Wolf vs Siegel: EMH Smackdown
By Barry Ritholtz - October 30th, 2009, 9:00AM
You might have missed yet another smackdown yesterday: A debate on the Efficient Market Hypothesis in the FT vs the WSJ:
• Martin Wolf: How mistaken ideas helped to bring the economy down (FT)
• Jeremy Siegel: Efficient Market Theory and the Crisis (WSJ)
My read is Wolf trounced Siegel, but as a non-fanboy of EMH, I am biased.
My own short but devastating critique of Fama’s EMH, which according to Siegel, “states that the prices of securities reflect all known information that impacts their value.”
That assumes that their is nothing in the price that is non-informational in nature — no emotion, no panic, no greed.
That is simply wrong. It is the fundamental failure of EMH.
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October 30th, 2009 at 7:36 am
And thats before we get to other non informational effects such as trend, fraud, false info, etc.
October 30th, 2009 at 9:08 am
I agree with you that emotion and urgency is not factored in using the EMH. Fraud, false info, etc also plays a part as you stated. Price data in the information age, with its wide availability and speed at which it can be obtained, might play the biggest role of all.
October 30th, 2009 at 9:24 am
Thats the point — its not magic, and someetines its reflected, and soemtiems it isnt.
Enron –the biggest fraud in US history — was revealed a full year before the stock went to zero
October 30th, 2009 at 9:42 am
I’ve been saying this for years — I don’t understand how EMH (a great fund manager I once worked with used to call it the “Efficient Market Viewpoint”, often preceded by the word “silly”) was ever taken seriously. It can’t just be because Fama is a volatile screaming asshole who flips out in scary ways at dissenters, though I’m sure that’s part of it, at least in academic circles. I don’t get it. And I definitely don’t get why anyone suggests that it’s a Nobel-worthy idea.
October 30th, 2009 at 9:43 am
if Jermey had worked at some of the places i’ve worked he would know that markets are not efficient..
October 30th, 2009 at 9:46 am
i remember when i was getting my finance degree many moons ago- EMH was crammed down our throats as part of the curricula-
being wide eyed and eager to learn- i bought it hook, line and sinker-
now i wonder- what the hell were they thinking teaching that nonsense-
brainwashing i say
also- BR- following up on your Anglophile comment from last night-
what- no mention of Benny Hill?
October 30th, 2009 at 9:47 am
The degree to which participants have been willing to act on all information is reflected in the price…
October 30th, 2009 at 9:47 am
BR wrote:
I think the obvious out for EMH-proponents to the argument you’re making is that the prices of securities are the result of market participants having quantified these elements (the emotional elements or trends) to incorporate them as information, and in the case of fraud, the result of not being able to distinguish between good and bad information, when the information first becomes available to affect stock prices. After all, fraud, when it’s discovered, is almost always discovered well after the fact.
Where information is concerned, it may be more useful to consider stock prices at any point in time to be the result of a combination of signal and noise. Signal represents high quality information, which is comparatively stable over time, and which would change as the respective companies’ business fundamentals are expected to change. Noise would represent poor quality information, which spans emotions, trends (maybe inertia would be the better word here), fraud, etc. and would be responsible for much of the apparent randomness in the prices of securities over time.
I’m not sure which, if any, variant of the EMH would apply for what I’ve described above. It may be that the EMH’s value is in stating that stock prices incorporate known information (which would kind of be like stating that water is wet), but like the zeroeth law of thermodynamics, is something obvious that needs to be stated somewhere.
October 30th, 2009 at 9:49 am
Didn’t someone get a Nobel Prize for EMH?
~~~
BR: FAMA? Nope
October 30th, 2009 at 9:54 am
I am 43.2% scared right now after reading this post.
October 30th, 2009 at 9:59 am
Barry one thing I do not understand about finance is the mass aggregation of false and misappropriated theories. In one fell swoop here you’ve pointed out some huge problems with the EMH. Enough problems to, under scientific review, falsify it.
So why is it being taught and followed? Taleb gave an interview last year where he questioned the same thing, focusing on Black-Scholes.
I greatly respect this blog for coming at finance from an analytical, logical viewpoint and while this question may seem simple I am very seriously asking it: Why doesn’t everyone else do the same?
(As an aside, I’ve been reading your blog over the past couple of years, though this is my first time commenting. I’m 23, an Econ grad, and hands down have learned more macroeconomics from this blog than I ever did in class. Thank you.)
October 30th, 2009 at 10:02 am
EMH = another scam (or gag?) run by the elites on the Sheeple. It’s so ridiculously wrong, it must be right. It’s like that esoteric piece of crap “artwork” in some chi-chi “Modern Art” museum that nobody in their right minds thinks is “art”, but goes along with it because the elites tell them it is.
October 30th, 2009 at 10:29 am
LSS: EMH was a discarded idea until it became useful for selling MutFundz, or, Worse, Index Funds.
http://www.jstor.org/pss/2327056 (1979) as a singular rebuttal.
never one to “Look a Gift-Horse in the Mouth”, soon, thereafter, we saw “EMH was crammed down our throats as part of the curricula” -a, key, first Prop of the FIRE “Economy”..
“Ask Abigail”, for one, the value of ‘the Font of the Eternal Bid’.
October 30th, 2009 at 10:46 am
New to all this all I have to say is wouldn’t spec play stocks totally counter EMH?
October 30th, 2009 at 10:57 am
“That assumes that their is nothing in the price that is non-informational in nature — no emotion, no panic, no greed.”
And no fraud, gambling schemes dressed up as investments, etc. EMH is about “rational” actors, not messy, greedy, crooked humans who seem to all be in charge of Wall Street these days. Rational actors are only found in academia, busy devising theories. Although if you set them free to argue at a conference or back and forth in a journal or on a blog, they get pretty messy too. They just don’t acknowledge that side of themselves, which allows theories like EMH to remain born free–as free as the wind blows, as free as the gas flows, from academia to you and me.
http://wallstcheatsheet.com/breaking-news/executive-pay-is-not-the-problem-stealing-is/?p=2973/
October 30th, 2009 at 11:33 am
Jeremy Siegel is a clown and a dope. He was basking in his own stupidity before this crisis hit with pump after pump about how cheap stocks were and how great the economy was. It’s apparent he has again hit his head in another fall during one of his mental masturbation sessions – a favorite pastime of ivory tower academics. How anyone ever listens to him is beyond me. That the WSJ prints his slobbering drool is another confirmation of how pathetic the WSJ has become.
Jerry, come on out in the real world a little bit. We can introduce you to reality.
October 30th, 2009 at 12:10 pm
I read the book about Enron, dozens of people who worked for the company were questioning things 3 years before the fall. Our Houston branch in 1999 was courting work on there new world headquarters we were basically told we should do the work for free as a marketing tool, yeah, right a million dollar contract for free, lol…….in any business you have war stories yet when I heard this one I had too laugh because one of our competitors was considering the offer, which makes it even funnier, how folks act in the beginning of a deal is usually somewhat commensurate of how the whole deal will go, thus it was a have at it moment. Back to Enron, the main issue when you get into the details was how many outside vendors who questioned lot’s of things, yet, just let it slide because the contracts were rich and always plentifull, and I’m talking Merrrill Lynch, the accouting firms, the lawyers, the consultants, I am sure it is just and exact duplicate as Bail Out Nation…….no one believed in it, yet, the profits were plentifull and consistent while it lasted.
October 30th, 2009 at 12:15 pm
I imagine that EMH is going to be unpopular here. After all, if we believed in it we would all be 100% SPY and living the good life in Tahiti. I think it is evident that information moves at a finite speed and trading moves at a very finite speed so traders who consistently get their information before the average time and people who can trade more quickly than the average should be able to beat average returns consistently. I look at the lags in information and trading speed as momentum and think that the momentum of the market can provide useful signals. And, of course, good research may well discover information that is not widely known and that too can provide signals. I’m convinced that a combination of fundamental analysis and a careful use of technical patterns can give a trader a consistent advantage. That’s why I visit this blog. It is a truism that on average the population of investors will win and lose in a balanced way within the distribution but I think it is circular to argue from there (as I believe the EMH does) that individuals must somehow win and lose randomly. Seems to me that EMH is essentially making the argument that everyone who takes a test must get the average mark if they take it long enough. That’s just silly — we know some poor bugger will fail it every time and some bright persons will ace it every time.
October 30th, 2009 at 1:02 pm
Wait a minute: what EMH is saying is that it is tough to make money trading in markets. Lehman, Citicorp, UBS and others thought they could see an arbitrage opportunity in AAA rated CDOs: their analysis told them the market price of the bonds was too low: guess what? they levered up to buy and the prices went lower still. Surely their very losses CONFIRM the EMH that it’s hard to tell if a price is too high or too low??
~~~
BR: Its tough to make money trading the markets, or as Pro football player, or as a moving man, or as an accountant, or as . . .
October 30th, 2009 at 1:18 pm
The problem with EMH is not that it isn’t valid as one of many components in determining price, it is that it was touted as the most influential and the others are de minimus in price determination. Many of us have know for sometime that the inverse is true–EMH has been given far too much weight as a factor in the price equation. But if you are an academic, it’s the most appealing measure as it is conveniently quantitative whilethe other larger factors (in terms of multipliers and weight) as less so.
Reminds me of the joke: It’s near midnight and a beat cop comes upon a drunk is down on his hands and knees scrutinizing the ground under a streetlight. The cop walks up and asks what he’s doing. The drunk says:” I lost my hotel key”. The cop says: “I’ll help you look. Where’d you lose them?”. The drunk point over to a dark alley and says: “Over there back in the alley”. The cop scatches his head and says: “Then why are you looking here then?”. “Because the light is better” replied the drunk.
October 30th, 2009 at 1:21 pm
EMH also infected the law, although to their credit a lot of judges and lawyers never drank Posner’s kool aid. But over the last 25 years a lot of influential case law was made based on the non-sanctity of contracts and the assumption of perfect pricing in negotiating contract terms. Influential legal scholars questioned whether insider trading should even be a crime. The bullshit runs deep throughout the System.
~~~
BR: I think Posner has been America’s longest running legal fraud — he should hav ebeen thrown off the bench yearsa go.
He ignored the constitution to build his own belief system into the judicial process
October 30th, 2009 at 1:29 pm
“Influential legal scholars questioned whether insider trading should even be a crime. ”
Wow, that’s amazing. I didn’t realize that. They sure drank the kool-aid, eh?
October 30th, 2009 at 2:21 pm
@MEH
As long as WS fund managers can’t read a balance sheet, EMH and index funds will continue to look good (relatively speaking).
October 30th, 2009 at 2:44 pm
emmy,
Financially? maybe. Economically? Never.
also, if peep(“investors”) can’t read a Balance Sheet, they shouldn’t be exposed to Equities, through any Vehicle..
past that, your statement ignores the Value of the, aforementioned, Font, and misses, totally, the Capital Cost advantage bequeathed to Co.s who happen to selected, by some unknown ‘Formula’, to be ‘in the Index’..
it’s sad, if ‘they’ published the ‘Formula’, caeteris paribus, S&P 501-510 ‘Index Funds’ would outperform ‘the Mkt.’.. then 511-520, 521-530, … it’s ridiculous in, too, many ways..
October 30th, 2009 at 3:29 pm
“no emotion, no panic, no greed.”
Uh, that would be Asimovian robots.
October 30th, 2009 at 3:42 pm
I like what Don Worden has to say on this one:
“Much of that which is known about a stock is reflected in its price.
Sometimes some of that which is NOT generally known about a stock is also hidden in its price.
Sometimes that which is knowable is NOT reflected in the price of a stock because it has remained unrecognized.
Sometimes the price of a stock simply does not coincide with reality because of poor judgement, propaganda, fraud, manipulation, intentional misinformation or hysterical mob behavior.”
October 30th, 2009 at 4:22 pm
Costanza paraphrased: “I know less about [EMH]…than anyone in the world. But the one thing [I think] I know is that” the EMH should instead be known as NEMH (“nearly”).
http://www.youtube.com/watch?v=8bkOVOOTkeI
Maybe if the Famiegels of the world spewed forth about the nearly efficient markets, they’d be onto something (but of course, nobody would care – it would be a non-story). I am not closely familiar with the details of their work, but I suspect that the EMHers don’t speak of EVENTUAL efficiency but rather speak to tick-by-tick or similar short time frame efficiency. To that, I would simply echo “bgd123′s” above post. Freakin’ clowns.