"Refuted economic doctrines #1: The efficient markets hypothesis
By jquiggin | January 2, 2009
I’m starting my long-promised series of posts on economic doctrines and policy proposals that have been refuted or rendered obsolete by the financial crisis. There will be a bit of repetition of material I’ve already posted and I’ll probably edit the posts in response to points raised in discussion.
Number One on the list is a topic I’ve covered plenty of times before (in fact, I was writing about it fifteen years ago), the efficient (financial) markets hypothesis. It’s going first because it is really the central microeconomic issue in a wide range of policy debates that will (I hope) be covered later in this series. Broadly speaking, the efficient markets hypothesis says that the prices generated by financial markets represent the best possible estimate of the values of the underlying assets."
Here's where I stand. I propound a form of Behavioral Finance:
(((((("Criticism and behavioral finance
Investors and researchers have disputed the efficient markets hypothesis empirically and theoretically. Behavioral economists attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidence, overreaction, representative bias, information bias, an inability to use configural rather linear reasoning, and various other predictable human errors in reasoning and information processing. These have been researched by psychologists such as Daniel Kahneman, Amos Tversky, Richard Thaler, and Paul Slovic. These errors in reasoning lead most investors to avoid high-value stocks and buy growth stocks at expensive prices, which allow those who reason correctly to profit from bargains in neglected value stocks and the overreacted selling of growth stocks.
Empirical evidence has been mixed, but has generally not supported strong forms of the efficient markets hypothesis[3] [2] low P/E stocks have greater returns. In this paper he also refuted the assertion by Ray Ball that these higher returns could be attributed to higher beta,[12] whose research had been accepted by efficient market theorists as explaining the anomaly[13] in neat accordance with modern portfolio theory.
Speculative economic bubbles are an obvious anomaly, in that the market often appears to be driven by buyers operating on irrational exuberance, who take little notice of underlying value. These bubbles are typically followed by an overreaction of frantic selling, allowing shrewd investors to buy stocks at bargain prices. Rational investors have difficulty profiting by shorting irrational bubbles because, as John Maynard Keynes commented, "Markets can remain irrational longer than you can remain solvent." Sudden market crashes as happened on Black Monday in 1987 are mysterious from the perspective of efficient markets.
Another anomaly exists in the form of the investors who beat the market soundly on a long-term basis, including Peter Lynch, Warren Buffett, George Soros, and John Templeton. Warren Buffett has commented that "I'd be a bum on the street with a tin cup if the markets were always efficient".
Burton Malkiel, a well-known proponent of the general validity of EMH, has warned that certain emerging markets such as China are not empirically efficient; that the Shanghai and Shenzhen markets, unlike markets in United States, exhibit considerable serial correlation (price trends), non-random walk, and evidence of manipulation.[14]
Behavioral psychology approaches to stock market trading are among some of the more promising alternatives to EMH (and some investment strategies seek to exploit exactly such inefficiencies). But Nobel Laureate co-founder of the programme—Daniel Kahneman—announced his skepticism of investors beating the market: "They're [investors] just not going to do it [beat the market]. It's just not going to happen."[15] Richard Thaler has started a fund based on his research on cognitive biases. In a 2008 report he identified complexity and the herd behavior as central to the global financial crisis of 2008.[16]"))))))
Back to Quiggan:
"The hypothesis comes in three forms.
The weak version (which stands up well, though not perfectly, to empirical testing) says that it is impossible to predict future movements in asset prices on the basis of past movements, in the manner supposedly done by sharemarket chartists. While most of what is described by chartists as ‘technical analysis’ is mere mumbo-jumbo, there is some evidence of longer-term reversion to mean values that may violate the weak form of the EMH.
The strong version, which gained some credence during the financial bubble era says that asset prices represent the best possible estimate taking account of all information, both public and private. It was this claim that lay behind the proposal for ‘terrorism futures’ put forward, and quickly abandoned a couple of years ago. It seems unlikely that strong-form EMH is going to be taken seriously in the foreseeable future, given the magnitude of asset pricing failures revealed by the crisis.
For most policy issues, the important issue is the “semi-strong” version which says that asset prices are at least as good as any estimate that can be made on the basis of publicly available information. It follows, in the absence of distorting taxes or other market failures that the best way to allocate scarce capital and other resources is to seek to maximise the market value of the associated assets. Another way of presenting the semi-strong EMH is to say whether or not markets are perfectly efficient, they’re better than any other possible capital allocation method, or at least, better than any practically feasible alternative."
Here's a similar list and explanation:
(((((("There are three common forms in which the efficient-market hypothesis is commonly stated — weak-form efficiency, semi-strong-form efficiency and strong-form efficiency, each of which have different implications for how markets work.
[edit] Weak-form efficiency
- Excess returns cannot be earned by using investment strategies based on historical share prices.
- Technical analysis techniques will not be able to consistently produce excess returns, though some forms of fundamental analysis may still provide excess returns.
- Share prices exhibit no serial dependencies, meaning that there are no "patterns" to asset prices. This implies that future price movements are determined entirely by information not contained in the price series. Hence, prices must follow a random walk.
[edit] Semi-strong-form efficiency
- Semi-strong-form efficiency implies that share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on that information.
- Semi-strong-form efficiency implies that neither fundamental analysis nor technical analysis techniques will be able to reliably produce excess returns.
- To test for semi-strong-form efficiency, the adjustments to previously unknown news must be of a reasonable size and must be instantaneous. To test for this, consistent upward or downward adjustments after the initial change must be looked for. If there are any such adjustments it would suggest that investors had interpreted the information in a biased fashion and hence in an inefficient manner.
[edit] Strong-form efficiency
- Share prices reflect all information, public and private, and no one can earn excess returns.
- If there are legal barriers to private information becoming public, as with insider trading laws, strong-form efficiency is impossible, except in the case where the laws are universally ignored.
- To test for strong-form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time. Even if some money managers are consistently observed to beat the market, no refutation even of strong-form efficiency follows: with hundreds of thousands of fund managers worldwide, even a normal distribution of returns (as efficiency predicts) should be expected to produce a few dozen "star" performers."))))))
Back to Quiggan:
"The hypothesis can be tested in various ways. First, it is possible to undertake econometric tests of its predictions. Most obviously, the weak form of the hypothesis precludes the existence of predictable patterns in asset prices (unless predictability is so low that transactions costs exceed the profits that could be gained by trading on them). This test is generally passed. On the other hand, a number of studies have suggested that the volatility of asset prices is greater than is predicted by semi-strong and strong forms of the hypothesis (note to readers - can anyone recommend a good literature survey on this point).
While econometric tests can be given a rigorous justification, they are rarely conclusive, since it is usually possible to get somewhat different results with a different specification or a different data set. Most people are more likely to form their views on the EMH on the basis of beliefs about the presence or absence of ‘bubbles’ in asset prices, that is, periods in which prices move steadily further and further away from underlying values. For those who still believed the EMH, the recent crisis should have shaken their faith greatly. But, although the consequences were less severe, the dotcom bubble of the late 1990s was, to my mind, are more clear-cut and convincing example of an asset price bubble. Anyone could see, and many said, that this was a bubble, but those, like George Soros, who tried to profit by shortselling lost their money when the bubble lasted longer than expected (perhaps long-dated put options would have provided a safer way to bet on an eventual bursting of the bubble, but Soros didn’t try this, and neither did I.)
More important than asset markets themselves is their role in the allocation of investment. As Keynes (allegedly) said, this job is unlikely to be well done when it is a by-product of the activities of a casino. So, if the superficial resemblance of asset markets to gigantic casinos reflects reality, we would expect to see distortions in patterns of savings and investment. The dotcom bubble provides a good example, with around a trillion dollars of investment capital being poured into speculative investments. Some of this was totally dissipated, while much of the remainder was used in a massive, and premature, expansion of the capacity of optical fibre networks (the fraudulent claims of Worldcom played a big role here). Eventually, most of this “dark fibre” bandwidth was taken up, but in investment allocation timing is just as important as project selection.
The dotcom bubble was just one component of a massive asset price bubble that began in the early 1990s and is only now coming to an end. Throughout this period, patterns of savings and investment made little sense. Household savings plunged to zero and below in a number of developed countries (including nearly all English-speaking countries) and the resulting current account deficits were met by borrowing from rapidly growing poor countries like China (standard economics would suggest that capital flows should go in the other direction). The massive growth of the financial sector itself, which accounted for nearly half of all corporate profits by the end of the bubble, diverted physical and particularly human capital from the production of goods and services.
Finally, it is useful to look at the actual operations of the financial sector. Even the strongest advocates of the EMH would not seek to apply it to, say, the Albanian financial sector in the 1990s, which was little more than a series of Ponzi schemes. They would however want to argue that the massively sophisticated global financial markets of today, with the multiple safeguards of domestic and international financial regulation, private sector ratings agencies and the teams of analysts employed by Wall Street investment banks is not susceptible to such systemic problems, and is capable of correcting them quickly as they arise, without any need for large-scale and intrusive government intervention. I’ll leave it to readers to make their own judgements (maybe with some links when I get around to it).
Once the EMH is abandoned( HERE'S MY FEELING. IT CAN HAVE SOME LIMITED USE. AFTER ALL, IT'S JUST A THEORY. IT HAS TO BE JUDGED BY A PARTICULAR USE. ), it seems likely( WAIT A SECOND. THAT DOESN'T FOLLOW AT ALL. ) that markets will do better than governments in planning investments in some cases (those where a good judgement of consumer demand is important, for example) and worse in others (those requiring long-term planning, for example).( THIS MIGHT WELL BE TRUE, BUT NOTHING FOLLOWS FROM THE PREVIOUS CONSIDERATION OF EMH, EXCEPT ABOUT EMH. THEORIES DON'T WORK THAT WAY. ) The logical implication( THERE IS NO LOGICAL IMPLICATION HERE AT ALL. WHAT'S THE DEDUCTION? ) is that a mixed economy will outperform both central planning and laissez faire, as was indeed the experience of the 20th century. More to follow!"
Here he goes again. That's what we have in the US. It's a Private Sector/Government Hybrid. It's a Welfare State. That's what we have, not just for economic reasons, but for social reasons. That isn't going to change. All that's changing is the mix. Pragmatism is our general method of dealing with crises. People looking for big and earthshattering movements are hopefully wrong. As a Burkean, I don't like big changes on principle. I don't so much disagree with Quiggan, as not know what he's getting at. I'd be more impressed if he just gave us the policies that he wants implemented, instead of sounding like Hegel or Marx.
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