Absurd statements on the Efficient Markets Hypothesis


In his opinion piece in today’s AFR John Quiggin rails against the damage done by the wide spread belief in strong form market efficiency.  What is he talking about?  I don’t know a single person who believes that the strong form version of market efficiency holds.  I challenge anyone reading this to name a single person of any repute who believes that strong form market efficiency holds.  Putting up this straw man of strong form market efficiency and then knocking it down does John no credit.

I have written previously about how the events of the GFC have lead respected columnists to make absurd statements about the Efficient Markets Hypothesis (EMH).   Let me be precise about what the EMH is, so that I can demonstrate that John’s comments are way off the mark.

The EMH has a long history dating back to Louis Bachelier’s 1900 PhD thesis.  Wikipedia provides an account of the history of the EMH.  Work on market efficiency proceeded slowly until the 1960s.  In 1964 Paul Samuelson proved that if all information is at all times incorporated into stock prices then those prices must evolve as a random walk.  At the same time Eugene Fama wrote his PhD thesis on the EMH, under Benoit Mandelbrot.  In 1970 Fama published a review of the theory and evidence of the EMH in the Journal of Finance.   Fama defined three forms of the EMH based on information sets.

Weak form efficiency:  A financial market exhibits weak form efficiency if all past price information is incorporated in current prices.    Can past prices predict future prices?

Semi-strong form efficiency:  A financial market exhibits semi-strong form efficiency if all  publically available information becomes immediately incorporated into asset prices after the creation of that information.  Can individual investors acquire information in the public domain and then trade to earn super-normal returns with that information?

Strong-form efficiency:  A financial market exhibits strong form efficiency if all information, public or private, becomes immediately incorporated into asset prices after the creation of that information.   Does private information exist?

The answer to the last question is an obvious and emphatic YES.  There is private information.  Information asymmetry does exist.  Insiders of firms at least sometimes have material information on the value of the firm’s securities that outsiders do not have.  Adverse selection and moral hazard problems in the capital markets are real.   Nobody, repeat nobody, believes otherwise.   Nobody, repeat nobody, believes that strong-form market efficiency holds in any capital market.

A definition of strong-form market efficiency only exists for the purpose of completeness.  It is a bookend to the other definitions of market efficiency.

It is simply wrong to say that there is wide spread belief that strong-form market efficiency holds.

12 Responses to "Absurd statements on the Efficient Markets Hypothesis"
  1. “It is simply wrong to say that there is wide spread belief that strong-form market efficiency holds.”
    Justin Fox doesn’t agree with you:
    [quote]I completely agree with Fama that most investing is done by active managers who don’t believe markets are efficient. Also, investors were blowing bubbles long before Fama starting writing about “efficient markets” in the 1960s. So investor behavior during the tech stock and real estate bubbles really can’t convincingly be attributed to the teachings of Fama and other finance professors.

    But I don’t think that’s the main point that fiercer efficient-markets critics than I like George Cooper and George Soros are making. They’re saying that the big problem was that regulators and central bankers drank the efficient market Kool-Aid. Adair Turner, chairman of the British Financial Services Authority, put it well in that famous interview that Prospectpublished back in September (subscribers only, I’m afraid; I happen to work with a subscriber):

    [quote][W]e have had a very fundamental shock to the “efficient market hypothesis” which has been in the DNA of the FSA and securities and banking regulators throughout the world. The idea that more complete markets and more liquid markets are definitionally good and the more of them we have the more stable the system will be, that was asserted with great confidence up to three years ago.[/quote]
    What Fama might say in response is, “Well, I never asserted that.” He’s probably be right. But as I wrote in my previous post on the topic, what Turner describes was the key message that emanated from academic finance and economics into the Wall Street and government-policy mainstream over the past few decades. Interestingly, some of the most interesting financial-economic research of the past decade-and-a-half has been about market failures. But the transmission of such knowledge into mainstream thinking occurs with long and variable lags—and Fama certainly wasn’t one of the people out there waving their hands and saying, “Hey, watch out! Financial markets can burn you!”[/quote]

  2. Mike
    In the quotes you provide the commentators mean “semi-strong EMH”.  They don’t refer to the strong form, which is what my post is about.
    Sam Wylie

  3. Umm, didn’t it occur to you that, in a 750 word Op-ed, there isn’t actually room to distinguish between the semistrong and strong forms of the EMH, given that the distinction makes zero difference to the issues discussed in the piece.
    Zombie Economics is easily available on the web and gives chapter and verse on weak, semi-strong and strong forms.

  4. John, how you explain these direct quotes:
    “In its strong form, the one that is relevant here, …
    “Support for the strong form of the efficient market hypothesis … ”
    As Sam rightly points out, what support?

  5. John
    The speed at which information becomes incorporated into asset prices is, I am sure you would agree, a very important subject.  The EMH hypothesis in its various forms provides such a framework.  It is a really a set of definitions for describing the level of informational efficiency of asset markets.
    Clearly the equity market in Australia is more informationally efficient than the equity market in Pakistan.  Public markets are more efficient than private markets.  Large stocks are more efficient than small stocks.
    That is the purpose of the EMH — to be a descriptive tool.  Nobody believes that any markets are perfectly efficient or perfectly inefficient.  But we need some way of describing what efficiency means and the level of efficiency of a particular market.
    I agree that some academics and regulators have overstated the level of efficiency of asset markets and have been too slow to understand the effects of low information efficiency in some markets.  I also agree that over reliance on the efficiency of markets lead to regulatory mistakes leading up to the GFC.
    But wholesale attacks on the EMH are very unhelpful.  They seek to take away the capacity to describe the rate at which information becomes incorporated into asset prices.  They seek to pull something down and put nothing in its place.

  6. <blockquote>I’m confident that anyone that publishes at Catallaxy believes in the EMH perfection model.</blockquote>
    Senexx – The EMH and the idea of perfect markets are two very different notions.

  7. it is important in this kind of debate to distinguish between the position of the academics that develop theories, and the intellectual framework that stakeholders surround themselves with to justify their positions. The latter position is invariably more naive, more uncompromising (‘markets are efficient!’), and invariably more wrong than the academic opinions they draw upon. And, equally often, the academic whose ideas are perverted has little incentive to protest too loudly since that would damage his consultancy income and the sales of his books.
    I know plenty of second-rate finance academics who loudly professed a deep belief in the strong version of the EMH to their students and, more lucratively, their clients. And Fama was and still is their hero. They made good money with this position and they will do so again with the same position because people making money from financial markets still dont want to hear anything else than that they deserve it and hence most certainly dont want to hear that the financial market should be more regulated and earnings should be curtailed.
    Somewhat off topic, the idea of perfect markets does come from the same stable as the EMH. They are peas in a pod. In perfect markets, there are no costs to information and no lags between new information arriving and being implemented.

  8. In perfect markets there are infinite numbers of buyers and sellers and no barriers to entry and exit with perfect information and complete futures markets. I have to say I’ve never seen those assumptions used to desribe efficient markets.

  9. Sinclair and Paul, thank you for explaining that.  From my POV, that is the role of academic blogs like these – to educate.
    So the conclusion I draw is that a perfect market is 100% wrong and weak form and strong form efficiency is 100% wrong and I’m very close to forming the same opinion about semi-strong efficiency (admittedly my grasp on all of those are extremely tenouous – wikipedia)

  10. Senexx – I would say that a perfect market is always (informationally) efficient but an informationally efficient need not be perfect (in theory and would never be perfect in practice).

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