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Efficient markets

January 11th, 2010

The efficient (financial) markets hypothesis still has plenty of defenders, though their arguments are looking rather ragged at present. Coincidentally, it’s ten years since the merger of Time Warner and AOL, the biggest and most disastrous in history. If any single event symbolises the failure of the EMH, it’s this merger, driven by the ludicrous valuations of the dotcom era. As I commented at the time

If the accounting numbers are taken at face value, AOL Time Warner will have a price-earnings ratio of about 350 to 1, modest by Internet standards. When options are taken into account, the ratio is more like 1000 to 1. It is difficult to see how an economy in which investment decisions are based on numbers like these can avoid some sort of financial catastrophe

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  1. gerard
    January 11th, 2010 at 14:50 | #1

    Sam Wylie complains that the attack on the EMH is an attack on a “straw-man”. Although he pretty much leaves it at that. If he wanted to make an actual defense, shouldn’t it be that the EMH does not predict that bubbles don’t happen – but that bubbles reflect all available information at any given time, even where “information” (so-called) has only a tenuous connection to the material world and pretty much amounts (in the manner of Keynes’ “prettiest faces” analogy) to the fluctuating opinions of speculative investors speculating on the fluctuating opinions of other speculators’ opinions on what other speculators are going to be thinking (and on ad infinitum…)

    So that you will have bubbles, but the market is “efficient” in that the “best” moment to jump off the bubble can never be predicted, even by really smart people (like Isaac Newton, who said “I can calculate the motions of heavenly bodies, but not the madness of people”after losing a fortune on the South Sea bubble).

    Of course defining “market efficiency” in such a counter-intuitive way pretty much inverts the meaning of “efficiency”. And in any case, the reason would seem to be that the “best” moment to jump off the bubble can only be determined after the fact, since it is the fact that people start jumping in anticipation of a bursting bubble that actually causes the bubble to burst.

    I won’t pretend to understand… But given that Cochrane does pretend to understand, it’s astonishing he can come out with mind-bogglingly stupid stuff like this:

    “What is there about recent events that would lead you to say markets are inefficient?” he said to me. “The market crashed. To which I would say, We had the events last September in which the President gets on television and says the financial markets are near collapse. On what planet do markets not crash after that?”

    WTF? Is this guy meant to be a professor? At least he didn’t blame the CRA.

  2. jquiggin
    January 11th, 2010 at 15:16 | #2

    Until the crisis, I would have rated Cochrane as one of the smartest, and clearest-thinking, guys at Chicago. But he’s obviously locked in to the EMH and willing to push really silly defences.

  3. Gerard
    January 11th, 2010 at 15:50 | #3

    But the weird thing to me is that he could still defend the emh by pointing out that there’s nothing about the crisis that (obviously) disproved the fact that an individual speculator can consistently outguess the market – which I thought was the basic point. Instead, the reaction seems to suggest that the emh held the very same meaning to cochrane as what Wylie described as a “straw man”; which can be summarized in caveman language as “MARKETS GOOD!”
    hence the emh has a double meaning – one, which seems halfway reasonable and says you might as well choose stocks by using a dartboard, and the other, which is simply a faith-based element of Chicago-wingnut theology that says unregulated financial markets are socially beneficial. To me this seems like a critical distinction and an obvious source of potential confusion

  4. Gerard
    January 11th, 2010 at 15:52 | #4

    Can outguess = can’t outguess in that first sentence

  5. Uncle Milton
    January 11th, 2010 at 17:18 | #5

    It was a good call on AOL Time Warner. Though if I recall correctly you did also say that there was no way that Google was worth the price it floated at, on the grounds that it had no revenues to speak of. They floated at $85 in 2004 and are now at $600, just about back at pre GFC levels. The market cap is $191billion. Back in ’04, you said that Google might be worth $35billion.

    Of course, you never know, today’s price might be a bubble.

  6. Uncle Milton
    January 11th, 2010 at 17:49 | #6

    I should add that with a P/E of 38 Google’s share price doesn’t look like a bubble, at least not by the standards of a decade ago. And they do seem to be able to see off their competitors in search, and come up with ways to actually sell things, the Iphone-like device being the
    most recent.

  7. Graeme Bird
    January 11th, 2010 at 19:15 | #7

    The efficient market theory, as applied to our own powerfully inefficient markets, is a harmful idea. Since it gets in the way of us improving our current markets. To make them more effective in share pricing and resource allocation.

  8. jquiggin
    January 11th, 2010 at 19:15 | #8

    I certainly underestimated their potential profit growth. OTOH, I remain bearish about Google. They are still a one-trick pony, though the phone might change this. But I don’t claim to be great at guessing which companies will do well and which will not. The thing about the dotcom era was that the prices made sense only if you thought every dotcom was going to be a Google.

  9. Uncle Milton
    January 11th, 2010 at 19:37 | #9

    My conclusion is that while the capital markets often get it spectacularly wrong, sometimes they get it right. This is why we have stockbrokers, who are better informed than most investors, though certainly not omniscient, and who can advise us on which stocks are under- and over-valued.

    The fact that stockbrokers (not to mention chartists) exist is proof that the capital markets themselves don’t believe in the EMH. But sometimes (as with Google, maybe) the market view turns out to be right, even if seemingly irrational.

  10. Alice
    January 11th, 2010 at 19:46 | #10

    @Uncle Milton
    I wouldnt trust a P/e ratio of 38 Uncle Milton even if pes were much higher years ago. Long term p/es should be about 15. A p/e ratio should tell you how many years it would take to buy oen share from its earnings to the shareholder. 38 years is half a productive lifteime.

  11. Alice
    January 11th, 2010 at 19:47 | #11

    @Uncle Milton
    With a p/e of 38 – its got bubble written all over it.

  12. Alice
    January 11th, 2010 at 19:48 | #12

    Cochrane has married into the EMH family JQ

  13. Graeme Bird
    January 11th, 2010 at 20:26 | #13

    “I should add that with a P/E of 38 Google’s share price doesn’t look like a bubble, at least not by the standards of a decade ago.”

    This is a case in point. Surely this is too high if the market really was efficient. Since its hard to imagine Google having higher market penetration than it does now. Price-Earnings of 38 would either mean a bad year or a company that was destined to grow a lot more.

  14. Graeme Bird
    January 11th, 2010 at 20:42 | #14

    This is a serious issue. Because if we are over-valuing some companies, we are also likely to be underpricing some companies and under-resourcing them with the capital they would need to grow. Failing our small companies that ought to grow is a serious handicap to our economy. I myself would like it that limited liability meant 100% equity finance. I think this would improve the pricing and efficiency of our markets. Also I think that getting rid of taxes on retained earnings of companies would help improve efficiency. As well as more stable monetary policy.

    There are some practices of various rogue companies that are a direct attack on efficient share pricing and therefore effective resource allocation. One of those is share-pyramiding. Otherwise known as naked-short-selling. The ringleader of the current banking heist in America, was a very big offender here. Their euphemism for share-pyramiding was “Prime Brokerage.”

  15. Uncle Milton
    January 11th, 2010 at 21:12 | #15


    Well maybe but perhaps today’s Google P is anticipating future higher E from their phone, reading tablet and other gizmos. Maybe that anticipation is right, maybe not. But a bubble is a price that goes higher purely because it is expected to higher. It doesn’t look like that to me. Of course anyone who thinks the stock is overvalued can buy a put option, or short the stock, and no doubt many will.

  16. January 12th, 2010 at 00:23 | #16

    Very interesting posts so far!

    The EMH is done and dusted. The remarkable thing, is that it has indeed taken this long. And that even at its wake so many deny the obvious: it’s dead.

    Same goes for the Chicago Boys. They, just like most bankers AND a whole lot of economists, are about to join the Dodo (and the real hunting hasn’t even begun, yet! ;-)

    Buckle up! It’s only just getting started:

  17. Tom Hickey
    January 12th, 2010 at 03:02 | #17

    REH And EMH models don’t take into account Irving Fisher’s theory of debt deflation (now QED), Hyman Minsky’s financial instability hypothesis (now QED), and uncertainty (Keynes, Taleb, Roubini, and Soros’s theory of reflexivity). How can REH and EMH be right when heterodox economists predicted the crisis, and the orthodox are still claiming that no one could have seen it coming? See James K. Galbraith’s “Who are these economist’s anyway?” (responding to Paul Krugman)

  18. Freelander
    January 12th, 2010 at 06:31 | #18

    @Tom Hickey

    That’s a very good article. Isn’t he the son of that other Galbraith who wasn’t an economist?

  19. Tom Hickey
    January 12th, 2010 at 06:40 | #19

    @ Freelander

    Yes, James K. (Jamie) Galbraith is the son of John Kenneth Galbraith, professor economics at Harvard.

  20. David Allen
    January 12th, 2010 at 07:53 | #20

    If you called it the Efficient Theft Hypothesis then I guess it’s fulfilled its promise.

  21. Ernestine Gross
    January 12th, 2010 at 09:03 | #21

    @Tom Hickey

    Thank you for the link to James Galbraith’s paper.

  22. Michael Harris
    January 12th, 2010 at 09:24 | #22

    I like what Herb Gintis says about the EMH.

    A few years ago business and economics journalist Justin Fox went to the University of Chicago to talk to Efficient Markets guru Eugene Fama and behavioral economist Richard Thaler. He then went back to New York and wrote an article entitled “Is the Market Rational?” The headline for the article read “No, say the experts. But neither are you—so don’t go thinking you can outsmart it.” Out of this encounter came this pretty mammoth, extremely informative, and lively written narrative of modern financial economics. If you read this book and take its arguments seriously, you can avoid the major pitfalls that doom some investors to penury. On the other hand, if you think you can beat the market through personal testosterone and shrewdness, don’t bother buying the book. Save your money. You’ll be on the bread line soon enough.

    Saying that people are irrational and the market is irrational is of course now all the rage. But, if you think you can romp your way to financial security by taming your animal spirits and feeding off the market’s irrationality, I assure you, and Justin Fox assures you, that such is not the case. “While behaviorists and other critics have poked a lot of holes in the edifice of rational market finance, they haven’t been willing to abandon that edifice.” (p. 301). The reason is that the edifice is usually correct, although it can experience spectacular failures. The problem is that we don’t know when it will experience these failures. We do know, or at least I strongly believe, that the failures are due to herd behavior of investors, which undermines the applicability of the normal statistical distribution, the mainstay of traditional financial theory.

    The theory that financial markets are rational is called the Efficient Markets theory. It has two parts. The first is that unless the investor has some inside information not available to other investors, he cannot tell if stock prices are too low, too high, or just right. This means that on average you can’t gain by using a general theory that says when stocks are over- or under-valued. The evidence in favor of this theory is overwhelming. If your stockbroker tells you he can pick winners, run as fast as you can. Indeed, the best policy is simply to invest in low-overhead mutual funds, and look VERY closely at the overhead. You’ll do very well that way over the long haul. Trust me.

    The second half of the efficient markets theory is that market imbalances cannot persist for more than a very short time, because as soon as they are discovered, they will be arbitraged away. There is fairly good evidence that this half of the theory is often wrong; the stock market, for instance, can suffer run-ups for long periods of time; everyone knows the market is out of balance, but no-one knows when to get off the gravy train. Moreover, a financial manager that fails when all others fail (e.g., after a melt-down) will not be blamed, but one who gets off the train too soon will be widely vilified and discredited. I recall that some economists were predicting a financial crisis a full three years before it actually occurred. This is okay for on-lookers, but real players cannot get off the train too soon. Whence the failure of the second half of efficient markets theory.

    This book is an extremely valuable resource for the non-professional. There are no equations, but Fox gives one a pretty good idea of what assumptions lie behind a theory, and what arguments and data can be erected for and against it. Financial economics is about the most difficult area of economics because it uses very high-powered math, including stochastic differential equations. The huge amount of financial data makes it relatively easy to test financial theories, so we know fairly well what works and what doesn’t. Fox does a totally convincing job of being balanced without ever being boring or simply taking the middle-road. The book deserves it widespread popularity.


  23. Tom Hickey
    January 12th, 2010 at 10:24 | #23

    @ Michael Harris

    Then Goldman is cheating. (Zero Hedge claims that they are using HFT to frontrun markets, producing results that defy probability.)

  24. smiths
    January 12th, 2010 at 10:53 | #24

    it is a gangster system that is beholden to private bankers and ‘defense’ and energy companies, it has been thus for quite sometime
    whatever mask you put on it john, the outcome would be the same,
    equilibrium, rationality and free information in markets might be bogus but the ultimate causes of this would corrupt any attempted economic system that was based on the lie that we live in democracies and that the rule of law is applicable to all

  25. Illyria
    January 12th, 2010 at 11:41 | #25

    The premise of this whole thread is wrong. Nobody has used PE ratios to value companies for decades.

  26. Graeme Bird
    January 12th, 2010 at 13:29 | #26

    Well theoretically you might use a compromise between these three:

    1. Estimate of discounted future dividends to be paid by the company.
    2. Estimate of discounted future retained profits to be earned by the company.
    3. Estimate of the companies current asset value.

    But the thing is, if the company is using debt and is subject to a tax on its retained earnings then the right behaviour, in terms of management serving the shareholder interest, is indeterminate. Even if you could predict their potential earnings you are still not to come up with a good share price, nor can you prescribe what management behaviour ought to consist of with certainty. Because management doesn’t have a clear policy with which to act upon.

    If there is debt involved the companies valuation can be dependent on the rate of monetary growth. Since a highly leveraged company can be better off with a burst of monetary growth. If the company goes for a high return on total assets it will wind up paying a lot more tax and it is not really possible to know if management is thereby doing the right thing. What this leads to is a massive magnification of the problem of agency.

    The market can therefore be made more “efficient” by removing those factors which create all this ambiguity and by at the same time allowing the company to buy back shares.

    Debt-financing, erratic monetary policy, and taxes on profits all add ambiguity to the job of pricing the shares. But without these factors the job of management is very clear cut. They ought to maximise book value divided by outstanding shares. And if the company is undervalued they can use their profits to buy back some of these shares. Without the ambiguity of the factors mentioned then its clear that the company must strive at all costs to make a profit every quarter. Even if this means going into retrenchment.

  27. gerard
    January 12th, 2010 at 13:48 | #27
  28. Alice
    January 12th, 2010 at 15:46 | #28

    Thats because P/E ratios have been living in bubble land.

  29. Ernestine Gross
    January 12th, 2010 at 15:46 | #29

    @Michael Harris

    “The first is that unless the investor has some inside information not available to other investors, he cannot tell if stock prices are too low, too high, or just right. This means that on average you can’t gain by using a general theory that says when stocks are over- or under-valued. The evidence in favor of this theory is overwhelming”.

    Would the investor, Mr or Ms “on average” please stand up?

    The article refers to the Fama strand of the efficient market literature. The Fama strand is methodologically severely flawed. The original 1970 and 1976 Fama hypothesis (3 forms) is not refutable by design. The above quoted statement relates to a severely watered down statement (as per Frank Milne’s 1983 unpublished paper). But even this watered down version is fundamentally flawed:

    If the entire financial system collapses (characterised by no issue of and no trade in financial securities – not a farfetched scenario) then by the methodology of Fama and his disciples, the hypothesis that ‘the market’ is efficient can’t be rejected because nobody is making any monetary profit as of the date of the meltdown event. (But those who have a few chooks in the backyard may survive and prosper relatively well in a commodity exchange community at least for some time. This corresponds to some general theory and to empirical evidence in the form of Germany after WWII)

  30. Alice
    January 12th, 2010 at 15:51 | #30

    Smiths – the rule of law is applicable to all only in criminal law and only in prosecution. Defence is available only to those who can afford it or only to those with such a low income that legal aid applies. Civil law is available only to those who can afford it. Law may be applicable to all but the protection it affords is not available to all.

  31. smiths
    January 12th, 2010 at 16:45 | #31

    well that was my whole point alice, thats why i said it was a lie

  32. Alice
    January 12th, 2010 at 19:09 | #32

    yep – I agree Smiths

  33. January 13th, 2010 at 00:32 | #33

    The real hunting might, just might be about to begin:
    “Even my parents think I’m overpaid, admits RBS chief”

  34. gerard
  35. January 14th, 2010 at 02:12 | #35

    More hunting…
    @SEIU: The Wall Street CEOs are reading written statements now. Q&A comes next. Should get interesting.. http://seiu.me/fcic

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