Use and abuse of the EMH


Before the GFC journalists and columnists seldomly mentioned financial market efficiency.  Not only was the efficient markets hypothesis (EMH) not a hot topic, but I think that journalists realised that the market efficiency has a precise definition and without a complete understanding of that definition they might come unstuck by discussing the EMH.  But now it is trendy, almost compulsory in some quarters, to mention the EMH as a primary cause of the GFC and disparage it wherever possible.   Here are some examples of discussion of the EMH.

1. From the FT on 27 October 2009       “… and a belief in efficient markets proved wrong. These beliefs must be abandoned.”       This is an example of the common usage of the EMH as a straw-man.  Nobody believes that financial markets are perfectly efficient.  Grossman and Stiglitz proved in 1982 the impossibility of perfectly efficient markets.  All financial markets are inefficient to a greater or lessor degree. 

2. John Quiggin writing in the AFR on 5 Nov 2009.     “With the spectacular failure of the efficient markets hypothesis over the last two years, it is no longer possible to put any faith in general claims about the superiority of the private sector”.         This example shows that “failure” of the EMH can now be used to explain anything.

3.  Brian Toohey in the AFR on 14 November 2009 quoting Jeremy Grantham     “… it is worth noting that every valued job created by financial complexity is paid for by the rest of the real economy, and talent is displaced from real production, as symbolised by all the nuclear physicists on proprietary trading desks.”       This quote is an example of the desire to talk about market efficiency leading respected columnists a long way from their area of expertise.

4.  The Economist on 12 December 2009 in the Economic Focus column    “If markets were truly efficient, carry trades ought not to be profitable because the extra interest earned should be exactly offset by a fall in the target currency”.       This example makes my point that journalists used to be reluctant to discuss market efficiency for fear of demonstrating that they don’t understand basic finance concepts.   But now even newspapers of the quality of the Economist are happy to publish anything that discusses market efficiency, regardless of how uninformed the commentary is.

19 Responses to "Use and abuse of the EMH"
  1. EMH is a bit like Machiavelli’s writings – more often quoted, or disparaged, than understood. Maybe the local journos could use a Fin Man primer before editorializing.
    Mind, I’ve seen some nonsense written by financial commentators and analysts about CAPM as well.

  2. Straw men abound with regard to the EMH.  Quiggin keeps saying that the EMH claims that the market price is the correct price (rather than that they are a relatively better estimate of an asset’s value, on average, than other methods of valuation.)  Therefore all he has to do to dispute the EMH is to find instances where he can demonstrate (after the fact) that an asset was mis-priced.  Quiggin doesn’t bother with proposing alternate methods of valuing assets, he just assets that regulators can do a better job than markets.
    That said, I think there can be an argument for using regulation to limit volatility, because large swings in asset prices can have significant externalities, as the GFC has clearly demonstrated.  My preferred approach would be to limit the leverage of banks and other “to big to fail” financial entities, especially since they seem to have an implied insurance against bankruptcy.

  3. I don’t understand your excerpt of Brian Toohey quoting Jeremy Grantham.  Are you disparaging the former or the latter?
    If the latter, I would refer you and your readers to Grantham’s quarterly newsletters (at, from which the quote is taken, in which he frequently cites empirical evidence that totally refutes the EMH.

  4. Some quick responses
    1. Contrary to your claim, I’ve been writing about the EMH and its implications for well over a decade
    2. You’ve got the point backward. The EMH is a necessary condition for a general claim that private sector provision of goods and services will always outperform public provisions. If the EMH is false, no such general claim holds and it is necessary to consider the issues on a case by case basis, as I’ve argued many times
    3. Bruce gets my position wrong, as can be seen here
    My claim is precisely that the bubbles of the 1990s and 2000s could be and were recognised at the time and that price estimates formed on the basis of fundamentals will outperform those generated in bubble markets, and can therefore justify regulatory intervention.
    4. You’ve spelt my name wrongly, which confirms me in the view that you haven’t read me with great care
    5. What the GFC has shown is that most economists who have relied on the EMH don’t actually understand it. Those who still adhere to it are demonstrating a commitment to dogmatic reasoning immune to refutation.

  5. The EMH claims that financial markets are information-ally efficient not allocatively efficient. Information efficiency entails that financial markets trump all other predictive techniques in valuing assets. This implies 1) financial markets immediately reflect all public information and 2) financial markets can compute firm values better than any other model. Allocative efficiency implies the resources of an economy are allocated to maximise social welfare.
    The two don’t necessarily go together. A big, bad monopoly might be valued correctly by financial markets from a discounted cash flow perspective. However, in doing so, the monopolist might be larger than is socially optimal. So even if financial markets are information-ally efficient, it might be best to regulate them.
    But there are reasons to think that financial markets are not information-ally efficient. There is strong evidence of volatility clustering/memory in financial markets. EMH is inconsistent with volatility clustering because the EMH rules out future prices being dependent on past prices. This dependency means it is possible to develop a model that inputs past prices and generates forecasts which have some predictive power relative to the present price.
    Another reason to question the EMH is that is that financial markets are prone to bouts of illiquidity. In these situations, market prices do not reflect expected discounted cash flows. As these liquidity traps are self-generating from within financial markets, financial markets are like a thermostat that works only 80 per cent of the time. Furthermore, I think there are signs of impending illiquidity which are not reflected across all financial market prices.
    It is possible to claim that “but for the Government” financial markets would be efficient. But the amount of Government intervention in financial markets fell prior to the crisis. If financial markets cannot function in the presence of any Government actions, then they are not an appropriate mechanism for allocating capital in any society that has a state.

  6. I don’t imagine many people could argue in hindsight that a GFC asset-price bubble formed (as have done for centuries), however on what basis would a regulator step in? At what point does the market price assets in error?

    My understanding is that very few individuals and institutions (Bank for International Settlements, Barry Shiller come to mind) recognized the asset-price bubble of the GFC. Without a formal hypothesis or framework it would be a very brave regulator that goes against the grain under those circumstances.

    Don’t take this as an attack, but rather as a practical what-if question… An excellent working example of what appears to be an asset-price bubble is Australian (especially Melbourne) residential property prices. What is the way forward here for a knowledgeable regulator? Should the regulator in the form of the Reserve Bank put in a 0.5-1.0% (for example) interest rate increases because they decide that prices do not reflect “correct fundamentals” (my quote) and housing prices must come down? When does the regulator possess more information than the market?

  7. Using the very confident term “right price” in place of the much more modest “a relatively better estimate of value of an asset than other available estimates”, seems designed to distort the EMH position.  The EMH position is one of humility in the ability of individuals to outsmart markets in the long term, and this includes regulators.
    I think the worst critiques of the EMH are those which say that behavioural economics disprove the EMH, because it assumes that regulators are somehow immune from these same forces.  If regulators can successfully separate themselves from their “animal spirits”, why can’t hedge fund managers do it as well, and profit handsomely?  The best critiques of the EMH are those that demonstrate reasons why the crowd is unable to act on new information, such as the difficulty in profiting from long-term bets on the prices falling.

  8. @Jim: Informational efficiency of capital markets is necessary but not sufficient for allocative efficiency
    @Bruce: “Right price” is short and captures the intuition most users of the EMH rely on. Of course it needs a full explanation, which is why I gave it.
    As you say, the critique of EMH depends on the Keynes argument summed up by the quote “the market can stay irrational longer than you can stay solvent”, something supported by the experience of those who bet against the dotcom boom in the 1990s.
    As regards humility, I don’t see a whole lot of that coming from participants in financial markets.

  9. “Right price” implies something along the lines of the NPV of future cash flows, which is obviously unknowable, and I have only heard detractors use this term.  “Best estimate” is a far more descriptive short term for how people use the EMH concept.  The fact that it took a two-page justification for the “right price” term is evidence that it is not intuitively descriptive.
    As for humility, Fama pointed out that those active participants in financial markets build their entire businesses on the concept of market inefficiency.  They are the least likely supporters of the EMH!  Those who believe markets are mostly efficient look a lot more like John Bogle.

  10. Unless anybody involved in this thread thinks Adam Smith and the invisible hand of the market actually got it wrong over the longer-term then the market price is the correct price in the absence of any other measure.
    What seems to be the issue is risk management under conditions of a long-term bull market where corporate earnings growth are projected indefinitely into the future, asset price inflation is not targeted by central banks, and the inevitability of an actual downturn – the proverbial black swan event – that is ignored (very few notable exceptions) until everybody runs for the exit. All sellers, no buyers under panic conditions make a monkey of many models. And everybody subsequently announces the death of the EMH…

  11. Dave
    Regarding the quote from Grantham via Toohey.  Physicists are valued in investment banks for their techical skills, particularly in partial differential equations, probability measure theory and programming.  But those aren’t the skills of prop desk traders.  The Grantham quote is a jumble of ideas, which shows that he is speaking about something that is not close to his area of expertise, which has been common in discussions involving the EMH. 

  12. Sam,
    Thanks for your response.
    Well, you might be right about physicists and prop desks. But since the Grantham quote was not even about the EMH, I don’t quite see the connection.
    If you read Grantham you will realise that he has a great deal of expertise on the EMH.  Indeed, as a value investor, he has made his fortune on the back of the EMH being wrong. He articulates the causes of inefficient asset pricing very precisely, particularly the “career risk” associated with not following the herd.
    I might be wrong, but it would appear that all you know about Grantham is the colourful quotes that are picked by the Fin Review.  Since you have an interest in the EMH, I would recommend that you read his work.

  13. John (Quiggin)
    Apologies for misspelling your name — spelling is something of a challenge for me. 

    I  quoted from your AFR article  as an example of the disparaging of the EMH in an article  that has really nothing to do with financial market efficiency.  My recollection is that the article from which I drew your quote was discussing the privitisation of the Queensland railway network.  Then right at the end of the article the EMH pops up.  What has the EMH got to do with the privitisation of railway assets in Queensland?

    The reason I have found discussions of market efficiency in the media and blogoshere perplexing during the GFC is that the EMH is really just a definition. 
    We need some framework in which to think about how much of the total information set germaine to an asset price has been used in forming the asset price.  

    What does it mean to says “adherents of market efficiency”.  All markets are inefficient to a lesser or greater degree.  I would say that is theoretically, demonstrably and obviously true.  

    The EMH justs gives us the language and definitions needed to talk about price formation.  It is not a theory or a philosophy.  There are not people who believe in the EMH and those who don’t. 

    There is a genuine distinction in finance between behavioural finance and the neo-classical paradigm.  But your quote refers to a “spectacular failure of the EMH in the last two years”.   What failure?  How can a definition fail spectacularly?  

  14. The New Yorker this week has a feature, “After the Blowup” in which John Cassidy reports on a visit to University of Chicago, where he interviewed an number of economists to find out how the “Chicago School” has fared in the wake of the GFC. Those he interviews include Robert Lucas and Eugene Fama.
    The article is gated but Cassidy discusses it in a 14 minute audio clip available online here.
    Biggest revelation: Richard Posner has become a Keynsian.

  15. “What has the EMH got to do with the privitisation of railway assets in Queensland?”
    A lot. For many/most privatisations, the sale price is less than a reasonable estimate of the present value of future earnings under continued public ownership, discounted at the real government bond rate. That’s because of the equity premium demanded by private investors to bear the systematic risk in returns. But the equity premium is much larger than it should be under standard versions of CCAPM (this is the equity premium puzzle). If you accept strong-form EMH[1], the private WACC and not the government bond rate is the appropriate rate for evaluating the returns to public assets and this is a non-problem. Provided the private sector is at least as efficient in operational terms, EMH yields a general presumption of superiority for private ownership, as I said in the article. But if you reject EMH, it’s reasonable to conclude that the public sector really does face a lower cost of capital, so privatisation has to be assessed on the case by case basis of whether private owners can make sufficient operational improvements to offset their higher cost of capital.
    fn1. As the acronym implies the EMH isn’t the definition of an efficient financial markets, it’s the empirical hypothesis that actual financial markets satisfy this definition. This hypothesis has indeed failed spectacularly.

  16. Sam,

    Great article. I think you have touched a raw nerve!


    You quote the strong-form EMH. What about semi-strong or weak? You agree that information is perceived differently amongst different people, correct? That is all part of the economy including markets and the government because people’s perception influences their decision-making processes. This impacts on government decision-making as well.

    What would you have done differently? Would you have said that X commodity is overpriced or Y stock is undervalued and then get the regulator to step in?

    I think you are using the EMH incorrectly to state and restate your central premise that Government knows best.

  17. Sean, the big divide is between weak (with which I have no real problem) and strong (semi or otherwise) which is clearly false.
    As to what I would have done differently, I was on the record at the time calling for a restructuring of the financial sector along narrow banking lines to constrain asset price bubbles.

  18. JQ:
    From what I understand of the EMH it means that markets are information efficient, but it hardly means they are efficient in respect of future earnings estimates, as we can’t tell the future, no one can. In fact it would be wrong to categorize any aspect of EMH that way.  And this is why say stock prices move around a lot, as people are attempting to figure what information they gleaned means for future earnings.
    As for the internet craze. I can see both sides of the argument. One argument suggests there was a bubble of large proportions.
    However another , I think more correct side suggests that it is extremely difficult to price future earnings for a technology suite that potentially offered so much. It wasn’t so much that the information wasn’t efficient, as the information was pretty much built into the market place, however the real question was to do with estimating future earnings in a technology sector that was revolutionary.
    As for pricing Queensland’s assets—- I would say that wouldn’t  be at all hard. One would look at what other assets are trading in PE terms both here and abroad and work from there. So in that respect markets are efficient information wise.

  19. ProfQ,

    Can you please explain how it is that you are a major critic of EMH extending this to claiming that the price-setting mechanism of the marketplace is faulty but you are a supporter of the ETS which is about setting a market price for carbon (and the corresponding speculation like in other commodities)?

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