The Efficient Market Hypothesis and its toxic fallout

The framework for understanding financial markets has always been flawed

The Economics Nobel has always been somewhat of an oddity compared to its more illustrious (or should I say, less dismal) counterparts in the natural sciences, literature and peace. First and foremost, it really isn’t a true Nobel Prize: it is awarded by the Swedish Central Bank in memory of Albert Nobel, for Mr Nobel himself didn’t see the need to give an economist such grand an accolade. But more curiously, it is the one prize in which two people can be awarded the prize for saying the exact opposite thing since economics, by its virtue of a social science, is essentially never right (and as more than one economist would like to think, never wrong either). This happened early in the prize’s history when Gunnar Myrdal, one of the foremost social-democratic thinkers of his time, shared it in 1974 with none other than F. A. von Hayek, the intellectual godfather of the Austrian school of free-market loving economists. Fast forward to 2013 and history has repeated itself, this time even more blatantly by giving it to Eugene Fama who authored the Efficient Market Hypothesis, and Robert J. Shiller who has spent his academic career destroying it.

Eugene Fama created a monster, and got the Nobel in return

Eugene Fama created a monster, and got the Nobel in return

Perhaps all that the Nobel Committee wanted was to stir some controversy. It has after all, given the Nobel Peace Prize to President Barack Obama because he wasn’t George W. Bush, even if he ended up conducting an even more intense drone strike campaign than Dubya himself. It also gave it to the European Union for not annihilating itself, since that has been the norm in Europe since the collapse of the Roman Empire. This year’s dubious recipient seemed to be yet again the Peace Prize, awarded the Organization for the Prohibition of Chemical Weapons, probably because giving it to Vladimir Putin directly would have been even too appalling for the fellows in Oslo. Yet in my view, giving Eugene Fama the Economics Nobel came nearly as bad. I will certainly not deny that the Efficient Markets Hypothesis has been one of the basic frameworks upon which financial economics has rested since Fama’s seminal 1970’s paper that formalized it. Yet at the same time, it may well have been one of the biggest intellectual frauds ever imposed on (and by) the economics profession.

What is the EMH?

“I believe there is no other proposition in economics which has more solid
empirical evidence supporting it than the Efficient Market Hypothesis.”
– Michael Jensen (1978)

The EMH rests on the assumption that, in Fama’s own words, “securities prices at any time fully reflect all available information. A market in which prices always fully reflect available information is called efficient”. By implication, nobody can consistently beat the market because prices instantly adjust to all new information, and any variation in future prices that isn’t already priced in essentially takes the form of a random walk. Taking this one step further, we can see that if markets are as efficient as Fama claimed, the asset price bubbles would be impossible to form because this would imply that market participants failed to incorporate available knowledge in their pricing decisions over a sustained period of time. So we have it that according to the EMH, any company’s stock price currently reflects everything that people can know about the company: its cash flow, balance sheet, price-earnings ratio, heck, even the track record of the CEO. Take Apple for example, and how its stock price plunged upon the news of Steve Jobs’ death; markets simple priced in the fact that Jobs’ eventual successor would not be the technology savant that the guy with black turtlenecks was (looking at Apple’s stream of flops since, this has been proven patently true). The first question you might ask yourself is: don’t stock prices change every day? Every hour? Every minute? Yes, they do, but according to EMH, this is all random since the only time prices adjust to fundamentals is when publicly-available information about the company is released, and this usually happens only a few times every month or quarter. So therefore, you might pick the right stock today but your gains will be offset by the losses tomorrow when you’re just as likely to pick the wrong one. To consistently beat the market every time is impossible.

Even without a degree in economics, if the EMH’s basic proposition makes you slightly uncomfortable then you are not alone. It seems a bit too perfect, which is why in a profession that values mathematical elegance above anything else it was not quite surprising that it found its niche as the perfect framework for financial economics, which in the sixties and seventies was gaining strength and becoming a discipline in its own right. Let’s be honest, we economists have physics envy. We want everything to be mathematically demonstrable. As another Chicago Boy, John H. Chochrane, said in a rambling critique of Paul Krugman, “Crying ‘bubble’ is empty unless you have an operational procedure for identifying bubbles”. Really John? If there’s no math behind it, it simply doesn’t hold true?

There’s never perfect information

Remember transaction costs? Apparently Fama forgot about them when he assumed that publicly available information was freely available. But in fact, there are substantial costs for any economic agent in obtaining perfect information (a Bloomberg terminal alone costs $24K a year), and as a result not all agents involved in financial transactions will be so perfectly informed. What happens afterward is what everyone involved in the financial industry knows: that financial transactions are zero sum games because only one side is going to profit from the eventual movement of an asset’s price, whether this be up or down. And the side who has better information will usually be the one to do so. In Tetsuya Ishikawa’s How I Caused The Credit Crunch, a certain investment banker would always ask his clients “so, explain to me how is it you are going to fuck me?” Now, few traders are likely to be so blunt but this information asymmetry is the main reason why prices don’t actually reflect information perfectly. If both sides had all publicly available information about an asset, transactions based on the expectation of profit would not even take place because each side would know precisely when they’re being screwed over. And yet a huge amount of financial transactions taking place worldwide on a daily basis involve one side at least thinking that they can fool the other side into selling low or buying high.

This, ultimately, is why there are traders who can beat the market. Consistently. You ask why Goldman Sachs has its reputation, and that’s because it tends to be on the winning side of such trades more often than not. On an average quarter, it only has one or two days of trading losses, a streak that would be impossible if the EMH were true. Similarly impressive is how the notorious junk bond king of the eighties, Michael Milken, allegedly only had a 4 losing months of trading in 17 years working for Drexel Burham Lambert (the Lehman Brothers of its day). Likewise, some of the world’s biggest hedge funds have been in the game for years, ratching up mammoth profits on deals so risky they might as well be playing Russian roulette. If on average the market can’t be beaten it’s only because there’s enough people beating it as there are people losing, and this should not have been any less obvious in 1970 as it is now. As you can see, the very traders who hold the EMH to be sacrosanct are the one who are proving it wrong every day, every hour, every millisecond, which probably shows how they never actually read Fama’s paper and realized the contradiction (akin to an evolutionary biologist believing in creationism).

In his rather limp defense of Fama and the EMH, Financial Times columnist Tim Hatford (of The Undercover Economist fame) states the following:

Investors who believe in efficient markets make more money – or perhaps I should say lose less money. They do not pay fund managers huge fees to pick good stocks, because they do not think fund managers can pick good stocks. They ignore advertisements touting past performance, because in an efficient market past performance tells you literally nothing about the future. They do not try to time the market, which in practice has always meant rushing in during booms and panic selling during busts – buying high and selling low. In fact, they do not even look at what the stock market is doing from day to day. Why bother? It will not give you an investment edge, and it might well give you an ulcer.

Yet all of that is EXACTLY what the world’s best investors do. And they do it because there’s always going to be a sucker on the other side of the deal, many of who simply couldn’t spend enough to obtain the not-so-free perfect information that the hot shots did.

Forever blowing bubbles

“I don’t even know what [Bubble] means. People who get credit have to get it from somewhere. Does a credit bubble mean that people save too much during that period? I don’t know what a credit bubble means. I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.”
– Eugene Fama (2010)

As bad as the above flaws are, it is the EMH’s implicit denial of the existence of asset bubbles that ultimately did so much damage to the world economy these past years. Hartford tries to portray Fama as a humble academic by virtue of him spending “decades searching for exceptions to his own theory”, but it is clear from this 2010 interview for the New Yorker that he remains steadfastly unapologetic over the limitations of the EMH while living in complete denial over the obvious fact that a massive housing bubble was the immediate trigger for the global crisis (something that no serious economist could possibly deny). His analysis of the crisis is almost comically ludicrous for someone of his academic credentials: according to Fama, the Great Recession of 2009 was really just your average cyclical economic recession which then caused a financial crisis, not the other way around! Furthermore, it was impossible to predict in hindsight, never mind the clear warnings given by co-laureate Robert Shiller as well as many others who saw the mountain-sized housing bubble from miles away. His dismissal of Richard Posner – a very capable economist in my view – halfway through the interview also reeks of arrogance and contempt (“he’s not an economist *laughs*”), an attitude that permeates the whole of this intellectually disastrous interview. This is ultimately a man who knows very well that he got it wrong, that has always had it wrong, but will nevertheless bask in the glory of having a Nobel Prize with his name on it.

And yet Fama still has his acolytes. Tim Hartford ended his piece with this gem:

In the light of the financial crisis, the contribution of Prof Shiller to economic thought is obvious. Prof Fama’s is more subtle: if more investors had taken efficient market theory seriously, they would have been highly suspicious of subprime assets that were somehow rated as very safe yet yielded high returns. Any follower of Eugene Fama would have smelled a rat.

For someone like Hartford, it’s almost scandalous that he missed such a glaring argumentative fallacy and in the process showed how little he actually understands EMH. According to EMH, those subprime assets would not have been mispriced at all. There was no rat to smell. If those Fama followers indeed smelled a rat, it was a rat that was telling them that the EMH had completely lost its sense and validity in the shadow of the biggest asset price bubble of our times.

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