Efficient Markets Confusion

Matt Yglesias and Brad DeLong are both fond of this Economist quote:

The [Efficient Capital Markets] hypothesis has two parts, [Thaler] says: the “no-free-lunch part and the price-is-right part, and if anything the first part has been strengthened as we have learned that some investment strategies are riskier than they look and it really is difficult to beat the market.” The idea that the market price is the right price, however, has been badly dented.

These two parts are not, however, easily separated. That same article explained:

The efficient-markets hypothesis” (EMH). … Eugene Fama, of the University of Chicago, defined its essence: that the price of a financial asset reflects all available information that is relevant to its value.  … If the EMH held, then … deviations from equilibrium values could not last for long. If the price of a share, say, was too low, well-informed investors would buy it and make a killing. If it looked too dear, they could sell or short it and make money that way. It also followed that bubbles could not form—or, at any rate, could not last: some wise investor would spot them and pop them. And trying to beat the market was a fool’s errand for almost everyone. If the information was out there, it was already in the price.

EMH claims that current market prices are the best available estimates of asset values; it does not claim that these two sets of numbers are exactly equal.  After the fact you will of course be able to look back and see that price estimates were once in error, either too high or too low relative to the right answer.  But the EMH is only wrong if you could reasonably have known to say the direction of the error at the time, using info “available” then.   And if you could have known then that the price was too high or low, you could have bought or sold based on your info, and gained the “free lunch” of superior investment returns. 

On this topic, Paul Krugman was reminded of:

An old paper by Larry Summers mocking finance economists as the equivalent of “ketchup economists”, who believe that they’ve demonstrated market efficiency by showing that two-quart bottles of ketchup always sell for twice the price of one-quart bottles.

In the case of housing, buyers do carefully compare prices — with the prices of other houses. That is, they make sure that two-quart bottles of ketchup are the same price as one-quart bottles. As we’ve seen, however, they don’t do a very good job of checking whether the overall level of housing prices makes sense.  Yes, it was a bubble — and as Larry said way back when, the ketchup test just isn’t enough.

The key question of course is: who could have reasonably known it was a bubble at the time?  Any such person could have gained the free-lunch of superior investment returns.

There are several variations on the Efficient Markets Hypothesis, depending on what info counts as “available.”  Weak versions only count very widely and easily available info, while strong versions even count info available with difficulty to only a few.  The strongest possible forms are silly, and no one ever believed them.  Weak versions, which require info to be available to many deep-pocket market speculators, are much more plausible, and I don’t see recent history as offering much evidence against them.

What widely available info should have told you the market was in a bubble?  And if you think you see such info, why did so few investors actually attend to it?  And if you propose a regulatory regime to fix market mispricing based the existence of such info, how will you ensure that regulators attend to that info when investors do not?

The most plausible EMH violations are at the largest scales: long time-period slowly varying mispricings of large global financial aggregates.  This is because these are the most expensive mispricings for speculators to fix; for these problems it is not so much how many people know about them but how many are willing and able to devote resources to fix them.  Unfortunately, these are also the hardest mispricings for regulators to fix as well, for similar reasons.

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  • babar

    i thought there was a housing bubble (in new york at least) because i saw the extent to which people were leveraging themselves. i knew the basics of median income and interest payments, etc in the city and i figured that not everyone would be successful or lucky, and if enough people weren’t, there would be problems with the price level.

    is this ‘widely available info’?

    i did not see the financial crisis, and even if i had, i am sure i would have guessed in advance that the dollar would have been smashed by it. i wasn’t that sophisticated — i didn’t even see that basic macro aggregates would be so effected, and so i lost a lot of money in equities.

    BUT: when you say ‘few people benefitted from the housing bubble’, i am somewhat puzzled. a lot of people did by making money in bubble jobs on the way up. a lot of people did by selling their houses near the peak and buying something smaller or renting. and a lot of people refused to pay prevailing prices for housing. they all stood/stand to benefit at least somewhat. i did all three, to some extent.

    if you are saying that there were few leveraged speculators who cleaned up, that’s for sure. but remember that if you are shorting a market that is shooting up, timing is very important. the road must be strewn with the corpses of those who went short housing in 2004, 2005, and 2006.

  • The most plausible EMH violations are at the largest scales: long time-period slowly varying mispricings of large global financial aggregates.

    Great point, Robin. More generally, it would help if traders had access to the frequency spectrum of buying and selling from particular institutions in the market. Actually, there are all sorts of practical implications that flow from this observation, which I chip away at explaining at Broken Symmetry.

  • The idea that bubbles disprove the efficient market hypothesis is widespread but silly. The efficient market hypothesis says that the market price is the right price for the buyer. Not for the eventual owner.

    When options are bought by traders, who receive a huge bonus if their market value rises, and lose nothing, neither money nor reputation, if the entire market crashes, then the value of risky options to the humans doing the trading is much higher than their value to the corporations and other owners who end up holding them. The efficient market hypothesis then predicts that traders will always take on too much risk, and hence the market will always have periodic crashes.

    To say that the market crash proved that market prices were “too high” for risky investments, is equivalent to saying that the traders would have made more money if they had made less-risky investments. And they wouldnt’ have.

    Bailing out financial institutions, of course, makes the trader’s calculation of risk exposure even less in the future, intensifying future crashes.

  • (In my previous comment, I’m attributing the recent market crash to professional traders, not to individuals buying and selling their own houses. I believe this is the currently-accepted view.)

  • Captain Oblivious

    While in theory you can profit from any “insider knowledge”, in practice it’s hard to profit from a housing bubble… sure, you can sell all of your houses at an absurd profit – but most people only have one house, and they kind of need a place to stay, and buying another (inflated) house would eat up all their profits.

    In the stock market, you can “go short” to circumvent this problem, but I don’t think there’s a well-developed market for shorting houses. I tried to sell my neighbor’s house once, but even though I promised to buy it back after the crash he just wasn’t interested!

  • Hal Finney

    A good bubble test exists today: the price of oil. As this LA Times article quotes one analyst:

    “Here we go again,” Bart Chilton, a commissioner at the Commodity Futures Trading Commission, said late last month. “Crude oil prices are up 60% on the year. Supplies are at a 10-year high, and demand is at a 10-year low. You do the math. Why should prices be over $70?”

    (Prices have fallen since then but are still around $64 last I checked.)

    So, what is the objective test which will tell us whether or not this price is reasonable? And if it’s wrong, is it too high or too low? There should be some way to answer this, if the EMH is as wrong as critics claim.

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  • The market for horse betting is very efficient, yet on certain types of bets the market is systemically wrong.

    Here is a simple example. Suppose that horse X is a massive favourite. People correctly think that since the market prices risk right, then to bet the massive favourite to run second or third is not going to return much money.

    So many people don’t make the show or place bet.

    Since the show and place pool winnings are divided amongst only those who made the made, the small number of show and place betters on the favourite can make a lot of money, if the favourite runs second or third – especially if the winner was a long shot.

    This is fairly well known. I can send you the technical details if you care.

    • Constant

      About fifteen years ago I picked up a book about something very similar to this, possibly the very same thing. There was a formula, which I programmed into an HP calculator, you then punched in the numbers. The problem was that I simply wasn’t fast enough: it took time to punch in the numbers, run the formula, and go from where I could see the numbers some distance to the window where I could make the bet. It took long enough that the numbers changed, rendering my decision obsolete and essentially random. And the track takes such a large cut (15% I think) that random guessing loses money fast.

      • Constant;

        After the price for the bets are formed, it is possible to check the analysis of the model.

        Prior to betting, to make money, you have to do a lot more than use the formula. You have to know what you are looking for at the tote board volume changes.

  • m.r.

    Although I think the MEH is a very useful framework, I see two problems.

    1. It’s not consistent: If everybody beliefs in the MEH, noone is ready to bear the costs of research (i.e. idenfify the fundamental value). Therefore there’s no gravity towards fundamental value because you have to assume that even your private information is already priced in.

    -> This first problem ist not relevant in real markets, but I think it’s a fair characterization of most private investors (and pension funds). They don’t need to believe that the MEH is perfectly true, but they don’t have the ressources (time, skills, data) to identify the fundamental value.

    2. The problem is that another group of market participants which would have the capabilities and ressources to find the fundamtenal value faces perverted incentives. Most of them are part of an pricipal-agent relation where they do not care about long-term losses. The problem is that strategies based on the fundamental value are likely to yield short-time losses and long-term gains after an uncertain time. The agents (i.e. traders) do not have the incentive to follow such a strategie.

    Hence, there is nobody (are at least no major group of market participants) with the capabilities AND the incentives to bet against bubbles.

  • Michael Webster,

    Charlie Munger of Berkshire-Hathaway fame likes to compare the stock market to the pari mutuel betting system at race tracks. You give a great example of the kind of betting that he likes to do. Mispricings are pretty rare — especially the kind that will generate big returns — but if you wait around long enough to realize the gains, they are out there. Especially since the time horizons for most buyers and sellers could be measured in months rather than years.

  • Unnamed

    There’s the old saying that the market can stay irrational longer than you can stay solvent. Knowing that something is mispriced (contrary to the price-is-right part of the EMH) may not be that profitable if you don’t know when the price will fall back in line (consistent with the no-free-lunch part of the EMH).

    For the housing bubble, I wonder: is there a good way to make a bunch of money based on knowledge that houses are overpriced? Does it still work if he bubble continues to inflate for a few more years before bursting? Are those investments effective at bringing housing prices down (or do they just have indirect, weak effects)? And how strong are the forces that push in the opposite direction, tending to inflate a growing bubble (e.g. from companies that profit from the growing bubble without much exposure to the eventual burst).

    • You beat me to it. Your first paragraph is almost word for word what I was thinking when I finished the Robin’s post.

    • Hal Finney

      There exist housing price futures traded on the CME. You could take a short position there and profit if and when prices drop. If you didn’t use leverage, this would be like any other short trade; it would become profitable once prices fell below your entering price. Right now, U.S. prices are back down to what they were in 2003. If you’d become convinced that we were in a bubble in ’02, you’d still be waiting for profits.

    • One of the answers is to avoid leverage, which increases the probability that you’ll be wiped out before the mispricing is corrected. Consider, for example, how Kirk Kerkorian had to close out his position in Ford last year after getting a margin call and realizing that he might lose his casino. He wasn’t wrong about Ford, but his use of leverage meant that his timing had to be good, and it wasn’t.

      If you go long without leverage, you don’t have to worry how long it will take for the market sentiment to come around. This is, in fact, one of the worst kept secrets of Benjamin Graham’s style of investing. It helps, however, if you can pick Buffett and Munger style companies that will grow over time rather than cheap cigar butts, which again, tend to get wiped out in a bad market before you can get your last puff.

  • The key question of course is: who could have reasonably known it was a bubble at the time? Any such person could have gained the free-lunch of superior investment returns.

    It first might help to first define just what a bubble is, as well as what “normal” looks like.

    Armed with that definition, as the stock market bubble began, it would first be recognized as a disruptive event. Since it began with stock prices rising, the reaction of a rational investor would be to ride the rise, using progressively higher stop losses as time passed to maximize their returns, at least while dividends per share continued to increase. Such an investor would go out of the market and park the proceeds on the sidelines until forward looking fundamental prospects improved after being stopped out. My guess is that would happen either in June 1999 or September/October 2000 depending on where the stops might be reasonably be set.

    As far as “free lunch” returns go, yeah, it can be done (you find a number of such events from recent months documented at the link, three taken advantage of). As for being able to take advantage of such changes, that depends upon the resources one has available to do so at the time such an event that can be exploited occurs, the expected duration of the event, expected duration of the holdings, as well as the transaction costs involved and other opportunity costs. As a practical matter, it ain’t necessarily easy!

    The EMH works in a general, stochastic kind of sense. You have to accept the continuous and varying presence of noise in the system however to really understand how stock prices work, which the EMH really doesn’t in a useful way.

  • tg

    Would increase sales volume following price increases suggest speculative activity?

  • Jim Babcock

    The price-is-right hypothesis only works for commodities. It does not work at all for currencies, because there is no “right” price for, say, British pounds in American dollars. The problem is that most common investments, including stocks, are more like currencies than like commodities; they have almost nothing to anchor them to any particular price, so they’re worth whatever people think they’re worth, because people think they’re worth that much.

  • Roman Sanz

    I think the best way to kick start a sagging economy is to do nothing and let consumer confidence return on it’s own. When I say do nothing, I mean not trying to stimulate the economy by giving money to people, but rather to make changes to factors that effect the economy, such as regulating the credit card industry. This, I believe, is a more effective way to get people to spend if they believe that it’s safe to do so, giving money to people will likely just cause them to save it for another day.

  • tg

    A classic theory of price might suggest that an increase in sales volume in response to increasing prices (cet. par.) could be indicative of speculative activity.

  • The classic consideration values assets at their future income stream. Stocks can be volatile because earnings can be volatile but p/e can be a measure of risk if not value. Housing not so much as incomes and rents change slowly and the Fed considers income increases inflationary beyond a low level, dramatic increases can only signify bubbles. Debt based on prices and price appreciation rather than income are inherently bubbles. The Fed view institutions are big enough to know what they are doing, together with the institutions view they are only doing what the Fed wished was a prescription for disaster.

  • Psychohistorian

    What new information became widely available that caused the bubble to burst? The EMH is an affirmative theory and thus has a burden of proof. “It is not the case that the EMH is correct” is the default, null position.

    Also, see pretty much everything Shiller ever wrote on how we could have predicted the market collapsing. I’m not saying EMH is wrong; it appears to have meaningful long-term validity, but huge deviation appears possible in the short run. And merely saying “People can’t profitably short the market” doesn’t mean anything, the market can stay irrational longer than you can stay solvent; you need to know when, not just that the market will collapse, and that piece of information is pretty much never available.

    • Constant

      The EMH is an affirmative theory and thus has a burden of proof.

      The speed of light is proven to be what it is as follows: when conditions were just right that a test could be done (which they rarely are), it has been tested. It has been found, on those occasions, to be that speed.

      Similarly, it may be the case that the EMH has, on very rare occasions when conditions were just right for a test, been tested, and found, on those occasions, to be true.

      In that sense common to the empirical sciences, the burden of proof of the EMH may have been met (and I think probably has been met). It is not necessary that the EMH be tested or testable on every occasion, for it to be considered an empirically confirmed hypothesis. Thus the burden of proof does not extend to a requirement that it be specifically demonstrated to hold for a specific bubble, any more than the burden of proof for a claim about the speed of light extends to a requirement that the speed of light must be shown to be that speed right now.

  • svs

    The key question of course is: who could have reasonably known it was a bubble at the time? Any such person could have gained the free-lunch of superior investment returns.

    I think many knew there was a housing bubble but did not know when it was going to burst – so a big percentage of them stayed away (others thought they could get out before it burst and some did get out before it burst)

  • did anyone else desperately try to convince people with multiple homes to sell off all but their primary back in 2006? You’d think that i’d have gained some social capital after it turned out I was right.

  • Doug S.

    > The key question of course is: who could have reasonably known it was a bubble at the time? Any such person could have gained the free-lunch of superior investment returns.

    Could you explain how you make money betting against a bubble without knowing when it’s going to burst?

    • Constant

      Maybe one of Taleb’s methods for profiting from a black swan economic dive could be adapted for a burst bubble. The unpredictability of the timing of the burst seems a good match for the unpredictability of a black swan dive.

  • One reason for the housing bubble may be that there weren’t any convenient ways for people to bet against the bubble until it was too late. Quoting from http://www.aeaweb.org/annual_mtg_papers/2009/retrieve.php?pdfid=443:

    The ABX indices played several important roles in the panic. Starting in January 2006, the indices were the only place where a subprime-related instrument traded in a transparent way, aggregating and revealing information about the value of subprime residential mortgage-backed securities (RMBS). Other subprime-related instruments, RMBS bonds, Collateralized Debt Obligation tranches, Structured Investment Vehicles’ liabilities, and so on, do not trade in visible markets and there are no secondary markets.

    The CME housing futures that Hal mentioned were also created in 2006. It’s true that the correction/panic only started some months after the creation of these markets, but we can perhaps attribute that to a period of learning by the market participants.

    One interesting question at this point might be, why were these markets created so late?

  • During the tech boom I bought stock in a gold mining company because it seemed obvious to me that eventually the boom would end, people would get nervous, and gold would go up.

    If I recall correctly it was around $1, and the company had suspended much of it’s operations because the price of gold was too low to justify digging it out. But it had gold supplies on hand that were worth more than it current market cap, even at the low gold prices.

    The boom kept booming, the share price went as low as $0.25, and I wished I had more money to invest. After the bubble popped, I think I sold at around $6.

    I don’t think it requires special insight to see that people are trading with their emotions, and it doesn’t require perfect timing to just invest in things that aren’t the things that are obviously going to crash.

  • Caitlin

    The best part is that Larry Summers quotes Google searches on “recession” as a sign the economy is getting back to normal. http://www.newsy.com/videos/economy_and_the_search_terms As, Google holds the answer to our problems. Since people aren’t searching “recession” as much, the economy must be getting back on track

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  • eccdogg

    There were lots of ways to bet against the bubble.

    Shorting KB homes and Countrywide would have been a start. If there was a bubble those guys were sure to get nailed.

    Also you could have totally moved everything into cash out of the market or just shorted the S&P knowing that housing had been a huge driver.

    Big players could short MBS in a bunch of ways too, not just with the finacial contracts.

    Also the “The market can stay irrational longer than you can stay solvent” issue is overdone. As long as you don’t use leverage there is no reason that you can’t ride your bet indefinitely. Just set aside cash for margin calls,

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  • To people who overestimate (due to hindsight bias, etc) their ability to have made money, it is easy to mistake EMH claims as saying prices are wiser than EMH actually claims. So it might be better for explanations of EMH to put more emphasis on how much worse people have been at finding inefficiencies than they think they were or would have been.

    Your reference to “deep-pocket market speculators” suggests that acquiring valuable info requires money. My experience indicates that money doesn’t help much. The main costs are time (and probably loss of self-esteem) to learn to correct for overconfidence and to research a large number of potential inefficiencies (of which only a small number will turn out to be profitable).

    • Douglas Knight

      The “deep-pockets” isn’t about acquiring the info, but about moving the market. Maybe small players have lots of info not in the market, and make money off of it, but if they don’t move the market, they’re not relevant to the price. So the price doesn’t reflect that info (at least not very well), only the info available to big players.

      People like to bridge the two worlds by saying that rational agents will become big players. But people have declining marginal utility with their own money and skewed preferences with other people’s money.

  • Matthew C.

    In the very short timeframe (seconds and minutes), there are certainly price patterns in the stock market that allow for trading profits for experienced and talented traders who understand and can see the price / time patterns in the markets.

    I suspect that other traders than myself are able to capitalize on medium and long term price movements, but I can personally demonstrate that EMH is wildly incorrect for very short timeframes (if by EMH it is meant that there are no ways of predicting the timing and direction of financial instrument price changes accurately enough to profit from them).

  • David

    There is an assymetry between long and short which helps drive bubbles. Going short exposes you to unlimited risk. Buying puts requires a bet not only on how wrong the price is but when it will be corrected. I made a little money on long term puts on a couple of homebuilders, but I would have done much better had my puts expired a year later than they did.

    So I think you can know there’s a bubble–I was certain of it for years before it popped–and yet be at a disadvantage when trying to profit from it. The only low-risk way to benefit is to not participate. Unfortunately, I couldn’t even get that right. I bought a house in 2007.

    You asked about widely available info. There was plenty. The rate of growth relative to historical averages and the growth of personal income, rental propery selling with negative cash flow, posh hotels being converted to condos, DTI limits increasing from 25% to 55%, etc.

    • tg


      Could you corroborate the 55% DTI limit. Where did you get that?

      • David

        tg, personal anecdote. When I was shopping around for a mortgage in late 2006 I was hearing that from mortgage brokers. Googling DTI 55% turns up old sites like this one:


      • tg


        I had just read another blog citing 55% yesterday, hence my interest.

        From what I can tell, that 55% DTI is only for non-conforming loans and was a back-end DTI. That would have been a tough piece of data to cull in the moment, and likely would have been very few loans.

  • David

    tg, so what?

    • tg

      David, just saying that’s hardly widely available info.

      (That’s not why I wrote, though. Like I said, I read the number elsewhere without citation in which it was critical for an argument – so I was just interested in where that specific number is coming from.)

      • David

        I beleive it was common knowledge in 2006 to anyone who was paying attention. Certainly widely known enough for EMH to hold if EMH holds at all.

  • Charles Davi of Derivative Dribble started off his blog with The Not So Efficient Market (Theorem) Hypothesis, which explores the distinction between two different meanings.

    John Holbo has highlighted the EMH in his series of “refuted economic doctrines”, which are now going to be made into a book “Dead Ideas From Live Economists”.