are quite predictable from the signs of past orders; all else being equal, this would suggest a very strong market inefficiency. We demonstrate, however, that fluctuations in order signs are compensated for by anti-correlated fluctuations in transaction size and liquidity, which are also long-memory processes. This tends to make the returns whiter. We show that some institutions display long-range memory and others don't.