Teaching "The Efficient Markets Hypothesis" with a Straight Face

One of the central concepts in Finance Theory is "the efficient markets hypothesis" which says, in a nutshell, that if there is money to be made doing something, resources will flock to that something with the result that pretty much all investment opportunities will yield the same rate of return after an adjustment for risk. Further wrinkles of the hypothesis show that the risk adjustment is linear: i.e. as the risk (measured as variability) of an asset changes, market forces will adjust asset prices  so that the expected return adjusts by some constant amount.

Put differently (from Wikipedia):

In finance, the efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient", or that prices on traded assets, e.g., stocks, bonds, or property, already reflect all known information. The efficient-market hypothesis states that it is impossible to consistently outperform the market by using any information that the market already knows, except through luck. Information or news in the EMH is defined as anything that may affect prices that is unknowable in the present and thus appears randomly in the future.

I have taught courses in corporate finance twice in my life, both while visiting The University of Guelph: once in 1984 and again last fall (2007). Given my general feelings of bare adequacy in the area, I am delighted and relieved that I am not teaching the course now. It would be very difficult to cover this material with a straight face.

If the efficient markets hypothesis holds, and if investors are generally rational maximizers with rational expectations, then how did the current financial situation evolve? Why was there so much systematic error or bias for so long in investors' assessments of assets? Why were there not more smart people betting against the trend and the euphoria of the markets?And why didn't these contrary bets play the auto-correction role normally expected in financial markets?

Nearly four years ago, Barry Ritholtz tried to answer these questions on his blog as he criticized EMH. At that time I was unconvinced by his arguments, and to be honest, I still am somewhat skeptical the explanations offered in "behavioural finance"; I find it really hard to understand why so many investors might leave so much money lying on the table for any length of time without realizing it is there. To personalize it, why didn't more people, like me or like JD, move a sizable bunch of their retirement assets out of equities and into less risky assets?

It is really hard to preach and teach EMH and rational expectations when so few people bet so little against the market, especially after the Northern Rock debacle over a year before the market meltdown.Why did it take so long for stock indices to drop and for the housing derivatives market to be exposed as the modern-day equivalent of the emperor's new clothes? Posner and Becker attempt to answer these questions, but even they are not sure (still, their thoughts on this topic are still worth reading).

Even if prior to the summer of 2007, people did not see the housing crisis coming and did not raise their eyebrows about all the NINJA mortgages, the weird derivatives, and the alleged insurance schemes backing them, why didn't the Northern Rock episode set off more alarm bells?

Is there a chance that the episode did, indeed, ring alarms loudly but that decision makers continued to gamble, hoping to get out of the market before the others did? After all, stock market indices continued to rise until October, 2007, indicating that most people seemed unconcerned about the possibility of imminent collapse of the house of cards.

Or is it possible that people saw the meltdown coming but expected that, as has happened, the gubmnt would bail out the major mortgage and derivative insurers (and many but not all of the holders of this wacko paper)? Perhaps the EMH is still a pretty decent theory unless the gubmnt is involved in some major fashion.

At any rate, I sure am glad I'm not teaching a finance course this term. It would be a case of the blind leading the blind.

Note: I pretty much learned finance by teaching the course back in 1984. I had done some research before then that relied on many principles in finance theory, but I had never had a formal course in financial theory. But that's no big deal. I have never had a course in The Economics of Sports or in Economic Analysis of Law, either, and those are the main courses I have been teaching over the past decade or so. One nice thing about a lengthy academic career is the flexibility to change fields as one's interests change.

Comments

[Ironman]

"Is there a chance that the episode did, indeed, ring alarms loudly but that decision makers continued to gamble, hoping to get out of the market before the others did? After all, stock market indices continued to rise until October, 2007, indicating that most people seemed unconcerned about the possibility of imminent collapse of the house of cards."

Glad you asked! The market did provide two separate signals ahead of January 2008 that order was breaking down (see chart here):

http://tinyurl.com/4xpn6v

The first came between July 2007 and August 2007. The second came after the market peaked in October 2007. Given that the kind of sizable shifts you see in this chart often precede large disruptive events, that's about as clear a signal as you can get that the market was, in fact, anticipating significant trouble ahead. So, the question becomes why did investors stay in?

The answer to that, I suspect, is because investors are a lot like teenagers at a party where the parents are out of town, but are on their way back. A good number of the kids at the party know that, but don't know when they're going to show up.

So, they keep partying because they might miss out on the fun that's going on. And the later the party goes on, the more fun there is to be had.

Some kids leave early, having had enough fun. Others are out to get every last drop of fun they can, partying harder and harder as it gets later. And then the parents show up, just after midnight, and everyone runs.

In other words, they're rational maximizers. They receive at least a marginal benefit from staying at the party, even though they know its going to come to an end, badly. I strongly suspect the stock market works much the same way.

That end came in January 2008, after the focus of investors turned away from whether or not companies would hit their anticipated performance targets in the fourth quarter of 2007 and instead to whether they would hit any of the projected targets for 2008. The answer was no, and stocks began falling, initiating the early phases of the disruptive event in which we find ourselves today.

After that initial shift, order in the stock market (as determined by whether both stock prices and dividends per share are growing at exponential rates) didn't break down right away. It just plugged along at a lower level. That came to an end in July 2008 as dividends per share in the market began collapsing as distressed financial companies began slashing or suspending their dividends.

Ref: http://tinyurl.com/6lcxjr

In the charts in the post linked above, you can see order breaking down, once again preceded by those large downward shifts. For the month of October 2008, the average of stock prices for the S&P 500 now looks to be directly below that for September, only about 200 points lower. Order has fully broken down.

My best guess is that we've seen the absolute low for the market already, although as measured by the average of closing stock prices for each calendar month, we still haven't seen the peak of distress in the market. That will likely occur in the third quarter of 2009. Historically, peaks of distress in the stock market often coincide with it hitting at or near its bottom:

Ref: http://tinyurl.com/2xf8wq

Unless dividends go into reverse sooner. In that case, the good news is that peak of distress will also arrive sooner:

Ref: http://tinyurl.com/6gkl5h

Crap. Looking back over this comment, I can see that I'm going to have to convert it into a proper post! My apologies for cluttering your comment box!

[Robert C]

Buy it. Sell it. Make a profit. It doesn’t matter what it is. Doesn’t matter if we need it or want it. It’s All Tuna! is where you can find out about how the “market” treats its customers. Our lives are something for them to buy and sell and on which to make a profit. When the profits begin to fail, they make us “lend” them our futures too. The measure of performance for "an efficient market" is profits. The trouble with this is that a predatory investor can squeeze profits out of commodities and other resources along with the blood of people who actually produce something.

Kevin Phillips wrote in Bad Money that the Canadian financial community a few years ago wanted the government and news media to declare a credit emergency in order to get a bailout. They failed to get what they wanted. Our Congress was not so smart. Naomi Klein wrote us a history of laissez-faire economics in her book Shock Doctrine and demonstrates how far the powerful financial institutions will go to make a profit. Rampant Capitalism is just as bad as zealous Socialism.

The non-sustainability of unregulated capitalism comes because of the predation that is part of the financial culture of people who see The Market as a place to buy and sell without regard to the collateral damage that is done. We all love the gasoline that comes from oil and the US buys 25% of the Niger Delta oil production. The people there live in the worst poverty and polluted environment on earth. But the market measures it performance in profits not quality human lives.

Non-sustainability leads to the Principle of Imminent Collapse and future misery for billions of humans.

[Rick]

Isn't it less likely (read: impossible) to observe efficient markets so long as the Working Group exists?

[KevinT]

"...decision makers continue to gamble.."

That's exactly right. Think back to the comments made by Chuck Prince (of Citigroup) at the very moment this whole mess started to crumble. But instead of talking about gambling, he said Citi would remain on the dance floor until the music stopped.

[Ironman]

KevinT: How cool! I'll have to see if I can't find the exact Chuck Prince quote and incorporate it into that post I hinted at making earlier - it's a perfect fit!