In my discussion of the efficient markets hypothesis, I’ve asserted at various times that if (strong or semi-strong) EMH holds, then the market price of an asset “the best possible estimate of the value of the asset” or, more simply, the “right” price. Quite a few commenters asked me to spell out what this means, and there was some useful discussion. This really is the central issue in evaluating the EMH, so I want both to get it right and to express myself as clearly as possible for non-specialist readers. There’s a draft over the fold. I await your brickbats and (hopefully) bouquets.
The EMH implies that the prices generated by stockmarkets and other asset markets are the best possible estimate of the ‘right’ price for the assets concerned. But what does it mean to say ‘The Price is Right’?
From the point of view of an investor, the value of an asset is determined by the flow of income it generates over the period for which it is held and the disposal value (if any) at the end of the period. This stream of payments can be converted into a current value by a discounting procedure (the opposite of working out a future value using compound interest): the problem is to choose the ‘right’ risk adjusted discount rate.
Given efficient markets, economic analysis suggests that the discount rate should be determined by the socially efficient allocation of the aggregate risk for the economy as a whole among individual consumers. This gives rise to a model of the determination of the prices of capital assets called (perhaps unsurprisingly) the Capital Asset Pricing Model, or CAPM. Economists who want to stress the point that the asset prices are ultimately determined by the preferences of consumers sometimes make this explicit and refer to CCAPM, the Consumption-based Capital Asset Pricing Model. The difficulties of CCAPM will be discussed in Chapter …, but for the moment it is sufficient to note that the model depends critically on the efficient markets hypothesis.
If a stock price is indeed the best possible estimate of the risk-adjusted value of future dividends and resale values, then individual investors (at least those without inside information according to the semi-strong EMH) can do no better than to buy a portfolio of stocks and other asset prices that matches their risk preferences, without worrying about attempting to make their own estimates of the value of individual assets. In this sense, the price is right for them.
But there is a stronger, and more important sense in which the EMH implies that market asset prices are the right prices. Given any possible set of investments, market participants can estimate the value of those investments by considering the likely immediate impact on the stock prices of the companies concerned, or the likely return in an Initial Public Offering (IPO). Capital markets will fund the subset of investments with the highest market value. If there are no relevant market failures outside capital markets, the EMH says that these will also be the most socially valuable investments.
The qualification about market failures requires some clarification. Suppose a company is considering an investment that will be highly profitable but environmentally damaging. Then stock markets will value the company on the basis of the profits, and will fund the investment, even though it may be less socially valuable than an alternative, more environmentally friendly choice. In this case, the financial market price is not the ‘right’ price.
But, an EMH advocate will say, the answer is not to try and change financial markets, for example by promoting socially responsible investments. Rather the correct response is to address the market failure directly by imposing tighter environmental regulations. In fact, a sufficiently strong EMH advocate will argue, even the prospect of such regulations will depress the value of the company, and this will lead markets to kill socially damaging projects even before governments have got around to responding to them. Given the EMH, all is for the best in the best of all possible worlds (provided “possible” is defined carefully enough).