Bookblogging: The rise of the EMH

A bit more from my book-in-progress. I’m currently toying with the title Zombie Economics: Seven Economic Ideas that Aren’t Dead but Should Be. As always, I’m keen to get suggestions on this, and on improvements to the text. I’m particularly happy to have putative errors pointed out. If I agree with you about the error that saves me from putting it in print. If not, it will be a point I need to anticipate and respond to.

The rise of the EMH began relatively modestly with the argument that the prices of assets such as stocks cannot be predicted from their past movements in they way claimed by “chartists” and “technical analysts”. In the popular terminology, prices follow a ‘random walk’. This idea had been put forward as early as 1900 in a neglected paper by a French statistician, Louis Bachelier, but it was not rediscovered until the 1950s.

The simple idea behind the random walk hypothesis was that, since everyone in the market could see the history of prices, any predictable pattern would soon be exploited and the very process of trying to exploit it would eliminate the pattern. The random walk hypothesis went against the powerful human tendency to find patterns in data, whether they exist or not. But it stood up well to initial statistical testing, and has done so ever since.

None of the patterns typically analysed by students of stock market charts, such as trends, reversals and support levels, appear to be of any use in predicting stock price movements. There remains some dispute about whether subtler features of the behavior of stock prices are consistent with the possibility of a profitable trading strategy based solely on observation of past prices.

A handful of anomalies such as the ‘weekend effect’ (prices tending to fall on Fridays and rise on Mondays) have been observed. However, the effects are usually too small to permit traders to gain significant profits after trading costs are taken into account. And most disappeared not long after they were discovered.

Two explanations of the disappearance of anomalies, both consistent with EMH might be considered. First, it may be that once the anomaly was publicised traders sought to exploit it (for example by selling on Thursday and buying at the Friday close). But such a pattern would produce a price increase on Fridays, and a decline on Mondays, wiping out the anomaly it sought to exploit.

The second, simpler, explanation is that the anomalies were just the product of human pattern-finding. The famous curse of the zero years provides an illustration. Beginning with the election of William Harrison in 1840, who died of pneumonia in 1841, all Presidents elected in zero years, up to and incluidng JFK died in office. It was after the Kennedy assassination that the curse was apparently discovered. But the next potential victim, Ronald Reagan, elected in 1980, survived for two terms and lived to the age of 93. George W. Bush also survived two terms, and the curse is now forgotten.

At a more sophisticated level, Andrew Lo, Director of MIT’s Laboratory for Financial Engineering has argued that because of investor irrationality, asset prices display some momentum over time. But this claim remains controversial, as does the performance of algorithmic trading strategies designed to exploit such patterns.

Among economists, the random walk hypothesis, now referred to as the ‘weak form’ of the EMH, is fairly generally accepted, and even the sceptics agree that any violations of weak-form EMH are subtle and hard to exploit. In a striking instance of the inefficiency of financial markets, however, investment banks continue to employ “technical analysts” using charting methods, decades after such methods have been shown not to work. The human desire to believe that there must be a way to beat the odds is reflected in the prevalence on the Internet of “systems” guaranteed to make you a winner betting on the horses or at the roulette table.

The success of the random walk hypothesis showed that the existence of predictable price patterns in markets with rational and well-informed traders was logically self-contradictory. It wasn’t long before economic theorists realised that the same point applied to other kinds of information, such as information about the likely future earnings of companies. If this information is publicly available, then traders should take it into account, just as they do with the past history of the stock price. So, the stock price will be the best available estimate of the future value of the stock, taking account of all

The key steps in the discovery of the strong EMH were taken independently by Paul Samuelson, the leading Keynesian economic theorist of the postwar era, and Eugene Fama, who soon became a leading figure in the free-market Chicago school, and is widely regarded as the father of modern finance. As we will see, they took the idea in rather different directions.

There was one more subtle distinction to make before the EMH assumed its modern form. The arguments so far concerned publicly available information, but what about information that was only available to some people, such as company insiders, or customers? Some theorists argued that such information would inevitably be reflected in market trades. Others stuck with the traditional focus on publicly available information.

Fama proposed a distinction between the weak form (EMH), which excluded profitable trading based on price history, the semi-strong form, which extended the claim to cover publicly available information, and the strong form, which claimed that the stock price incorporates all information held by traders, whether it is public or private. 1

Although the EMH made a big difference to the way economists viewed financial markets, it had much less impact on financial markets themselves. An entertaining and economically literate description of the stock market scene in the 1960s, The Money Game by ‘Adam Smith’ (a pseudonym for George Goodman) describes ‘a random walk professor choking on his icecream at the thought that there are people called “technicians” who claim to forecast the stock market”, but makes it clear that the vast majority of Wall Streeters believed the technicians more than the economists.

The economic theory that really changed thinking in financial markets was the model of pricing options1 developed in a 1973 paper by Fischer Black and Myron Scholes and subsequently formalised by Robert Merton. The model was named Black-Scholes, but Merton got his share of the glory when he shared the 1997 Nobel Memorial Prize in Economics with Scholes (Black had died two years earlier).

The Black Scholes model showed that, under plausible assumptions, it was possible to duplicate the payoff from an option2 by a combination of trades in the original stock and in high-grade bonds. Hence, the ‘right’ option price could be calculated by looking at the interest rate on bonds and the variability of the stock price. If the market price differed from the Black-Scholes price, traders could make money with little or no risk by combining trades in the two markets.

It took some time for financial traders to come to grips with the Black-Scholes model, and, while they did, sophisticated “quants” or “rocket scientists” who understood the model made big profits at the expense of old-fashioned traders working on rules of thumb and “seat of the pants” judgement. Eventually, the quants came to dominate the market and prices came more and more into line with the Black Scholes rule. The quants went on to design more and more exotic derivatives on which to practise their skills, and the role of finance theory was established, seemingly on a firm foundation of success.

There was something of a paradox here. The Black-Scholes pricing rule shows how an option price ought to be determined in an efficient market. But traders can only make a profit using Black-Scholes and similar rules to price derivatives if the market price deviates from the ‘correct’ price, that is, if the efficient markets hypothesis is not satisfied. This paradox was given a rigorous formulation in a famous 1980 article by Sanford Grossman and Joseph Stiglitz, one of the contributions that later earned Stiglitz the Nobel Prize in economics

Economists have wrestled with the Grossman-Stiglitz paradox for a long time without working out a completely satisfactory solution. The most common view was one that seemed to preserve the efficient markets hypothesis while justifying the huge returns reaped by financial market professionals. This is the idea that the market is just close enough to perfect efficiency that the returns available from exploiting any inefficiency are equal to the cost of the skill and effort that goes into discovering it.

1. Since the weak form of the EMH is relatively uncontroversial and mostly unimportant, I will use the term EMH to refer to the strong and semi-strong versions from now on. Where the distinction between the two is important, I will try to make it clear which one I mean.

2. An option is one of the simplest kinds of financial derivatives, that is, assets derived from other assets. An option gives you the right to buy (or sell) a given stock at a given price and on a given date

18 thoughts on “Bookblogging: The rise of the EMH

  1. Solid, although I disagree with your statement, “Although the EMH made a big difference to the way economists viewed financial markets, it had much less impact on financial markets themselves.”

    The EMH had a profound impact on the way money was invested in equity markets: capital shifted away from traditional “active” investment strategies”, which contribute to improving informational efficiency, to completely passive indexing.

    I have seen different estimates over time, but a rough number would be that 40-50% of ALL institutional capital changed into naive, passive indexed products that devote zero effort to improving the informational efficiency of the market, exclusively on the basis that the market was already semi-strong form efficient and hence that there are not systematically exploitable pricing inefficiencies that investors can capitalise on (refer to my previous note on this subject–the biggest fund managers in the world–Vanguard, State Street etc–are wholly or partially index-based operators).
    As an aside, perhaps the most successful hedge fund in the world over the long-run is a group called Renaissance Technologies, which is an incredibly impressive quant shop that exploits systematic patterns in capital markets’ behaviour.
    I would encourage you to have a read of this:

  2. I had heard (maybe I’m wrong), from the econophysics literature IIRC, that market prices tend to vary to a much greater extent than is predicted by a random walk hypothesis; changes in prices follow a power law distribution and so large changes are much more frequent than a random walk would suggest. This has been taken as evidence that markets are driven by internal dynamics as much as by responses to outside information.

  3. How about this for a title, John.

    “Ipso fucto: a critique of failed market assumptions”.


  4. I’m a bit naiive on this subject, but I have a question concerning the EMH (in any form). As we go into bubbles such as the most recent one, volatility often goes through the roof as investors and traders “panic” in the sense that they are trying to reconcile their view on where the market will go (in the short term) versus information they are receiving. Once the burst bubble has become rubble only the battle-hardened sneak back to buy what a hopefully bargains (burst bubbles often “burst” twice) and the volume of trade is weak for some time.

    Now what I want to know is what do these volatility spikes (and the GFC volatility spikes were huuuge) mean for the EMH? Are they statistically robust evidence against the EMH?


    PS: My characterisation of bubble/bust behaviour are, of course, an example of a simple human – me – looking for patterns in data. It’s a bad habit, I know. 🙂

  5. Everyone is ganging up on the Efficient market hypothesis. Why echo the chorus?

    The real question our tax-funded economists need to answer – is why do we have to suffer capitalism? population increases? cuts to minimum wages? etc etc.

    Other blogs are prattling on and on about how bad debt is – without looking at the underlying issues.

    So far it appears only Stilwell is looking in the right places.

  6. So Chris Warren, what do you to replace capitalism with? Isn’t capitalism a natural extension of human tendency to trade?

    In regards to Chris Joye’s comments. I totally agree with that passive investment is a waste by professional managers. They are by nature too cautious and worried about their own jobs than on finding discrepencies to exploit.

  7. SeanG

    Capitalism is not the natural extension of a human tendency to trade. It is the financial extension of a human vice to plunder.

    Markets based on competition are the natural extension of the human tendency to trade and as you should know (see Marshall’s ‘Principle” and etc), true competition always removes capitalist profit (provided there is no debt increase).

    You can not extract a capitalist profit under free trade.

    This is all VERY VERY basic.

  8. @Chris Warren
    Chris – only Stilwell AND the Prof.
    On another topic – Hallelujah — a few minutes ago the ACCC got more regulatory powers over price fixing. Thankyou G. Samuels and Rudd government for co-operating. They can be fined a multiple of what they make in profits and corporate criminals can face up to ten years in jail. Its about time. I doubt this would have happened under the Coalition ..its more regulation (for those who hate the idea of more regulation) but its damn fine regulation and its been a long time coming.

  9. Chris,

    “The financial extension of a human vice to plunder” – WTF? So does trading goods for a profit equate to plunder? Perfect competition in theory elimiates profit but the profit is the return for the financial risk taken on which means if profit is eliminated so is the return. But that is beside the point. The first two questions are the most pertinent.

  10. @SeanG
    Sean – I think you are missing the concept of return implied in normal profits. If markets were truly perfectly competitive (which they are not) we would not see the sort of obscene profits that exist in the financial sector, that permit obscene remunerations. As Chris suggests capitalism has become “the financial extension of a human vice to plunder”. You dont have to look too far to notice it.

    (a natural inclination of capitalism if its weaknesses are not checked or there is no central planning authority as Adam Smith suggested was needed (and no the market isnt efficient enough to centrally plan itself as has become pretty evident).I think we can safely put some of the large banks in box labelled “the ugly face of capitalism.”

    But one small step for Australians happened tonight in the fight against what is NOT competition but imperfect and ugly noncompetitive market plunder by few..

  11. @Alice
    Yeah, it sure was good to see Samuel’s lay down the law, so to speak. Real jail terms. Real fines. Less “self-regulation” – surely “self-regulation” is one of the most used euphemisms among the free market advocates – and more appropriate regulation.

  12. Don – interesting to note changes to cartel legislation barely made the OZ or SMH news at all (no round of applause from either of them – as expected) Just one tiny piece by Fels and someone else buried in the middle and barely noticeable.

  13. SeanG

    Just to keep it simple.

    Obviously trading goods outside of a competitive market equates to plunder.

    Obviously trading goods inside a competitive market does not equate to plunder.

    Capitalism is the first – profits are boosted by expropriation.

    I support the second – profits are limited to actual growth.

    You understand neither.

  14. In my experience the problem with EMH, in respect of equity markets, is that there is usually a lag in share price movements such that current prices often reflect what prices should have been in a prior period, i.e., 3 – 18 months ago. I say this with tongue in cheek, yet it is very often the case.

    Another issue is the deeply flawed assumption that everyone has equal access to, and a common understanding of, the same information. If that assumption was even remotely reliable it would suggest that a group of students who study the same course and sit for the same exam should all achieve a perfect mark. Knowledge, experience and specific “market” information (and its interpretation) are so infinitely wide and variable that no one, except the irredeemably ignorant, could claim to have a complete grasp of all the relevant facts at any one point in time. When the maths PhDs applied the concepts of stochastic process to the pricing of credit derivatives no one could deny their prowess with numbers; but had they sat down across the kitchen table of some potential sub-prime borrowers and looked them in the eye (and the property they were offering as security) and asked them how they could afford to repay the loan, well, year 8 maths would have given them the right answer.

  15. First, a title suggestion:
    Zombie Economics: Seven Economic Ideas That Refuse to Die

    Second, a question about technical analysts. You write, “Among economists, the random walk hypothesis, now referred to as the ‘weak form’ of the EMH, is fairly generally accepted, and even the sceptics agree that any violations of weak-form EMH are subtle and hard to exploit. In a striking instance of the inefficiency of financial markets, however, investment banks continue to employ “technical analysts” using charting methods, decades after such methods have been shown not to work.”
    Is it possible that these methods don’t work precisely because there are still hundreds of people paid to try and exploit these trends? That is, if you everyone stopped paying any attention to these sorts of trends, would they continue to look at random? As you go on to say, “The success of the random walk hypothesis showed that the existence of predictable price patterns in markets with rational and well-informed traders was logically self-contradictory.” So, either the charting methods are part of the necessary toolkit of rational and well-informed traders, or the traders are irrational? Is there a bit of a contradiction here?

  16. Chris: With this accommodation, the EMH, which now formed the basis of the dominant approaches to financial economics, could co-exist with a large and expanding financial sector devoted to finding, exploiting, and thereby eliminating, opportunities for profitable trades. For those unable to afford such expensive talent, the EMH offered a solution: simply buy a portfolio of stocks that mimics, as closely as possible, the market as a whole. Investment in such index-linked securities has grown to reach 40 or 50 per cent of total capital holdings. There is, however, a catch. With such a large share of the market allocated to index-linked funds, it is difficult to tell how closely any given index matches the holdings of the informed investors the index-linked strategy is trying to mimic.

    Dan: I quite like your title

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