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.