Last week I introduced the efficient market hypothesis (EMH), the theory that prices in financial markets are an accurate reflection of fundamental values based on all available information, and hence those prices follow a “random walk” around the fundamental value making small changes in response to new information. I also suggested that if you think financial crashes must surely refute this theory you would be right, and gave a brief justification. This week I want to look briefly at some of the problems with the theory.
The EMH assumes that traders are looking solely at information about the markets, not at each other’s behaviour, and has been criticised for this since its earliest formations. Traders are also looking at each other’s behaviour. If an asset is rising because some traders are buying, others may assume that those traders have good reason to buy and so buy as well.
Basically, humans have a herding instinct and a tendency to follow trends. Whereas with consumption goods rising prices will discourage buying, if asset prices are rising, and traders take this as a signal that they are likely to rise further, those traders will buy the asset and that itself could be enough to cause the price to rise! This is, in fact, a non-random trend found in stock-price data, that a stock that has been rising is more likely to keep rising above market averages, and falling stocks are more likely to fall. Such self-fulfilling prophecies can cause severe distortions in markets, as history so frequently attests.
The EMH can in fact survive a good degree of irrational or incompetent trading. As long as there are some expert traders who will step in and profit from the imperfections in the market that this uninformed trading will creates, such actions will quickly drive prices back to their fundamentals. But the question is how quickly, and in the meantime are ill-informed traders making further bad trades, pushing markets away from fundamentals in different ways? Even Eugene Fame eventually concluded, (in a paper with Kenneth French, “Disagreements, Tastes, and Asset Pricing”, 2007):
“Offsetting action by informed investors do not typically suffice to cause the price effects of erroneous beliefs to disappear with the passage of time.”
The conclusion of the EMH, backed by research evidence, that it is near impossible to beat the market, led to the rise of index tracking funds (explained 4 weeks ago), and ironically this may have contributed to this failure of markets to self-correct. Because these funds simply buy representative “baskets” of stocks to track the market as a whole, they are basically uninformed investors on a mass scale. An index fund won’t pull out of a market because it thinks it’s over-valued, it will keep pumping pension contributions and dividends back into that market. I must confess I haven’t found this argument made by another economist, or research to back it up, but it seems such an obvious effect that I’m sure it has been written about, and I just haven’t found it yet.
And this point leads on to another. The EMH is actually stating that the relative prices of assets will reflect all available information. You can’t beat the market because if any asset is over- or undervalued the smart investors will jump on this imperfection immediately and it will soon disappear. This is fine if you are talking about an individual share, bond or derivative. But if all asset markets are overvalued traders are left with nowhere to go. And the exact argument of this blog is that a demand for assets that outstrips supply at current prices will cause asset price inflation across the entire financial market. If the “dumb” investors (e.g. unmanaged pension funds) are flooding into stock market index funds and inflating prices, smart investors will sell stocks in those markets and buy other assets. This will cause these other assets to rise (and provide some degree of brake on the stock market rise). The “equilibrium” will be the point where the relative values of these markets are “correct” – you can no longer improve your expected profit by selling the stock and buying the other asset. But at this “equilibrium” both markets could be overvalued.
Larry Summers (US Secretary of the Treasury 1999-2001, and director of the National Economic Council under Obama in 2009-10) famously said that the EMH is like assuming that the tomato ketchup market is efficient because because a two-quart bottle of ketchup costs exactly double a one-quart bottle – the prices are correct relative to each other, but both prices could be over- or undervalued.
And even if you work out that a market is in a bubble, what do you do? You might think the obvious thing to do is sell – but what if the market continues to rise year after year before the bubble bursts? And where do you put your funds in the meantime? This problem is well-documented in the literature. Tim Harford tells the cautionary tale of Tony Dye in his book The Undercover Economist. Dye was Chief Investment Officer at Phillips & Drew, one of Britain’s biggest asset management firms, and he saw in 1996 that stock markets were in a bubble. He withdraw £7bn of his clients’ fund from the stock market. As prices continued to rise he became a laughing stock, until he was forced into early retirement in 2000. Before Phillips & Drew could reinvest its funds, the market crashed. (I don’t recommend Harford’s book, by the way, I’m just citing the source of the anecdote. Published in 2006, it includes the great statement on page 152 that, “We are probably not on the verge of another depression”, demonstrating the incredibly accurate insights we have come to expect from mainstream economists!)
Dye saved his clients a small fortune, yet it cost him his job, while all the fund managers who lost millions kept theirs. We’re back to herd behaviour again, this time the safety found in them – if everyone fails, you can’t be singled out for your failure.
And this leads us to a famous and profound insight of Keynes, found in The General Theory of Employment, Money and Interest. He points out that if a trader believes a stock is overvalued, but if he also believes that other traders will keep buying it, then the rational thing to do is to stick with that stock. Tony Dye was right about the stock market, and did make money for his investors in the end, but he would have made a substantially greater profit if he had stayed in the market for another 4 years and got out just before the crash.
Keynes put this brilliantly:
“They [the trader] are concerned, not with what an investment is really worth to a man who buys it ‘for keeps’, but with what the market will value it at, under the influence of mass psychology, three months or a year hence… For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.
“Thus the professional investor is forced to concern himself with the anticipation of impending changes, in the news or in the atmosphere, of the kind by which experience shows that the mass psychology of the market is most influenced.”
Keynes goes on to compare this behaviour to entering a newspaper competition in which readers have to pick the prettiest face from a selection of photographs. The competitor seeking to win should not in fact pick the face that they find prettiest, but the face that they believe others will find prettiest. And then knowing that others will be approaching the competition in the same way, they should in fact pick the face that they believe other competitors believe that other competitors will find prettiest, and so on. This brilliant analogy is now known as the “Keynesian beauty contest”, and you will often find Keynes’ explanation of this directly quoted. I have chosen to quote his words describing behaviour in the market itself, as I believe it is equally brilliant and clear in explaining why traders will be looking at each other’s behaviour, not just market fundamentals.
What is perhaps most remarkable about this whole debate is that in all their pontification economists have almost never thought to research how traders do actually make decisions in the real world and then develop a theory based on such empirical evidence (Bob Shiller being a notable exception). This sad fact pretty much encapsulates a large part of what is wrong with the economics profession.