Efficient Market Hypothersis - Literature review Example

Efficient Market Hypothesis Introduction The 2008 economic recession and the current European Sovereign Debt Crisis have brought economics to the forefront of public thought perhaps more than anytime since the Great Depression. While the American economic collapse exposed many of the high risk and borderline unethical practices of large-scale investment banking and insurance agencies, an even deeper concern were the structural aspects of government that allowed these practices to occur. Related to these practices is the understanding that their occurrence is directly connected to the regulatory environment that allowed for their occurrence. The drastic deregulation that occurred during this period is in part linked to a theoretical belief in market efficiency, as policymakers have been accused of having too great a faith that the market would undergo self-correcting behavior. While the extent of the validity of these criticisms remains debated, the efficient-market hypothesis (EMH) has held a pronounced influence on political and academic thought. This essay considers the extent that the market, as Warren Buffet claims, functions under irrational processes, or can be explained in rational terms through the efficient market hypothesis. Outline of the Efficient Market Hypothesis (EMH) In its modern incarnation Professor Eugene Fama first articulated the efficient-market hypothesis in the early 1960s during his time at the University of Chicago Booth School of Business. From an overarching perspective, the efficient market hypothesis theory contends that for investors it is impossible to ‘beat’ the market on a consistent basis. The main reasoning behind this notion is that the market will reflect all available information for the particular investment, such that gaining any sort of edge over other investors is made impossible. This contention does not necessitate that individuals act in rational ways. Indeed, the efficient market hypothesis understands that a number of individuals will both over and under react to available market information. The cumulative impact of these reactions results in market efficiency, as the random reactions will fall proportionally along a normal distribution pattern. In these regards, it’s possible for an individual to be right or wrong about the market, but the market itself is necessarily an accurate reflection of available asset information. Structural Components There are three major versions of the efficient market hypothesis, each of them resting on a different part of a spectrum of efficiency. The first version is the weak-form efficient market theory. Within this perspective all prices on past publically traded assets, including stocks, bonds, and property, already have factored into them all publically available investment information. The semi-strong version of the hypothesis takes this a step further and argues that current asset prices reflect all publically available information and that when new information emerges prices change instantly to reflect this new public information. The third version of the efficient market hypothesis is the strong-form version. The strong-form version of the hypothesis goes even further in that it argues in addition to asset prices immediately reflecting public information, asset prices also instantly reflect insider or otherwise concealed information. Analysis Seminal Literature There are a number of seminal studies that established core elements of the efficient market hypothesis. While Fama first articulated the theory in its modern context, its original formulations were explored as early as the 19th century. Kirman (2009) notes that French mathmetician Louis Bachelier established many of the general tenants of this theory in his ‘Theory of Speculation’ published in 1900. The early years of the 20th century witnessed another prototypical formulation of this perspective in the random walk model; this was a notion that stock prices operated through random steps and as such gaining a long-term predictive edge was impossible. In the 1960s, individuals such as Fama and Paul Samuelson further advanced this theory; Cooter (1964) published a collection of work, including Bachlier’s study and the random walk model in a seminal collection of literature. Fama would go on to formulate the efficient market hypothesis theory through a hybrid combination of his own theoretical perspective and the random walk model; he would later articulate the three versions of the hypothesis. Samuelson’s contribution to the theory formulated the argument in macroeconomic and microeconomic terms. In these regards, the main understanding is that the efficient market hypothesis functions most notably in terms of specific asset prices, but when extended to macroeconomic market concerns the market is largely inefficient. While Samuelson’s contentions implemented quantitative analysis, it wasn’t until recently they were further supported through regression models and scatter diagrams, most prominently by Yale Professor Robert Schiller (Jung & Schiller 2005). Modern Support In understanding modern formulations and support of the efficient market hypothesis it’s necessary to examine the theory in accordance with its varying structural versions. Perhaps the most readily accepted form of the efficient market hypothesis is the weak version. While weak-form efficiency has been described above, it’s necessary to consider in terms of its deeper theoretical principles. The weak-form hypothesis is firmly rooted in the foundational aspects of the random walk model. Essentially this model notes that all future price movements are entirely unpredictable. This unpredictability makes it such that determining future price moves is made impossible. While aspects of fundamental analysis may be possible, the notion that one would be able to implement technical analysis to predict future price movements is made impossible through market efficiency measures (Palan 2011). As indicated earlier, the semi-strong efficiency version of the EMH goes a step further in this formulation. In these regards, while weak-form efficiency allowed for the possibility of fundamental analysis to determine market conditions, semi-strong efficiency restricts this even from occurring. There have been a number of studies that have examined this process. For instance, information regarding potential mergers has been examined in demonstrating instantaneous price corrections (Palan 2011). The strong-form hypothesis is perhaps the most theoretical in that it necessitates there being no legal barriers for private information – an aspect of theory that does not reflect the current regulatory environment. Still, this theory also holds that even hedge fund managers will not be able to predict future market conditions. While there may exist a few individuals that demonstrate above average market results, strong-form efficiency attributes this to a normal distribution, rather than predictive forecasting (Palan 2011). Criticisms While the efficient market hypothesis is a cornerstone of modern financial theory, there is a considerable amount of controversy surrounding the theory’s validity. Billionaire investor Warren Buffet once seminally noted, “When the price of a stock can be influenced by a “herd” on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical” (Buffet 1984). Indeed, a general perusal of financial websites or television shows demonstrates that widespread public perception of the market is that through diligent research and analysis one is able to gain an advantage. When one considers the nature of the market as experiencing bubble periods that are seemingly distinct from public information, the notion of market efficiency becomes complicated. Indeed, the notion that there is a direct link to information and price from a pragmatic perspective seems entirely fanciful. Perhaps the most pronounced criticism of the efficient market hypothesis has emerged from behavioral science. The central thorough-put in terms of the behavioral economic understanding is that rather than information driving market prices a large degree of investor bias in terms of over or under confidence is a determining factor. A growing body of modern theory has come to rest squarely on the side of the behavioral economic approach. One of the most popular and convincing refutations of the efficient market hypothesis in recent years has been that levied by Robert Schiller in his text ‘Irrational Exuberance’. Theorists such as Malkiel (2006) have argued that much of Schiller’s findings can be explained in terms of efficient market theory when one factors in interest rates; still, it appears that the preponderance of Schiller’s approach is a firm indictment on human irrationality in degree driving market conditions. This text seems to clearly refute the random walk model through its understanding that market conditions had reached an irrational rate and predicting that in the future prices would necessarily need to be corrected. Schiller states: [t]he stock market has not come down to historical levels: the price-earnings ratio as I define it in this book is still, at this writing [2005], in the mid-20s, far higher than the historical average. (Schiller 2006, pg. 65). Shiller’s analysis is truly powerful when one considers that he was able to predict much of the future price declines that would occur in the both the stock market and the housing bubble. While Shiller constitutes perhaps the most recognized critic of the efficient market hypothesis, he is not alone in his support of a behavioral model. A study conducted by Dreman & Berry (1995) found that there was a significant correlation between stocks with lower price to earnings (PE) ratios and further positive earnings. One also considers that high PE ratio ratios have also been demonstrated to have significant correlation with declining stock values. Fig. 1 demonstrates the late 1990s divide that occurred between PE ratios and stock prices; as is clear after the greatest divide occurred, there was a sharp market correction. Such findings seem to refute notions that technical and fundamental analysis has no determining insight into future market prices. Fig. 1 Real S&P Stock Price Index, Earnings, and Dividends The Efficient-Behavioral Turn The ultimate truth of the market may not have the articulative beauty of Fama’s rationality or Shiller’s irrational exuberance. While there is a substantial amount of analytical literature supporting behavioral models on market change, the issue is complicated by questions concerning the extent that such indicators fall outside of the realms of efficient market theory. Undoubtedly the leading theorist in this context of investigation has been Nobel Prize Laureate Daniel Kahneman. While Kahneman is one of the central thinkers of the behavioral economic paradigm, to a large degree he situates such behavioral patterns within a structure of rational determination. Kahneman & Tversky (2000) argue that while the notion that humans act in irrational ways is irrefutable, the extent that such an understanding contradicts the efficient-market hypothesis is a matter of framing. Kahneman argues that while irrationality exists, it is possible to quantify such an understanding in predictive patterns and that the failure of the Federal Reserve to place too high a reliance on rational actions by key financial players is what contributed to the recent recession ("Efficient market hypothesis ," 2011). This ultimately leads Kahneman to argue that it is impossible for investors to beat the market long-term. Still, this hasn’t deterred investors and analysts. Lo & MacKinlay (2001) claim to have developed a sort of third order model that takes into account not only irrational behavior, but analysis of the analysis of this irrational behavior, in developing a predictive model of future market change based on data-snooping biases. Conclusion The extent that the efficient-market hypothesis is accurate may ultimately remain a question of semantics or framing. The preponderance of evidence seems to support Kahneman’s notions that asset prices are driven by irrational behavior, but predicting future patterns is made impossible as the market efficiently frames within it this irrationality; in these regards, EMH simply needs to be expanded. Still, a general pragmatic survey of financial markets seems to indicate that a conservative approach has some predictive impact. From a qualitative perspective, one considers that even in the last few months initial public offerings of the high-public interest tech stocks Linkedin and Groupon, despite rigid valuation mechanisms, immediately jumped in value, only to crash down below IPO prices. It would not have been impossible for a keen investor to consider this irrational exuberance and bet against these stocks in the derivative market. Ultimately, the truth of EMH is a complex notion that is perhaps only articulable through metaphor – what came first, the chicken or the egg? References Malkiel, Burton G. (2006). A Random Walk Down Wall Street. New York: Templeton Press. Cootner (ed.), Paul (1964). The Random Character of StockMarket Prices. MIT Press. Dreman David N. & Berry Michael A. (1995). "Overreaction, Underreaction, and the Low-P/E Effect". Financial Analysts Journal 51 (4): 21–30. Efficient market hypothesis . (2011). Retrieved from http://www.asymmetricinvestmentreturns.com/resource-center/efficient- market-hypothesis/how-greenspans-framework-and-efficient-market- hypothesis-went-awry---daniel-kahneman.html Jung, Jeeman; Shiller, Robert (2005). "Samuelsons Dictum And The Stock Market". Economic Inquiry 43 (2): 221–228. Kahneman, Daniel. & Tversky, Amos. (2000). Choices, Values, and Frames. Cambridge University Press. Kirman, Alan. "Economic theory and the crisis." Voxeu. 14 November 2009. http://www.voxeu.org/index.php?q=node/4208 Lo, Andrew & MacKinlay, Craig. (2001). A Non-Random Walk Down Wall-Street. Princeton University Press. Palan, Stefan. (2011) The Efficient Markets Hypothesis and Its Validity in Todays Markets. Stefan Palan. Schiller, Robert. (2006) Irrational Exuberance. New York: Crown Business. Warren E. Buffet, (1984) The Super Investors of Graham-and Dodsville, transcript of a talk given at Columbia University in 1984’. Columbia Business School Magazine. available at: http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Warren%20 Buffett/Superinvestors%20of%20Graham%20and%20Doddsville%20- %20Hermes.pdf [accessed 10 October 2011] Read More