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20 November 2009
*Extract of a speech by Professor Stephen Brown, the David S. Loeb Professor of Finance at New York University and keynote speaker at Deakin University’s Finance on the Move Symposium, ( Friday November 20).
We are now approaching the 40th anniversary of the publication of Eugene Fama’s classic paper “Efficient Capital Markets: A Review of Theory and Empirical Work” which is the fundamental statement of the ‘Efficient Markets Hypothesis’ (EMH) as it has become known.
Many commentators, including Australia’s Prime Minister Kevin Rudd and Minister for Finance Lindsay Tanner have suggested that economists in general and financial economists in particular have some responsibility for the recent global financial crisis. They argue they were blinded by an irrational faith in a discredited EMH and failed to see the bubble in asset prices and to give due warning of its collapse. The irony in this commentary is that the strong implication of this hypothesis is that nobody, no practitioner, no academic and no regulator had the ability to foresee the collapse of this most recent bubble.
While the term EMH means many things to many people, its creator – Eugene Fama – has stated that the term has a very precise meaning. It is nothing more than the statement that security prices fully reflect all available information. A market in which prices fully reflect all available information is said to be efficient. Nevertheless, there is a great deal of confusion in the public discussion of the EMH.
The statement that prices “reflect all available information” implies that no trader has any kind of informational advantage in the security markets. If this is so, then the price today reflects the common or ‘market’ expectation of what the security would be worth tomorrow. However, the EMH does not imply that prices are set in some kind of competitive market equilibrium.
The EMH also does not specify the mechanism by which prices “reflect all available information” and so does not imply that market prices are “right”. It does not specify how market expectations are formed whether on the basis of a clear-headed analysis of fundamentals, or on a ‘castles in air’ behavioural basis. For this reason the EMH is silent on whether current market expectations can reflect a nascent bubble. Most certainly it gives no guidance to policy makers who might seek to detect when an asset bubble is forming and when it might collapse.
In reality, few people today believe in the literal truth of the EMH. Over the past 40 years there have been many studies which have challenged its empirical validity. However, the question is not whether the hypothesis is true or false, but whether it is sufficiently true to be a practical benchmark for money manager performance. Can it be used to show whether particular kinds of announcements convey material information to investors. Can it be used to usefully estimate and manage investment risk?
In the period leading up to the current financial crisis few practitioners believed that the EMH had any practical implications. It was believed to be rather easy to make money investing in short term trends. Consequently, hedge funds and other investors borrowed heavily to invest. The resulting increase in leverage and heavy debt burden taken on by financial institutions was a leading causal factor of the recent global financial crisis.
Indeed, one might take the view that it was the failure to believe the EMH – that security prices would indeed fully reflect all available information – that was in fact responsible for the crisis!
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