How To Dis EMH

A recent dispute on the EMH (Efficient Market Hypothesis).  John Cochrane:

“What is there about recent events that would lead you to say markets are inefficient?” he said to me. “The market crashed. To which I would say, We had the events last September in which the President gets on television and says the financial markets are near collapse. On what planet do markets not crash after that?”

Paul Kedrosky:

The only reason the markets crashed in 2008 was because the U.S. President got on TV and said they might? … We had had an unprecedented run on the shadow-banking system, assets for many banks looking like zero, Fannie/Freddie as state wards, banks up to Goldman and Merrill wobbling, and it was the President that made a crash happen? Simply staggering – and, in its fact-free and inflexible defense of a particular economic ideology, a crushing indictment.

Brad DeLong:

Unless you think that one speech by President Bush had a profound effect on dividend levels and discount factors in 2019 and beyond, you simply cannot (a) know enough about the dividend-discount model to remember that at a dividend yield of 3% three-quarters of the present value comes a decade and more hence, (b) claim that the market is “efficient,” and also (c) claim that a speech by George W. Bush caused the meltdown.

Look, everyone, this game should have rules.  EMH (at least the interesting version) says prices are our best estimates, so to deny EMH is to assert that prices are predictably wrong.  And for EHM violations to be relevant for regulatory policy, price errors must be so systematic as to allow a government agency to follow some bureaucratic process to identify when prices are too high, vs. too low, and act on that info.

So the clearest way for EMH skeptics to show they are right is to collect a track record showing that they can predict, ahead of time, when prices are too high, vs. too low.  There’s little point in picking out some year old event, and saying, “see that price drop was too big.”  Monday morning quarterbacking is way too easy.

But if just before a price drop you’d been on record saying the price was too high, or if just after you’d said the price was too low, well then we could include your purported error in a EMH-skeptic track record.  And with enough skeptics identifying enough purported price errors, it wouldn’t take long to collect enough data to see if EMH skeptics really do have a system for identifying price errors.  (Of course some would do well just by chance, so we’d need to look at the whole set.)

With a proven skeptic track record, we could then begin a conversation about whether their system was the sort that regulators should embody in some official government process, in order to improve our financial system.  (Or whether skeptics should just post their errors, and let speculators fix prices.)

But all this continual harping year after year on how EMH is obviously wrong, based on selective stories of past prices you say were obviously wrong, sounds awful suspicious when you don’t bother to publicly flag price errors at the time, much less to collect and publicize a track record of such error flags.  (E.g., care to declare which prices are wrong today?)  What’s up with that?

HT Rajiv Sethi.  See also previous OB posts.

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  • Bill

    You know, what you think is an efficient market has to be a transaparent market.

    If I devise a market in which transactions are recorded publicly, and at the same time enter into a CDS going two times the other direction, and CDSs are not public, what you see is the first transaction and not the second.

    Go ahead and bet using the information contained in the public transaction because you believe the market is efficient.

    I have a CDS–based on private knowledge that the initial transaction was two times covered in the other direction–and will be happy to collect from you.

    Efficient markets depend on transparancy and that all, or most, transactions are aggregated.

    Good luck.

    • Tom P

      Usually one party to a CDS (like the issuing bank) will hedge its risk in the open market. That way, private prices get incorporated into market prices.

      Moreover, you’re suggesting that this CDS is basically an arbitrage because the price differs from the market price of the exact same instrument (maybe a bond with the same risk characteristics as the CDS). In general there is not that much arbitrage out there in reality.

      So, I’m just saying that most of these secret transactions do get priced in in the real world.

      • Bill

        That’s not true.

        Some CDS are public, but others are not, and coverage is not in the market.

        Look at the Goldman – AIG transactions. Look at Cargill’s recent losses.

      • MDF

        Bill is right. During the run up to the recent unpleasantness, many CDSs weren’t hedged in the open market, or were double or tripled downed, rather than hedged. That’s actually the real source of the subprime crisis, because even if every single subprime mortgage defaulted, with no foreclosure recovery, the losses to the banks would not have been nearly as great as they actually turned out to be. And this was because many CDOs contained derivatives doubling or tripling the bets on a possible upside, so any losses by defaults were correspondingly magnified.

  • brazil84

    I basically agree with you. That said, I have made a decent amount of money in the markets over the last 10 or 15 years just with simple observations and common sense.

  • Aria Stewart

    Or, there’s the systematic case: Perhaps the whole market is systematically overvalued, all the time, and the variation we’re seeing is still within that.

  • Bill

    I disagree with your statement: “So all it takes for EMH skeptics to show they are right is to collect a track record showing that they can predict, ahead of time, when prices are too high, vs. too low. ”

    No, that’s not the point at all.

    Taleb and Mandelbrodt, and my next door neighbor, a mathematician who works with large financial institutions, would say the world is fractal, not predictable, and has a lot of randomness and chaos. The point is: you can’t predict anything, much less can you say that the market is efficient and complies with gaussian certaintly. To say the market is efficient is to say that it is rational. Good luck.

    It is chaos, fractal.

    • MDF

      That can’t be right. Some things are clearly predictable, inductively if not deductively. We can predict the sun will rise tomorrow. From there, we can predict some things. We can, with a degree of confidence, predict whether a cash rich commercial paper issuer is going to default in the next three days.

      If nothing were predictable, it would be impossible to have a market at all — any market. You couldn’t borrow money to buy a car because the bank couldn’t predict whether some kind of space vortex was going to suck your house into the void tomorrow.

      What I think you are trying to say is that we apparently cannot predict some things as accurately as we thought we could. But this doesn’t disprove the EMH. If anything, if shows it works, because as soon as information about this overestimate of our abilities came to light, the market very rapidly adjusted to this newly learned fact.

      • Bill

        As you will see later in my posts pointing to Mandelbrodt/Taleb, having a range of predictable doesn’t exclude the random. How else does one explain a bubble or a crash.

  • Bill, if you can’t predict anything, then what estimate is better than the current price? If none, then price is best, then EMH, QED.

    Aria, all prices are relative, so if one thing is priced too high, something else must be priced too low.

    • Bill

      Repeating the statement that if you can’t predict, then the market is correct is not to prove that EMH is correct.

      Here is a short summary of Mandelbrodt in Forbes:

      He also wrote a book on this, and will look for it at home; You might also want to look at Taleb’s Black Swan and another book on fooled by randomness.

      Classical analysis is fine if you presume rationality. Good luck there. Then the behaviouralist wouldn’t be able to point to endowment effect that kept people holding onto stocks when they should have sold. Or, that the market includes all the information. Good luck there, if ther are side bets that aren’t in the market.

      The world is not black or white either. Within some range, EMH works as a hypothesis. But, the world is wild, chaotic and information is incomplete…so it is better to plan for, as Taleb says, extremistan.

    • Jason

      But if you can’t predict anything, then any price is a “best” estimate and the EMH has no content.

      I was under the impression that most of the criticism of the EMH was either a) it was without content, or b) that markets included human behavioral biases in addition to pricing information.

      However behavioral approaches may also be without content: as humans it is difficult to step outside of our own nature. Deviations from “rationality” due to human behavior will likely be as invisible to us when making predictions as secret CDS transactions.

      We need to build robots that behave like classical rational investors to trade in our markets. I guess that is the goal of regulations.

      • Constant

        But if you can’t predict anything, then any price is a “best” estimate and the EMH has no content.

        Yes, but if you can’t predict anything about one company or sector, but you can predict something about another, then EMH only has no content WRT the first. WRT the whole it still has content, only less than if you could predict everything.

      • Chris

        I’m not sure how regulators push the goal of rationality.But rational investment is the goal of the (villainous, if you believe the media) algorithmic traders.

    • Mr. E

      You cannot claim you’ve never seen the Robert Schiller study about long term P/E ratios and future returns.

      You’ve seen this study right? It is a great asset allocation tool if you have long term time horizons

      Then, how about all of the Haugen studies?

      I mean, this isn’t even a contest. There are dozens of “anomalies” in stock markets – and this is the market that should be most “efficient”

      Then there how about the famous noise trader study by Delong?

      Some people call these anomalies, but I like to call them what they are – proof the EMH is BS and has always been BS.

      You can lead a horse to water, but you can’t make him drink.

  • MPS

    You say “all it takes for EMH skeptics to show they are right is to collect a track record showing that they can predict, ahead of time, when prices are too high, vs. too low.”

    That’s not how I (who am admittedly completely uneducated about economics) sees it. As I see it, we live in a world with a large number of regulatory rules and financial traditions. The debate, in my mind, is whether a modified set of rules might help the market work in a more “efficient” manner (or obtain some quality that is prized more than “efficiency” — like perhaps a degree of stability). For example, to me it seems completely different to claim that I or a government agency can predict when there is a bubble, than to say for instance raising or lowering capital gains tax, or limiting or expanding the extent to which one can leverage investments, would affect bubbles in such way to lessen their negative effects.

    I guess my point is it is not clear to me there is an unambiguous definition of exactly what a market is (once we accept we cannot realistically obtain the theoretical idealization). The essential dynamics — which to me seem to derive from competition and a form of survival of the fittest — arise with and without many forms of regulation.

    • EMH could be correct (“current prices are our best estimate of the value of the item”), but you can still adopt policies which improve things over the long term. For example, central bank monetary policy can provide negative feedback to boom-or-bust cycles. Or, individual investors can put part of their regular paychecks into the market, and win through dollar cost averaging.

      EMH doesn’t prohibit all actions or interventions.

      • Right; the issue isn’t zero vs. non-zero regulation.

    • James K

      For example, to me it seems completely different to claim that I or a government agency can predict when there is a bubble, than to say for instance raising or lowering capital gains tax, or limiting or expanding the extent to which one can leverage investments, would affect bubbles in such way to lessen their negative effects.

      That’s because it is different. The confusion here is that efficient has a different meanings when economists discuss markets generally and when its used to discuss financial markets.

      In general terms an efficient market (one that cannot benefit from regulation, even in theory) is allocatively efficient, which means that all goods are allocated to their highest value use.

      If a financial market is said to be efficient, that means its informationally efficient, which is to say all information available to it is priced into its securities (what counts as available information depends on which EMH you’re talking about). This is a much weaker standard than allocative efficiency.

      As such, its entirely possible that there would be regulations that could improve an efficient financial market, just so long as those regulations weren’t premised on regulators being able to outguess the market.

      Unfortunately, the evidence on bubble prevention and correction is not encouraging.

  • Matthew C.

    This is the wrong methodology for disproving EMH.

    1) Find one of the top successful traders.

    2) According to EMH, his or her success is pure dumb luck.

    3) Do a study of this (until now) very successful trader and see if he continues to be successful or if his returns approach “noise trading”.

    4) If this trader continues to outperform noise trading (random trading) and outperforms the market, subject to an appropriate p value, then EMH is complete and utter tosh.

    5) I have little doubt that smart, successful traders can handily outperform the market since I have seen successful traders continue to have great success long after they were identified as being particularly successful.

    6) Successful trading is mostly about technical analysis (real TA that works like momentum analysis, not chart phrenology and numerology). Therefore statements like “the market is overvalued” or “the market is undervalued” can be true, but irrelevant. For example, right now the S&P 500 is horrifically overvalued versus the norms of the past 100 years, however technical strength (momentum) has the upper hand for now so until that strength reverses you would be a fool to go short.

    The success or failure of the legions of unsuccessful traders is not an issue — what is relevant is whether a successful trader can generate excess returns against the marketplace. If those returns are possible, then EMH is wrong.

    • You faith in technical analysis is not supported by researchers who study it.

      Similarly, your anecdotes about knowing successful traders is also not supported, when expanded to studies with rigorous controls.

      • Matthew C.


        As far as I know the studies looked at the dubious forms of technical analysis, like analyzing “head and shoulders” patterns, “cup and handle” and the like. Real technical analysis is about paying attention to important price levels in the market (support and resistance), and changes in price momentum (including looking at momentum statistics like NYSE TICK and the like). I know the right kind of TA works, because I use it, and, well, it creates a positive trade expectancy (ie: I am profitable).

        The issue with “anecdotal” is irrelevant — if a good trader right now is able to consistently outperform the averages for the next X amount of time with trade expectancy x number of trials that exceeds an arbitrarily high p value, then his trading is an experiment that, by itself, disproves (at least certain forms of) the EMH.

        Now if your version of the EMH allows for certain skilled traders to consistently outperform the averages (as Robin suggests below) then, in that case, I do not have any problem with that formulation of the EMH.

    • The issue is not whether some traders can consistently beat the market, it is whether a regulatory agency could do so.

      • Mr. E

        This is not true at all. The issue is something like “What is maximum economic risk adjusted growth?”

        EMH true believers think that the extra .2% per year we get is worth bank panics and depressions every 20 years.

        Most non-autistic people think differently. They correctly note that in a world with lots of bank panics and depressions, they have good odds of losing everything because of somebody elses bad decisions. They correctly note that maximizing gains is not optimizing risk.

        Even if the EMH was true – even if it was – using it as the exclusive guide in how to run the economy is stupid. We don’t want to maximize our wealth exclusively, we as a citizenry, like relative stability much more.

        How much of your net worth would you give up to guarantee you would not lose the rest? Pure EMH people say “I would never take this option”, but most people would say something like 10%

        We have laws and restrictions on every other area of complex human behavior. Would you really claim that we should abolish all stop lights and traffic laws?

  • salacious

    Discussions of the EMH always seem to elide the question of precisely what information/reality market prices are supposed to be efficiently reflecting .

    Look, a key intermediary step in the financial crisis was a precipitous drop in the risk tolerance of a wide swath of financially critical institutions. If you take that collapse in risk appetite as given, then yes, you could argue that plummeting asset prices are “efficiently” incorporation that new information.

    Except it doesn’t make sense to take the collapse of risk appetite as a given. It wasn’t some exogenous “surprise” like the discovery of gold or something. It was driven by falling asset prices making everyone doubt the solvency of the people who owed them money.. In other words, rather than being an exogenous phenomenon which the market needed to assimilate, it was a dynamic that was in some sense “internal” to the market.

    Even if the EMH as “price movements aren’t ex-ante predictable” is technically true, it doesn’t seem to capture the type of marketreal economy feedback loops that we know exist in real life.

    • Why must each true statement “capture” all real feedback loops?

      • Granite26

        I’m not claiming any relation to reality, but couldn’t a regulatory model be shown to A: improve the accuracy of EMH valuations (Likely for a growth cost) and B: Prevent systematic valuation errors without claiming better valuation in the first place?

        What value does denying EMH have for people who want more regulation?

  • brazil84

    Let’s assume for the sake of argument that there is some number of intelligent traders out there who can outguess the market. (Warren Buffet, Peter Lynch, etc.).

    One can expect that those guys will bid up the price of underpriced stocks and bid down the price of overpriced stocks until the prices are pretty close to being correct.

    It follows that even if such men exist, the market is reasonably efficient.

    The only other possibility is that the market is inefficient but unknowably so. But how would one falsify this possibility?

    So I’m inclined to think that the market is reasonably efficient.

    • SJA

      Nicely stated, brazil84.

  • I don’t consider myself an EMH skeptic, but I do have some problems with it. It assumes price is determined by all available information, but I think it ignores those who for some reason cannot act on their information, and those who act for reasons other than their information, such as a margin call. Also, if the best estimate of next years price is today’s price, what about expected gain? Finally, is the EMH price the value to the outside passive minority investor, or is it the price for a firm or management seeking control?

  • Bill

    Here are some additional attacks on EMH by Mandelbrodt and Taleb:

    Mandelbrodts book: Fractals and Scaling in Finance (here’s an Amazon review: This book deserves to receive 6 stars.Mandelbrot serves up overwhelming empirical,statistical,and historical evidence that financial decision makers are dead wrong in assuming,contrary to the available evidence, that a normal probability distribution describes the outcomes accurately in financial markets .In fact,the Cauchy distribution is substantially more relevant than the normal distribution.Mandelbrot’s work simply means that the standard theoretical models taught in all colleges and universities,the CAPITAL ASSET PRICING MODEL(CAPM) and the BLACK-SCHOLES equation, give correct answers if and only if the relevant probability distributions about the movement of prices in financial markets over time are all normal

    An article in Scientific American about Mandelbrodt fractals and finance and effects on discrediting EMH:

    Taleb’s Black Swan

    If you can’t predict, then it is chaos, QED.

    • Peter Twieg

      Does the EMH rely on normally-distributed financial outcomes? Non-linearity really doesn’t imply unpredictability. It’s my impression that this is a particular critique aimed at some tools used by professional traders. Is this argument being extended to argue that traders are just so disastrously insistent on using normal convenient distributions that a government bureaucracy would be able to outpredict them?

      • Bill

        It is that the world is not normally distributed, and is fractal and chaotic, subject to wild pertubations.

    • CAPM and EMH are quite separable theories.

      Eugene Fama agrees with Mandelbrot that the distribution is not Gaussian but has fat-tails.

    • Doug

      The distribution of returns has nothing to do with whether the market is efficient or not.

      Case in point let’s say I am selling a security that has a random payoff of $100 with 1/10 chance and $0 with 9/10 chance. Let’s also say this security is not correlated with any other asset price, so that all marginal buyers are risk neutral.

      As long as the security is prices at $10 it is “efficient” but the returns to it certainly are not normally distributed.

  • bogdanb

    In light of a couple of comments above, I’m not totally sure I understand what’s meant by “efficient” in the term EMH.

    But if I understand it correctly, there seems to be a hidden circularity in your argument. To distill what I think you’re saying, “if the markets were not efficient, there would be a practical method to out-guess markets with regards to future prices (and evidence thereof, i.e. people with long strings of successful predictions)”.

    However, the prices we’re discussing (and their variation) are effectively caused by the markets. So in practice the evidence only indicates that there’s no “better” method than markets to determine the future prices caused by markets, which isn’t that remarkable.

    For instance, if prices were (in an alternate world) simply random* (decided by a lottery at regular intervals), it’s quite certain that nobody would be able to have a “winning streak”; but that wouldn’t be evidence in favor of the “Efficient Lottery Hypothesis”. Similarly, if all prices were fixed all the time, nobody would be able to have “winning streaks”, but that wouldn’t be evidence for “Efficient Conservatism Hypothesis”.

    (It seems obvious that both systems I mentioned would fail eventually; we even have some examples for economies with state-directed prices. But markets bubble and crash, too, every now and then. Anyway, I’m not arguing if the system works or not, only that the EMH doesn’t mean exactly what people seem to say it means.)

    In my view, the test of the EMH (the way to falsify it) is not to find a method to outguess the prices it itself will generate. The test would be to check if the prices generated by other methods (i.e., without a market, or with a differently-regulated one) can lead to a more “efficient” (by whatever definition) distribution of resources. That’s not a very easy experiment to make…

    • bogdanb

      *: Actually, I think randomness has a significant part in the prices of actual markets, which might explain why it’s so hard to outguess markets.

    • Peter Twieg

      There is a notion of a “right” price out there for a financial derivative, based on the value of the underlying asset upon which the derivative is based. The question is whether the market prices that actually arise reflect the best possible estimate of this value (the EMH), or whether there is some other, better mechanism that the state could employ to estimate prices.

      That’s my understanding of things, at least – “market prices” don’t arise randomly and justify themselves. I think the biggest problem for EMH critics is that they have to assert a better pricing mechanism than markets, and then argue why their mechanism isn’t or can’t be incorporated by traders into market prices – that not only do you know how to improve on markets, but that incentivized traders are just too dumb to incorporate your insights.

      • Someone from the other side

        Derivatives must have a correct price in relation to the underlying asset (and a bunch of other variables, often volatility and interest rates) to conform to the non-arbitrage condition.

        Now, in reality, something along the following should happen: If any arbitrage between asset and derivative is possible, actors will quickly eliminate exploit it and bring the pricing in line with the correct relation.

        However, this may not always work as market are neither complete nor perfect, so some of the trades required to bring the relation back to it’s correct state may not be possible or the fees attached may make them losing propositions.

  • Scott Sumner

    I’ve argued that we shouldn’t be arguing about whether the EMH is true of false, but rather whether it is useful. In my view the EMH is very useful. It helps us understand why markets respond immediately to new information, and why it is difficult for investors to make money with either technical or fundamental analysis. It also explains why index fund investors usually do better than managed fund investors. The anti-EMH model or models? Not very useful as a guide to investors or policymakers, for the reasons Robin already identified.

    I do agree with someone who said that much of the financial data is not normally distributed, but I see that as a side issue.

    • anon

      Nicely put, Scott.

  • Constant

    And for EHM violations to be relevant for regulatory policy, price errors must be so systematic as to allow a government agency to follow some bureaucratic process to identify when prices are too high, vs. too low, and act on that info.

    Despite the distinction made in comments between the EMH and efficient allocation of resources, I would extend the above quote to market failures in general: for market failures (i.e. the failure of the market to conform to some ideal of efficiency) to be relevant for regulatory policy, [etc.]

  • Rich Rostrom

    “EMH skeptics [should show] that they can predict, ahead of time, when prices are too high”

    Nope. Proving that some particular method doesn’t work doesn’t require demonstrating a better method. For instance, a matchmaking service might claim that it can pair ideal partners based on their phrenological indices. Strict reliance on this method has produced some successes, and also some catastrophic failures. Does one have to have a reliable system for picking successes to be able to say that a system which produces frequent gross failures is defective?

    In this case: one first has to define a market (in general, and then some specific examples), and define price and value in that market. One would then need to determine the actual price amounts (not always easy) and the value amounts (often very hard), Then one could compare the prices to the values over time, and see how much they differed.

    AIUI, EMH contends that the differences should be within fairly tight limits. There will be differences, but not very large or very long. If one could show that in some market, the differences were larger and longer than would be possible if the market were “efficient”, that would challenge EMH.

    (An example of a possible EMH violation: what is now being referred to as the “bubble” in higher education. Students, parents, and governments have paid out immense sums to acquire college degrees that don’t have proportional value. The feedback in this market is slow and noisy.)

    • Jeffrey Soreff

      Nope. Proving that some particular method doesn’t work doesn’t require demonstrating a better method. For instance, a matchmaking service might claim that it can pair ideal partners based on their phrenological indices. Strict reliance on this method has produced some successes, and also some catastrophic failures. Does one have to have a reliable system for picking successes to be able to say that a system which produces frequent gross failures is defective?

      I’m not convinced that an after-the-fact demonstration of gross failures is sufficient to say that the process was not efficient. The problem is that the failures might have been truly impossible to forsee with the information available at the time.

      An example of a market that would radically undervalue and overvalue (in retrospect!) securities, yet is nonetheless efficient: Consider securities which have a payout set at $0 or $1, based on the toss of a fair coin. Until the coin toss, these will all be valued at $0.5. After the coin toss, a decision to purchase a losing security at say $0.49 will look like a gross failure – but there was, in fact, no better valuation at that time.

      The only way to demonstrate that an estimate truly is inefficient is to display a better one, computed at the same time as the inefficient one.

  • Doug S.

    Was the market for Beanie Babies efficient?

  • James Andrix

    Typo: EHM

  • Anon

    Wikipedia defines the EMH as:

    In finance, the efficient-market hypothesis (EMH) asserts that financial markets are “informationally efficient”, or that prices on traded assets (e.g., stocks, bonds, or property) already reflect all known information, and instantly change to reflect new information.

    This is a bit different from “prices are our best estimates”.

  • Matthew C.

    Markets exist for “dead stocks” which are headed into bankruptcy and a share price of zero. Their prices usually tend to “bounce around” above zero until finally being delisted.

    In an efficient market all such stocks would go to zero and stay there. . .

    • Doug S.

      There’s a perfectly valid reason for someone to be buying a “dead stock”. Short sellers are contractually obligated to return the stock they “borrowed” to its original owner, even if it has become worthless in the meantime. So if you short sell a stock, and the underlying company goes bankrupt, you still have to go out and buy the stock of that bankrupt company from someone so you can return it – and they’ll charge you for the privilege.

      On the other hand, this does show that the current price of a stock depends on supply and demand, instead of being a direct function of the value of the company.

    • Chris

      Markets exist for “dead call options” which are headed out of the money and into an exercise value of zero. Their prices usually tend to “bounce around” above zero until finally the exercise date is reached at which point they are not exercised.

      In an efficient market all such options would go to zero and stay there…

      (Hint: equities are call options on the value of the underlying company, at least for a corporation with limited liability. )

  • Intriguing! Are most economists in favor of the EMH? How about investors?

  • Aron

    Is a market with strong short-selling restrictions still efficient? Have we magically found the regulatory combination that guarantees efficiency? Did enthusiastic economists who disagreed with the short selling restrictions on financial stocks make some bank?

  • Geoff B.

    Prices make good bait, but they tell us precious little about economic reality until its too late. After twenty five years in the market, I have noticed that prices are efficient at one thing however, efficient at telling us about ourselves. All economists repeat after me, “The price is a worm”.

  • David J

    Civilians hear the term “efficient” and think it means something it doesn’t.

    “Efficient” is a loaded adjective for what the EMH really means, which is that if you had a way to reliably predict price movements, you’d keep it to yourself! Or if you didn’t keep it to yourself, others would use and over-use the prediction until it didn’t work any more.

    So how about we call it the “Unpredictable Markets Hypothesis”? That would better reflect the meaning of the concept.

    Unpredictability does not mean that the price is actually of any use to anyone. It’s perhaps the best prediction of the future price, but perhaps not a prediction of anything else.

  • Bureaucrats may not know better than the markets what the price should be, but they can know whether a pricing system is stable or unstable; that is, whether or not the pricing system suffers from serious positive feedback.

    When a pricing system has sufficient negative feedback, the EMH is a very useful hypothesis. The market’s best guess is reflected in the price. With instability, the pricing system can give spurious results, results sometimes worse than a central planner’s.

    Case in point: look at the silver market back when the Hunt brothers were trying to corner the silver market. The market was doing a terrible job of pricing silver. The commodities markets suffer terribly from positive feedback. Contract holders are able to double up or double down. A price rise finances the bull’s ability to make the price rise higher. Conversely, a price fall finances the bears. Too much leverage makes for positive feedback, turning speculation into a poker game.

    You can find similar action with thinly traded penny stocks. Short traders can be squeezed by manipulators. When manipulators buy up enough shares, the shorts get margin calls forcing them to buy even though they are bears. The markets reflect the inverse of their opinions.

  • If there is such a thing as overvaluation, the market cannot possibly be efficient. An efficient market is one that sets prices properly. An overvalued market is by definition one that is not properly valued. So all that we need to do to show that the market is not efficient is to show that overvaluation is a meaningful concept.

    Yale Professor Robert Shiller did this in 1981. He showed that through the entire history of the market stocks have generated better long-term returns starting from fair or low prices than they have starting from high prices. Valuations have always affected long-term returns. The market has never been efficient. At least not in the way that the conventional theory posits.

    The confusion stems from the fact that the market must be efficient in the long run. The entire purpose of a market is to set prices properly. So there is a good deal of efficiency after 10 years and a high amount of efficiency after 15 years. Market prices are set by emotion in the short term and by economic realities in the long term.

    This means that market prices are predictable but only after the passage of 10 years of time or so. It also means that the conventional investing advice of today (rooted in the old understanding that efficiency takes place immediately rather than only after a long passage of time) is the opposite of works. In a market in which prices are set by emotion in the short term but by economic realities in the long run, investors should be changing their stock allocations in response to big price changes, not practicing Buy-and-Hold strategies.

    There is such a thing as market efficiency. But the old understanding is more wrong than right. The idea that investors don’t need to change their stock allocations in response to big changes in stock prices has caused the biggest loss of middle-class wealth in the history of the United States. So we do need to get that old understanding corrected. And policymakers should be encouraging investors to lower their stock allocations when prices get to insanely dangerous levels (rather than to buy stocks regardless of price, a “strategy” that benefits only The Stock Selling Industry).


    • This means that market prices are predictable but only after the passage of 10 years of time or so.

      I can ‘predict’ most things that happened in 1999 with relative accuracy.

      In a market in which prices are set by emotion in the short term but by economic realities in the long run, investors should be changing their stock allocations in response to big price changes, not practicing Buy-and-Hold strategies.

      That depends on your time horizon, doesn’t it?

  • Psychohistorian

    People often confuse EMH with “the market is rational;” I certainly did prior to writing my Master’s dissertation on the subject. The reality is that the market does not appear to be rational. The reality is also that humans are, in general, not systematically capable of out-predicting the market. Arguing that the market is Efficient in a strong sense, and then concluding that, say, regulation could not improve things, because the market is already Efficient, does not follow from the much weaker fact that people cannot routinely predict the market.

    In other words, the real problem with EMH is the claim that people cannot systematically outperform the market because the market is so damn smart. People also couldn’t outperform the market if prices were determined by pulling numbers out of a hat. The Crazy Market Hypothesis, or the Largely Random Market Hypothesis, don’t square quite as well with good ol’ neoclassical econ, so they get rather short shrift.

  • Don Geddis,

    Brock and Lakonishok a long time ago showed that technical analysts can beat the market. Robin is right that it is unlikely that any regulatory body will be able to replicate this. However, there may well be good reasons for certain kinds of increased regulations, such as to either outlaw certain particularly dicey derivatives, or at least to force the markets to be more transparent and public.


    Fama’s reply is disingenous. I have no idea what Fama has told his students, but one cannot find anything about fat tails in Cochrane’s book. If Fama spoke of fat tails, his students managed to completely forget it. His defense of “portfolio theory” as such is not of standard CAPM, but only of the most general sort of rule, such as a tradeoff between risk and return. Wow. It is also the case that Fama disagreed with Mandelbrot on some crucial points, such as that second moments vanish asymptotically, a key part of his argument for fat tails, although they can still arise if fourth moments do so, even if second moments do not.

  • Barkley, page 35 of Cochrane’s text book: “[In deriving the general price equation] we have not said anything about payoff or return distributions. In particular, we have not assumed that returns are normally distributed or that utility is quadratic.”

    Its when you write down a theory of the stochastic discount factor — when you give a specific theory of how the market prices risk — that you *may* have to make assumptions about the distributions of returns. The CAPM does have these assumptions, but this is not the only risk model.

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