Efficient Market Hypothesis
Jeremy Siegel of the Wharton School looks at the claims that the Efficient Market Hypothesis (EMH) is the cause of the current crisis and rejects these claims. The main part of his argument is,
But is the Efficient Market Hypothesis (EMH) really responsible for the current crisis? The answer is no. The EMH, originally put forth by Eugene Fama of the University of Chicago in the 1960s, states that the prices of securities reflect all known information that impacts their value. The hypothesis does not claim that the market price is always right. On the contrary, it implies that the prices in the market are mostly wrong, but at any given moment it is not at all easy to say whether they are too high or too low.
Now, a naÃ¯ve reading of this might be that markets incorporate all information that has an impact on the price of a security. This is an inaccurate reading. Consider the weak form of the EMH,
In weak-form efficiency, future prices cannot be predicted by analyzing price from the past. Excess returns can not be earned in the long run by using investment strategies based on historical share prices or other historical data. Technical analysis techniques will not be able to consistently produce excess returns, though some forms of fundamental analysis may still provide excess returns. Share prices exhibit no serial dependencies, meaning that there are no “patterns” to asset prices. This implies that future price movements are determined entirely by information not contained in the price series.–emphasis added
Note that last part. Price movements are determined by information not contained in the price series. If the failure of rating agencies to accurately reflect the actual risk of a security is not in the historical information, then it cannot be anticipated by market participants and will move asset prices in an unpredictable way, which is why the above definition of the EMH continues with, “Hence, prices must follow a random walk.”
Even a bubble, while anomalous, is permissible under the weak form of the EMH as a rare statistical event. So the mere fact that there is a bubble does not render the hypothesis moot either. Still, as Prof. Siegel notes, this does not absolve the various CEOs, regulators and politicians of responsibility. To use Donald Rumsfeld’s categorization, there are known knowns, known unknowns and unknown unknowns. It is the latter two categories that can lead you to ruin, especially if you pretend that the first category is sufficient to allow you to earn excess profits.