Wednesday, June 24, 2009

In defense of EMH

The sub-prime mortgage crisis may have battered many reputations, and questioned many of the fundamental tenets of modern finance like the Efficient Market Hypothesis (EMH) and Modern Portfolio Theory (MPT). However, in an excellent post, Edward Glaeser argues that bubbles and market irrationality doesn’t mean that markets are inefficient (prices do not reflect all relevant information and shares are under- or over-valued) and thereby abound with easy arbitrage opportunities.

He makes the distinction between "inefficiency" and "irrationality" and points to an old paper by Brad DeLong, Andrei Shleifer, Larry Summers and Robert Waldmann which showed that less-than-rational (or irrational) "noise traders" could move markets even when rational traders have arbitraged away all the free lunches. He writes,

"The market may be buffeted by strange forces, but those people who claim to be able to earn fortunes by understanding those forces are more likely to be charlatans than those who argue for the continuing relevance of the EMH. Still, recognizing the occasional madness of markets can provide a bit of investment guidance. The difficulty inherent in finding free lunches means that buyers can’t just buy a house, or a mortgage-backed security or a stock, trusting that the market has priced things correctly. A house doesn’t become a good buy just because some other idiot paid a fortune for a similar home down the street. A similar fool may not be around when you are looking to sell."

Update 1
Jeremy Siegel writes in defence of EMH (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... CEOs of the failed financial firms or the regulators who did not see the risks that subprime mortgage-backed securities posed to the financial stability of the economy. Regulators wrongly believed that financial firms were offsetting their credit risks, while the banks and credit rating agencies were fooled by faulty models that underestimated the risk in real estate."

Update 2
Rajiv Sethi argues that though it is possible to detect bubbles it is difficult to make money using that information - "the eventual size of the bubble and the timing of the crash are unpredictable. Selling short too soon can result in huge losses if one is unable to continue meeting margin calls as the bubble expands. Trying to ride the bubble for a while can be disastrous if one doesn't get out of the market soon enough".

He goes along with Richard Thaler in claiming that EMH may be only partially correct. While recent events have reinforced the claim that you can’t always beat the market or atleast can't do so without taking on more risk, it may not be correct to argue that "the market price is always right", especially given the widespread evidence of bubbles (despite Fama's denial).

Nick Rowe's take on EMH is very incisive and reflective of how differently academics and traders view EMH, "From the Econ Dept perspective, watching the players play, the Efficient Market Hypothesis makes a lot of sense. From the Biz Skool perspective, as one of the players playing, the EMH makes much less sense."

Update 3
Mark Thoma writes, "There are two versions of the efficient markets hypothesis, a strong version and a weak version. According to the strong version prices accurately reflect the underlying intrinsic value of financial assets, but the weak version only requires that prices be unpredictable, they don't have to accurately reflect fundamental values. The strong version is, well, too strong and it seems clear that this condition is not satisfied in asset markets, at least not on a continuous basis. The weak version, however, does have support (though even here there is not universal agreement). The distinction between the strong and weak versions, and the assertion that the weak version holds even if the strong version does not, is often used as a defense of the efficient markets hypothesis."

In light of this, Rajiv Sethi rephrases EMH as Invincible Market Hypothesis.

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