Efficient Market Hypothesis

BIBLIOGRAPHY

The efficient market hypothesis (EMH) holds that financial markets make efficient use of available information so that traders cannot base profitable trading strategies on available information. Such information will already be incorporated in asset prices, because when traders take advantage of profitable arbitrage opportunities, their trading changes the prices of assets, and thus public information cannot be used to outperform the market. The weak form of EMH holds that all past prices of an asset are fully reflected in its current market prices, so that charting and technical analysis of stock price movements cannot provide an abnormal profit. The semistrong form of EMH views asset prices as incorporating all publicly available information, so that fundamental analysis of a company’s business prospects, based on its reports and on published news and analysis, will not yield an excess return. According to the strong form of EMH, prices of securities fully reflect all public and private information, so that even insider trading does not achieve excess profits (see Fama 1970).

Although some earlier observers had the concept of market efficiency due to arbitrage (at least in the weak form of EMH and arguably in the semistrong form), notably Jules Regnault (d. 1866) (see Franck Jovanovic in Poitras 2006–2007, vol. 1), the mathematical implications were first set out with regard to the prices of options on French government bonds by the probability theorist Louis Bachelier (1870–1946) in his 1900 dissertation Théorie de la spéculation (translated in Cootner 1964). By analogy to fair bets in games of chance, Bachelier showed that the absence of unexploited arbitrage opportunities implies that changes in asset prices are unpredictable, so that in efficient markets asset prices follow a random walk (in discrete time) or Brownian motion (in continuous time), stochastic processes that Bachelier characterized five years before Albert Einstein (1879–1955) independently formalized Brownian motion for gas particles.

Although Bachelier’s thesis was published sixty years before John Muth proposed the rational expectations hypothesis, Bachelier assumed that speculators had what Muth would call rational expectations: Their expectations of prices were correct except for completely unpredictable, random errors. Disillusioned with the failure of stock market forecasting services to predict the crash of 1929, Alfred Cowles III (1891–1984) compiled evidence (1933) that the forecasters did no better than random portfolios would have done, so that the fees paid by their subscribers were wasted—although Cowles (1944) later changed his mind, accepting that one unnamed forecaster (apparently William Peter Hamilton’s [1867–1929] version of the Dow theory) had outperformed the market more often than could be attributed to chance. Cowles questioned why anyone who could actually predict the movement of stock prices would sell the prediction for a fee instead of making a fortune by trading on his or her own account. In 1934 Holbrook Working (1895–1985) showed that, for there to be no unexploited possibilities for profitable arbitrage, commodity prices must follow a random walk. Despite Cowles’s role as founder of the Cowles Commission for Research in Economics and Working’s influence on the Food Research Institute at Stanford University, the early research on efficient markets had little influence until the late 1950s (see Cootner 1964; Fama 1970; Poitras 2006–2007, vol. 2).

In 1958 Franco Modigliani (1918–2003) and Merton Miller (1923–2000) used the no-arbitrage principle to argue that firms cannot increase their market value by altering how their financial structure is divided between debt and equity, because if a firm could do so, then individual investors could make arbitrage profits by analogous portfolio changes between shares and bonds (see Miller et al. 1988). The Modigliani-Miller proposition abstracted from any differences in tax treatment of different financial structures and from the asymmetry that corporations have limited liability but individual investors do not.

As influentially expounded by Eugene Fama (1970) and Burton Malkiel ([1973] 1999), the weak form of EMH implies that the only way to profit from charting and technical analysis of stock price movements is by selling worthless forecasts to the gullible, and the semistrong form implies that investors should just invest in broad market averages, avoiding the costs of active portfolio management and security analysis. These ideas were anathema to the forecasters and managers whose livelihood they threatened, to successful investors who were told their above-average risk-adjusted returns were due to luck rather than skill, and to the widely held hope that there is some expert or formula that, for a thousand dollars, will tell one how to make a million. Nonetheless, the weak and semistrong forms of EMH became increasingly accepted and contributed to the growth of index funds.

The strong form of EMH, implying the failure of laws against insider trading, was advanced more tentatively even by firm believers in the weak and semistrong forms. However, the current status of the efficient market hypothesis is unsettled (see the debate between Malkiel and Shiller 2003). Financial markets cannot be more than approximately efficient, because perfect information efficiency would leave no incentive for professionals to discover the information that is incorporated in prices. Andrew Lo and Craig MacKinlay (1999) find evidence of serial correlation in stock price movements, contrary to the weak form of EMH. Robert Shiller (1989, 2005) presents evidence of excess volatility of asset prices, which move not just because of random shocks and rational expectations of underlying fundamentals but also because of what John Maynard Keynes (1883–1946) called “animal spirits” and Alan Greenspan termed “irrational exuberance,” as during the Internet bubble of the late 1990s. Defending the EMH against advocates of behavioral finance, Burton Malkiel argues that speculative bubbles can be identified only in retrospect and that “whatever patterns or irrationalities in the pricing of individual stocks that have been discovered in a search of historical experience are unlikely to persist and will not provide investors with a method to obtain extraordinary returns. If any $100 bills are lying around the stock exchanges of the world, they will not be there for long” (Malkiel and Shiller 2003, p. 80).

SEE ALSO Arbitrage and Arbitrageurs; Bubbles; Equity Markets; Expectations, Implicit; Expectations, Rational; Finance; Financial Markets; Gambling; Information, Economics of; Interest Rates; Modigliani-Miller Theorem; Random Walk; Risk; Speculation; Stationary Process; Stock Exchanges; Stock Exchanges in Developing Countries

BIBLIOGRAPHY

Cootner, Paul, ed. 1964. The Random Character of Stock Market Prices. Cambridge, MA: MIT Press.

Cowles, Alfred, III. 1933. Can Stock Market Forecasters Forecast? Econometrica 1 (4): 309–324.

Cowles, Alfred, III. 1944. Stock Marketing Forecasting. Econometrica 12 (3): 206–214.

Fama, Eugene. 1970. Efficient Capital Markets: A Review of Theory and Empirical Work. Journal of Finance 25 (2): 383–417.

Lo, Andrew W., and A. Craig MacKinlay. 1999. A Non-Random Walk down Wall Street. Princeton, NJ: Princeton University Press.

Malkiel, Burton G. [1973] 1999. A Random Walk down Wall Street. 7th ed. New York: Norton.

Malkiel, Burton G., and Robert J. Shiller. 2003. Symposium: Financial Market Efficiency. Journal of Economic Perspectives 17 (1): 59–104.

Miller, Merton H., Joseph E. Stiglitz, Stephen A. Ross, Sudipto Bhattacharya, and Franco Modigliani. 1988. Symposium: The Modigliani-Miller Propositions after Thirty Years. Journal of Economic Perspectives 2 (4): 99–158.

Poitras, Geoffrey, ed. 2006–2007. Pioneers of Financial Economics. 2 vols. Cheltenham, U.K., and Northampton, MA: Elgar.

Shiller, Robert J. 1989. Market Volatility. Cambridge, MA: MIT Press.

Shiller, Robert J. 2005. Irrational Exuberance. 2nd ed. Princeton, NJ: Princeton University Press.

Working, Holbrook. 1934. A Random Difference Series for Use in the Analysis of Time Series. Journal of the American Statistical Association 29 (1): 11–24.

Robert W. Dimand