“So we are again driven back to the position of the EMH (efficient market hypothesis). Pricing irregularities may well exist and even persist for periods of time, and markets can at times be dominated by fads and fashions. Eventually, however, any excesses in market valuation will be corrected. Undoubtedly with the passage of time and with the increasing sophistication of our data bases and empirical techniques, we will document further departures from efficiency and understand their causes more fully. But I suspect that the end result will not be an abandonment of the profession’s belief that the stock market is remarkably efficient in its utilization of information.” Burton G Malkiel, ‘efficient market hypothesis’ The New Palgrave: A Dictionary of Economics 1987
“Have capital market booms and crashes discredited the efficient market hypothesis? This column says yes and suggests a new model that explains asset pricing in terms of a battle between fair value and momentum driven by principal-agent issues. Investment agents’ rational profit seeking gives rise to mispricing and volatility.” Dimetri Vayanos and Paul Woolley, ‘Capital market theory after the efficient market hypothesis’ , October 2009
Nathanael Smith and I suggest in our 2009 book (Economic Contractions in the United States: A Failure of Government) that the efficient market hypothesis (EMH) did not fail in the United States over the period October 2007-June 2009, as so many critics of the rational choice model from the standpoint of behavioral economics allege. At least, EMH did not fail in any way that justifies a fundamental revision of its role as a mechanism for the allocation of scarce capital resources within the US economy.
Inevitably, the extreme movements in stock prices over the period under review have raised doubts about this proposition. The Dow Jones Industrial Average (DJIA) peaked at 14,200 on October 9, 2007, fell to 9,600 on November 4, 2008, declined to an apparent bottom of 6,500 on March 6, 2009 and rose to 8,750 in mid-June 2009, when our book went to press. Since then the DJIA has risen albeit unsteadily to 10,300 where it appears to have stabilized. These shifts in value are far cries from the marginal changes typically associated with the behavior of the DIJA. Nevertheless, in our judgment, these facts can be explained without abandoning the EMH paradigm as long as EMH is defined from an Austrian economics perspective in terms of dynamic rather than static criteria.
We use weak-form dynamic efficiency (in the Austrian sense) as the basis for our judgment. The basic postulates are that all actors maximize expected utility; that on average the expectations of the population of investors are correct in the long run; and that actors update their expectations to account for new economically relevant information when it appears. EMH allows that some investors may over-react and others-under-react to new information, but that such behavior is random and follows a normal distribution pattern.
Under weak form dynamic efficiency, future prices cannot be predicted by analyzing past price data, and excess returns cannot be secured in the long-run by using investment strategies based on historical share prices or other historical data. Prices follow a random walk. Because efficiency is not instantaneous (as the Chicago School suggests is the case) sophisticated models may be able to exploit short-term anomalies in the market, and take advantage of market momentum as the market over- or under-shoots its equilibrium. This opportunity explains the apparent successes of some hedge funds, brokers and investment banks during the early years of the 21st century. However, such returns on the average are wiped out in the long-run, as the market as a whole re-adjusts, as occurred in the United States late in 2008.
Stock market bubbles represent such short run anomalies. Note, however, that individual actors remain rational throughout the bubble, recognizing that the bubble exists, but unable to identify the peak or the trough, which is determined through interactive trading. In this respect, a distinction must be made between risk and uncertainty (in the sense of Frank Knight 1921). Risk can be calculated (albeit subjectively) on the basis of past experience. No such probabilities can be attached to uncertainty, because of the absence of a relevant past.
During a stock market bubble, the turning point cannot be calculated in terms of probabilities. The best predictor of the immediate future is the immediate past. Many actors therefore rationally follow the trend (momentum) and continue to buy during the upturn, even borrowing money to buy on margin. For a number of reasons, including inertia and differing attitudes towards risk, some stockholders sell, thus clearing the market at any point in time.
Those who sell at or near the peak are lucky. Those who are left holding over-valued stock once the music stops, and the bubble bursts, are unlucky. The selloffs that follow are entirely rational, even when the downturn overshoots, under the influence of downward momentum decision-making.
Those who find fault with the EMH, and suggest that profit opportunities are available for exploitation, should be subjected to the empirical test. Are they billionaires or are they not? Yes, Warren Buffet passes that critical test. Others who put their faith in Buffet typically do not fare quite so well. Many others lose their shirts on their market gambles. Talk is cheap, and for the most part should be downplayed for what it is. Actual market success is a better guide; and remember that we define efficiency as a long-term concept, rendering transient short-term market successes less relevant for EMH.
Readers should be alert to the fact that many of those who criticize EMH also criticize free markets more generally. By instinct, they are interventionist, by nature they are paternalistic (albeit with other people’s wealth). In essence, they tend to be advocates of Lange-Lerner, advocating the substitution of socialist calculation in place of free market values. They believe that a central planning agency (in the United States read the Federal Reserve Board and/or the Treasury Department, and/or the FDIC) is able to determine stock prices more efficiently than the free market; that such a central planning agency should oversee the stock market with detailed financial regulations, in order to head off unjustified market movements. Well, we know what such central planning did to the economies of the USSR and its Evil Empire, do we not, Dear Readers? We know, pretty much, what is happening in Venezuela and Bolivia, to say nothing of Cuba and North Korea; is that not so?
The error inherent in the ruminations of such market critics is the complete absence of the Austrian economics insight. Stock market valuations reflect a continuous, decentralized process of information creation, assembly and dissemination that cannot be replicated by a central planning body. A risk-averse bureaucratic central authority could never adequately take into account the wide range of attitudes towards risk and uncertainty; nor could it recognize and evaluate the multiple opportunities for investment that commingle in a market economy.
Do I believe, and believe fervently, that a deregulated US stock market is more dynamically efficient than would be some suitably weighted Bernanke/Geithner/Bair triple in allocating capital resources across this great nation? I suspect that you know the answer to that rhetorical question.
Tags: Austrian economics, dynamic efficiency, efficient market hypothesis, financial market regulation, momentum investing, principal-agent problem, risk versus uncertainty, socialist calculation debate, stock market bubbles