What we talk about when we talk about the efficient market hypothesis

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Okay, this is gonna get wonky. Giuseppe Paleologo writes, in a comment to my post on Krugman vs. Chicago,

It is not true that:

“The central empirical prediction of the efficient market hypothesis, as laid out by Eugene Fama at the 1969 annual meeting of the American Finance Association, was that markets would move over time in accordance with the Capital Asset Pricing Model.”

CAPM, and all factor models, are *much* stronger than the EMH, i.e., they imply the EMH, but are not implied by it. CAPM’s predictions are also much, much stronger. This was made abundantly clear by the empirical tests summarized by Fama in survey of the empirical literature in 1970 and 1997. …

Incidentally, to point out the inadequacy of CAPM, one should mention the seminal papers by Roll in the seventies. All of this has nothing to do with the EMH. Fama and French in 1992 was aimed at advancing factor models, not defending the EMH from CAPM’s (or any one-factor model) empirical failure.

It is rather sad that Fox is officiating this debate, if only in his own mind. In my understanding, referees are supposed to know the rules of the game. Fox is a self-described “non-economist semi-intellectual” who clearly doesn’t intimately understand what he’s talking about. The impression one gets is that he’s dancing about architecture, and he doesn’t realize it.

As a non-academic who often writes (sometimes at inordinate length) about academic economics and finance, I do often worry that maybe I’m just missing the point because I can’t entirely follow the discussion—and I’m sure that sometimes I am just dancing about architecture. But responses like this make it clear why I need to keep trying: because the insiders get so caught up in their insider debates that they forget what it was they were talking about in the first place. The EMH that emanated from the University Chicago in the late 1960s was a theory not just that market movements can’t be reliably predicted but that prices are right. Here’s Eugene Fama, in the famous efficient market paper he delivered in 1969 and published in 1970:

The primary role of the capital market is allocation of ownership of the economy’s capital stock. In general terms, the ideal is a market in which prices provide accurate signals for resource allocation: that is, a market in which firms can make production-investment decisions, and investors can choose among the securities that represent ownership of firms’ activities under the assumption that security prices at any time “fully reflect” all available information. A market in which prices always “fully reflect” available information is called “efficient.” (Eugene F. Fama, “Efficient Capital Markets: A Review of Theory and Empirical Work,” The Journal of Finance, May 1970, p. 383.)

Fama said that in order to test whether markets were efficient in this sense you needed an economic theory of how prices were determined. He chose the Capital Asset Pricing Model, devised a few years before by Jack Treynor, Bill Sharpe and John Lintner. It said risky stocks would outperform less-risky ones, with the risk that mattered being something called beta—the correlation of a stock’s movements to those of the overall market.

Roll started pointing out issues with CAPM in the 1970s, and Fama and French concluded in 1992 that the conjunction of CAPM and the EMH simply didn’t match the data. They chose to jettison CAPM, not the EMH (Fischer Black made more or less the opposite choice). But without an economic theory of how stock prices should move, there’s no way of testing the claim that markets are efficient in the “price is right” sense. Pricing models like the arbitrage pricing theory or the Fama-French factor models simply assume that prices are right, then extrapolate from that what the relevant risk factors must be that determine prices. But this assumption that prices are right is now based on no empirical evidence at all. In fact, both Fama and Roll have said that there’s just no way to tell whether prices are right or not.

That leaves us with an efficient market hypothesis that merely claims, as John Cochrane puts it, that “nobody can tell where markets are going.” This is an okay theory, and one that has held up reasonably well—although there are well-documented exceptions such as the value and momentum effects. But if “we can’t tell where the markets are going” was all the finance professors had to offer, they wouldn’t have had much influence. They certainly wouldn’t be paid as well as they now are. (You just got a Ph.D in not knowing where the markets are going? Great! Have $120,000 a year. And hey, how about a couple of lucrative consulting gigs?)

The price-is-right combo of EMH and CAPM allowed finance professors to say much more than “we dunno.” They may not have known exactly where a stock’s price was headed, but thanks to CAPM they could confidently predict the bounds within which it would move. Thus armed they went on to conquer the world, eventually transforming MBA curricula, legal thinking, corporate governance, financial regulation and many aspects of investment practice. It’s admirable that finance scholars—especially Fama, since it was his theory in the first place—kept sniffing around and eventually concluded that the EMH/CAPM combo didn’t match the evidence. It’s not so great that some of them now pretend that the price-is-right version of the efficient market hypothesis never existed, and fail to fully confront what its demise means for a lot of the other things taught in finance and investment classes.

Update: If you just can’t get enough of this thrilling topic, here I am talking with Leonard Lopate about it today on WNYC radio.

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