Believe in market efficiency

How efficient are markets really?

In October 2013, the Nobel Prize for Economics was awarded to Professors Eugene F. Fama (University of Chicago), Lars P. Hansen (University of Chicago) and Robert J Shiller (Yale University) for their empirical analysis of capital market prices. The Prize for Economics, donated by the Swedish Reichsbank in memory of Alfred Nobel, subsequently sparked a lively debate on the subject of market efficiency. The positions of Fama and Shiller seem too contradictory and incompatible for the award to proceed without controversy.

Basically, it was about whether the efficiency market hypothesis postulated by Fama - EMH - (Fama, 1970) is to be regarded as falsified in 2013. Fama and his students like Jensen say NO, Hansen says YES and Shiller says a resounding YES.

The answer is not only relevant for the Academia. It has far-reaching consequences for investors because numerous EMH-based portfolio optimization models from the 1970s and 80s are still in great use. Let's take a look at the current state of applied research on market efficiency.

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The FAMA position

Eugene F. Fama became known as the father of the efficient market hypothesis (Fama, 1970). He was a student of Milton Friedman and a classic representative of the Chicago school. Fama did not invent the concept of market efficiency, but began to coined it with his paper "Random Walks in Stock Market Prices" from 1965 (Fama, 1965). His greatest contribution was the assumption that the efficiency market hypothesis could not be tested without referring to the "Model of Market Equilibrium". This means that you can only test it if you put the expected value and risk in relation. He used William Sharpe's CAPM for this.

His idea explains in his own words: “The general proposition is straightforward. It says prices reflect all available information. That's it. The difficult part comes in developing tests of that idea, but the idea itself is quite simple. "

Fama notes that most asset pricing models follow its EMH. He spent the last 40 years testing these models. His scientific curiosity, which led him to relativize the EMH in the course of his later research activities, should be given high credit to him. He showed that in the longer term there are definitely factors that increase the quality of the prognosis (Fama, French, 1992). He explicitly names the dividend-stock price ratio (dividend yield). When it is high, expectation values ​​tend to be high and vice versa. Another result of his tests is the Fama-French 3-factor model for the Equity - Size - Value Premia (Fama, French, 1993). All three are highly correlated to the course of a company's business, i.e. to company-related fundamental data. They concluded from this that the correlation is an expression of a rational expected value.

Sidenote: although popular and widely used by academics and investors, he sees the theoretical basis of the 3-factor model as quite unstable. Fama-French saw the samples in the market and tried to explain them. That's all.

Fama sees himself and Shiller in agreement in the assumption that there is a variation in the expected value that leads to an increased quality of predictions of returns. In his opinion, the two differ in the assumption that this variation is rational or irrational in nature. Fama sees the question not yet finally answered by the available evidence in financial market research.

The SHILLER position

Richard Thaler (University of Chicago) and Robert Shiller disagree on this point. They assume that expected values, even if they were influenced by the course of business, can be shaped irrationally. Consequently, Shiller calls the award to him and Fama "discordant", that is, contradicting.

Shiller criticizes Fama for ignoring the effect of psychology and emotion on the investor's side. Shiller was awarded his Nobel Prize with reference to his work on Asset Bubbles. Ignoring the effects of psychology, Fama claims he doesn't know what an asset bubble is supposed to be.

Shiller's Critical Appreciation

According to Shiller, the EMH, with its great efficiency, says that all available information is included in the market price and that it is therefore perfect. Shiller argues that this theory makes little sense except in a trivial sense, namely that market prices include available information, but not extensively and not rationally. Shiller refers to the "human error", the human error as the cause of this irrationality. Behavioral finance research provides empirical evidence on this.

Shiller does not completely reject the EMH. He calls it a half-truth. If one did not want to read more from the EMH than that an average amateur investor cannot make quick money by trading on the basis of publicly available information, the theory would be spot-on. But the EMH is used for wider implications. The market price is seen as the true value of a rational pricing process. According to the established saying “The market is always right”, an oracle-like wisdom is ascribed to the market price.

Shiller classifies the belief in efficient markets as dangerous. He sees him as partly responsible for the slow overcoming of the financial crisis, because he is complacency about increasing leverage, asset mispricing and the instability of the global financial system. In fact, markets are not perfect, and so are market prices. Shiller worked out how the phase of deregulation that began in the early 1980s was justified by the fact that markets were rational and efficient. Accordingly, deregulated or self-regulated, they wanted to have surgery.

Shiller also sees a contradiction in Fama's theory and its practical application as an advisor to Dimensional Fund Advisors, an investment manager with $ 296 billion in AuM. Dimensional is based on the Fama-French 3 factor model in its investment approach. Shiller shows that size and value anomalies are due to market inefficiencies, i.e. correspond to the opposite of the EMH postulate.

"The question of financial-market efficiency is no longer an open one."

Let's take a look at the current state of research. Part of the task problem is the definition of market efficiency by financial economists. In other areas of economics, efficiency is defined by how well markets allocate resources. When a market distributes resources in such a way that one person's prosperity cannot be increased without reducing the prosperity of at least another person, it is called Pareto efficiency.

Since Fama's hypotheses in the 1960s, financial market efficiency has been defined differently.

# A market is weak-form efficient if it reflects all relevant market information from the past, such as price developments in the past. Implies that technical analysis is not possible in a weakly efficient market.

# A market is semi-strong-form efficient if it reflects all relevant past and currently publicly available market information. Implies that fundamental analysis is not possible in a moderately efficient market.

# A market is strong-form efficient when it reflects all relevant public and private information.

Now we cannot directly ask a stock whether it contains all relevant public information. As a result, economists with an affinity for EMH concentrated on testing EMH consequences, such as the question of whether the quality of a forecast can be increased via fundamental analysis. Interestingly, this path led to the EMH being falsified rather than verified. More on that later.

It was clear from the start that Fama's concept of efficiency was problematic. In theory, it can at best be an approximation. When markets are highly efficient and consequently it is pointless to work your way through quarterly reports, industry statistics and market reports, the practical question remains how new information is then incorporated into the price. As Joseph Stiglitz and Sanford Grossman noted in 1975 (Grossman, Stiglitz, 1975), highly efficient markets are impossible.

Even Hansen, the third Nobel Prize winner in the group, although declared by Shiller as Fama-affine, distances himself from the concept of efficiency, Fama, because the tool he developed, the “Generalized Method of Moments”, led to the falsification of EMH-based optimization models.

Hansen distinguishes between two types of market efficiency:

Type A - What are the consequences of efficiency? According to Hansen, the real efficiency problem arises as to whether we distribute resources well or badly in society. Are markets efficient in this regard? Sometimes yes sometimes no. This is an approximation of the concept of efficiency.

Type B - If we look at a model in which we assume rational agents in the financial market, we have to realize that it is just a model and consequently at some point it will be wrong. The question is, does a by-definition limited model lead to false predictions? If you abandon the strict efficiency assumption and call agents irrational, you have not won anything. Meaning is only created through a concrete concept of irrationality.

Hansen can then live well with the naming of irrational agents and consequently inefficient markets if the term is implemented in a formal and rigorous way (concrete applicability of BF - ie AMH).

This is where the search for the answer begins to get interesting.

Let's summarize. Fama was a child of his time. Socialized at the University of Chicago under Friedman, the assumption of a homo oeconomicus was en vogue and accordingly understandable. Fama transferred the alien assumption of the individual as a rational market participant to the markets by assigning them an efficiency that was theoretically illogical (Stiglitz, 1975) and practically impossible (Fama, 1993; Shiller 1980).

The intersection of Fama, Hansen and Shiller results in the following: Market prices behave arbitrarily in the short term (strongly or completely - unexplained). Trying to time the market is accordingly counterproductive. But we know, thanks to Shiller et al, that market prices can be valued irrationally even over long periods of time thanks to “human error”.

Thanks to the findings of behavioral finance research, the EMH can be classified as falsified.

That's the easy part. Now the interesting part begins. What do we gain from the insight that market participants are irrational and that markets are consequently inefficient. Following Hansen, we initially gain nothing in terms of practical use.

It is precisely this sobering realization that we lived in the 1990s and at the beginning of the millennium. Despite empirical evidence, the behavioral finance research results were of little use in guiding action for practitioners. It was good to know that the list of identified cognitive dissonances kept growing (we are currently at 90+ identifications), but how should an investor counteract these in his investment behavior or benefit from them?

Paul Samuelson helps. As one of the most important economists of the 20th century, he concluded that markets are “considerable micro efficient” but “considerable macro inefficient” (Samuelson, 1998). The distinction between considerable efficiency at the individual stock level and considerable inefficiency at the aggregate level - be it the overall market or an index - goes d´accord with the behavioral finance findings of Thaler, Shiller or Lo. Shiller was in communication with Samuelson. In a paper published in 2005, Shiller validated Samuelson's dictum (Shiller, 2005). He sees it in line with his own research results (Shiller, 1981), but also, for example, with those of Dr. Tuomo Vuolteenaho (Vuolteenaho, 2002) and Prof. Cohen from MIT (Cohen, 2003). Important: You define market efficiency as the predictability of future price developments.

How can Samuelson's dictum be interpreted now? The price movement for a single title is dominated by information about the company's future cash flows. However, the price movement itself is not a perfect indicator of future cash flows. In short, the connection between the expected future real economic development of the company and the price development is closely related. This means that individual stocks have a more predictable course in terms of profit and cash flow developments.

At the aggregated level, the relationship between the expected real economic development of an economy / market and the formation of market prices is significantly less pronounced. So stock markets are dominated by fashions in their pricing.

In summary, the dictum means that markets are neither efficient on the micro (single title) nor on the macro level (market / economy), but that there is a gradual decrease in efficiency from the bottom up.

What specific implications can an investor draw from these insights? Answers will follow in the next expert contribution by Markus Schuller (2nd half of February).

Mag. Markus Schuller, MBA, MScFE
Managing director

Panthera Solutions

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