The Flat Earth Society has all but disappeared, but the efficient-market hypothesis is alive and well. This week, the Nobel Memorial Prize in Economic Sciences was awarded to its most tenacious advocate, Eugene F. Fama of the University of Chicago.
The hypothesis posits that the stock market is an “efficient” calculating machine, and that stock prices are rational computations of observable facts. It follows that future prices are unpredictable.
As Fama wrote in a version of his doctoral thesis 48 years ago, “If the random walk theory is valid and if security exchanges are ‘efficient’ markets, then stock prices at any point in time will represent good estimates of intrinsic or fundamental values.”
This idea is contradicted by the view that human behavior is often irrational (or imperfect) and that, therefore, the market not infrequently gets it wrong. It is also contradicted by the many investors who have exploited mispricings to beat the market and by the many examples of investor folly or bubbles.
Robert Shiller of Yale University dubbed the efficient-market hypothesis “the most remarkable error in the history of economic theory.” (Whoops: Shiller was one of three Nobel economics laureates this year, along with Fama and Lars Peter Hansen.)
By trying to have it both ways, the Nobel committee missed a chance to confirm that observed experience has undermined a beguiling but simplistic theory that has charmed the economics profession.
The efficient-market crowd contends that successful investors such as Warren Buffett are merely lucky; let enough people flip coins and someone will keep rolling heads, even over a period of decades. Behaviorialists (including me) point out that when the same people, following the same discipline -- patient, long-term searching out of underpriced stocks -- keep finding profitable opportunities, it means the market is imperfect.
For those in thrall to efficient markets, no such opportunities can be determined in advance, because if they could, smart people would have exploited the opportunity until it disappeared. (You know the joke: An economics professor stoops to pick up a $20 bill, and his colleague says, “Don’t bother; if it were really $20, it wouldn’t be there.”)
At root are two contrary views of human nature. One sees investors as counting machines, the ever-rational subspecies known as Homo economicus. But people succumb to irrational passions in love and war and religion and politics -- so why not in economics?
Behavioral economists such as Shiller and Richard Thaler, Nobel-winning psychologist Daniel Kahneman, and others have demonstrated that there are repeated patterns to people’s irrationality. One of the most common is that most people simply follow the crowd instead of calculating the intrinsic value of a stock. This is why bubbles occur.
The controversy has huge ramifications. If markets are perfect, stock-picking doesn’t make sense. Everyone should just index their portfolios.
It also affects government. If you believe in rational actors, there is no need to regulate against mass folly (only against chicanery).
This belief in rational actors has handcuffed the Federal Reserve. Former Chairman Alan Greenspan slept through the investor folly of the late 1990s, when the stock market put multibillion-dollar valuations on dot-com companies that were nothing more than business plans.
Greenspan refused to try to deflate the bubble because he didn’t believe that masses of investors would be foolish, or that such manias could be identified in advance. The current Fed chief, Ben S. Bernanke, then a Princeton University scholar, took the same position. Both repeated this mistake during the mortgage buildup. Neither placed emphasis on regulating mortgages because neither believed that bankers would succumb to mass folly.
The 1987 stock market crash, when the Dow Jones Industrial Average fell 22.6 percent in the absence of major news, should have dealt a death blow to the efficient-market hypothesis. But it didn’t. Fama and others argued that the crash reflected a rational repricing of expected corporate values. Similarly, after the mortgage meltdown, Fama was quoted in the New Yorker as saying, “I don’t even know what a bubble means.” In other words, the market wasn’t -- and couldn’t be -- wrong. The high price was as rational as the new one. Shiller, who surveyed investors after the 1987 crash, spotted something other than rationality: mass hysteria.
If behavioral theory, with its messy, imperfect view of investors, has won in the real world, the efficient-market hypothesis has long been trumps in academia as an elegant theory that offers a pleasingly ordered view of the world. People are deductive; prices are rational. Modern finance is built on mathematical models designed around a presumption of efficient and random markets.
Defenders of rational markets often point out that most investors don’t beat the market indexes. There is less to this observation than there initially seems. First, it is a truism that the average investor will have average performance. Second, the existence of occasional inefficiencies doesn’t mean that beating the market is easy. It requires work, analysis, patience and the fortitude to resist trends. Most stocks are probably priced about right most of the time. It’s the investor’s job to find the ones that aren’t.
Then there is the claim that markets are random “in the short run.” This is true but also not very important. For instance, even at the height of the dot-com bubble, no one could say what would happen over the next hour, day or week. But investors could nonetheless calculate that tech stocks were overpriced and would crash sooner or later.
Robert C. Merton, who won an economics Nobel in 1997 for his work in options theory, recognized how incompatible the two views are. “If Shiller’s rejection of market efficiency is sustained,” he wrote in 1986, “then serious doubt is cast on the validity of this cornerstone of modern financial economic theory.”
Merton was rudely validated some years later, when he was a partner at Long-Term Capital Management LP, which, like many other hedge-fund managers, used an assumption of randomness in its risk-exposure models. Those calculations turned out to be way off. Markets moved in the wrong direction, in very nonrandom ways, and the fund collapsed in 1998.
The fact that markets can move nonrandomly was documented in 1965 by none other than Eugene Fama. In that research, he observed that stock prices exhibit many more extreme movements than would occur in a normal, random distribution. Extreme changes that should occur every 7,000 years, Fama wrote, “seem to occur about once every three to four years.”
How many market shocks have to occur before people are no longer shocked, one might ask? But at long last, the prevalence of market bubbles seems to be denting the once-worshipful belief in efficient markets.
Academic textbooks once preached the hypothesis with religious fervor. Now, doubt is creeping in. N. Gregory Mankiw’s “Principles of Economics” asks “Is the Efficient Markets Hypothesis Kaput?”
Even Janet Yellen, who has been nominated to succeed Bernanke, said recently that the Fed should reconsider its traditional view that it shouldn’t attempt to pop or restrain market bubbles. Can the Nobel committee be far behind?
(Roger Lowenstein is writing a book on the origins of the Federal Reserve System.)
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