What Is a False Market?

A false market occurs when prices are manipulated and impacted by erroneous information, preventing the efficient negotiation of prices. These types of markets will often be marred by volatile swings because the true value of the market is clouded by misinformation.

Key Takeaways

  • A false market is a financial market that inaccurately represents the reality of the situation.
  • Investors and traders rely on accurate information to make buying and selling decisions in the financial markets.
  • A false market arises when prices are manipulated and impacted by information that is not true.
  • Volatility is common in false markets as investors alter their decisions based on false information.
  • Prices can be manipulated through the spread of false information, such as incorrect financial information, misrepresentation by the media, a release of fake news by criminals, false investment schemes, and more.
  • The Securities and Exchange Commission (SEC) is responsible for detecting and stopping false information, which can come with severe penalties.

Understanding a False Market

The health and success of financial markets rely on the dissemination and sharing of accurate information to all parties involved. Accurate information allows for the correct valuation of companies and allows investors to make judgments based on that information. Accurate information results in both buyers and sellers making the best decisions based on true knowledge.

When this information is tampered with or provided incorrectly, it results in decisions based on lies. When investors use inaccurate information to guide their investment process, they tend to be irrational and over- or underreact to news. The illogical decisions made by these investors skew the market, causing the true value of a security to be misrepresented, resulting in a false market that does not represent the true reality.

Causes of a False Market

False markets usually arise due to the dissemination of false information. This can include falsified financial statements by a company, inaccurate news spread by the media, a misrepresentation of business activity, such as in many financial schemes, and criminals spreading misinformation through a variety of channels.

When the false information is released and believed by investors they then make a certain decision. If a company somehow successfully presented that its earnings for a quarter beat estimates, when in reality it suffered significant losses, investors would buy the stock based on the idea that it was performing well.

This lie could only be upheld for so long and when the truth is revealed, the share price would plummet, causing the investor to lose on their investment because they purchased the stock based on a lie.

False markets hurt all stakeholders involved, even ones who do not buy the specific security linked to the false information, as financial markets are complex and intertwined.

False markets usually result in losses for investors and other stakeholders. It can, however, sometimes result in a profit if an investor purchases a security at a depressed price when they believe it is undervalued, which might be because of the false information provided on it.

Real-World Example

An example of a false market is the case of Scottish trader James Alan Craig whose false tweets that two companies were under investigation caused sharp drops in the stock prices of the two companies and triggered a trading halt in one of them in 2015.

The Securities and Exchange Commission (SEC) filed securities fraud charges against him. The SEC’s complaint alleged that Craig’s first set of false tweets caused the share price of Audience Inc. to fall 28% for the day before Nasdaq temporarily halted trading. The next day, Craig’s false tweets about Sarepta Therapeutics Inc. caused its share price to fall 16%.

For his fraudulent tweets, Craig created false Twitter accounts that looked like the accounts of two well-known securities research firms. On each occasion, Craig actively bought and sold shares of the target companies but failed to generate a large profit from his trades.

After the fraud was discovered, the SEC issued an Investor Alert titled "Social Media and Investing -- Stock Rumors" that was prepared by the Office of Investor Education and Advocacy.

The alert warned investors about fraudsters who may try to manipulate share prices via social media by disseminating false or misleading information about stocks. The SEC also provided tips for recognizing the red flags of investment fraud.