Friday, November 13, 2009

The Famous Efficient Market Hypothesis

A few days ago, surfing the net, I found Rortybomb. Rortybomb is a US blog, presenting some seriously interesting discussions. Although American, I would highly recommend it to Australian readers, especially those interested in economics: its posts are thoughtful and the subsequent discussions are often quite relevant.



One such discussion (Who believes market efficiency?) introduced a link to the Fama/French Forum. In it, Prof. Eugene Fama defended the Efficient Market Hypothesis, in the following terms:

"The premise of the Fox book ['The Myth of the Rational Market'] is that our current economic problems are largely due to blind acceptance of the efficient markets hypothesis (EMH)…

The book is fun reading, but its main premise is fantasy. Most investing is done by active managers who don’t believe markets are efficient. For example, despite my taunts of the last 45 years about the poor performance of active managers, about 80% of mutual fund wealth is actively managed. Hedge funds, private equity, and other alternative asset classes, which have attracted big fund inflows in recent years, are built on the proposition that markets are inefficient. The recent problems of commercial and investment banks trace mostly to their trading desks and their proprietary portfolios, and these are always built on the assumption that markets are inefficient. Indeed, if banks and investment banks took market efficiency more seriously, they might have avoided lots of their recent problems. Finally, MBA students who aspire to high paying positions in the financial industry have a tough time finding a job if they accept the EMH.

I continue to believe the EMH is a solid view of the world for almost all practical purposes. But it’s pretty clear I’m in the minority. If the EMH took over the investment world, I missed it."


Now, let me start by saying that I haven't read Fox's book. So I'll abstain to comment Prof. Fama's views on it.

But the substance of Prof. Fama's comment was his belief on the adequacy of the Efficient Market Hypothesis as a theoretical description about how markets, in general and financial markets in particular, work.

And here I believe I am as entitled a comment as the guy next door. In fact, I did leave a comment at Rortybomb.

As I am starting my blog and it takes me quite some time to write one of these pieces (which I try to research to a reasonable extent), I imagine Rortybomb will not mind if I reproduce my comment here.

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"This statement by Prof. Fama is bizarre...

A few years back (2004) Prof. Fama tested the CAPM and found that:

"Unfortunately, the empirical record of the model is poor - poor enough to invalidate the way it is used in applications". [1]

From the same paper, two of the assumptions of the CAPM are:

"The first assumption is COMPLETE AGREEMENT: given market clearing asset prices at t-1, investors agree on the joint distribution of asset returns from t-1 to t. And this distribution is the true one, that is, the distribution from which the returns we use to test the model are drawn". (My capitulars).

For those not too familiar, this is the Efficient Market Hypothesis (EMH).

Now, if a model derived from the EMH fares poorly in empirical tests, then I would say the EMH from which it derives becomes suspicious. Thus, Prof. Fama's claim ("I continue to believe the EMH is a solid view of the world for almost all practical purposes") is surprising, to say the least.

Still following the text above, Prof. Fama also claims that "most investing is done by active managers who don't believe markets are efficient".

If financial practitioners have abandoned the EMH -as Prof. Fama claims, without providing any evidence- it is a predictable and indeed understandable consequence of this poor performance of the CAPM, as measured by Prof. Fama himself.

But this disuse of the EMH has an striking consequence: if financial practitioners have abandoned the EMH, then in the terms used by Prof. Fama to describe the EMH, "there is NO complete agreement"...

So, we move full-circle and fall into what, to me, seems like a logical contradiction.

Note also that in a paper widely acknowledged as one of the foundational texts of modern economics, Prof. Friedman states that economics is a positive science [2]. By this it is meant that economics, among other things, is purported to describe economic phenomena which are independent of human desires. According to this view, the EMH empirical validity should not depend on financial practitioners deliberately following the EMH.

In this context, Prof. Fama's statements ("Indeed, if banks and investment banks took market efficiency more seriously, they might have avoided lots of their recent problems. Finally, MBA students who aspire to high paying positions in the financial industry have a tough time finding a job if they accept the EMH") seem not only oddly irrelevant, but they also seem to imply that the EMH is valid, only if people think it's valid.

These contradictions, by the way, seem to plague many defenses of the EMH. Prof. Robert Lucas, another renowned economist, has recently defended the EMH in the following terms: If people knew a bubble was going to burst next week, they would act accordingly now, bursting the bubble now, not next week.

Unfortunately, the text containing this defense (R. Lucas. "In defense of the dismal science". From The Economist print edition. Aug 6th 2009 [3]) is currently subscribers' content only. Anyway, for those subscribers, I include the link below.

One observes in Prof. Lucas' reasoning the same circularity present in Prof. Fama's. As in Prof. Fama's reasoning, Prof. Lucas seems to acknowledge that bubbles exist, although the EMH implies that bubbles cannot exist. This in itself seems like another contradiction, to me.

But, on top, this reasoning is factually flawed: people did know the bubble was going to burst, they acted accordingly, and the bubble did not burst as a consequence. Instead, it went on growing until it was ready to burst by itself.

Dirk Bezemer, in a recent paper [4], identifies 12 economists who did see the current crisis coming.

And, no, I am not one of those economists. Unfortunately.

Cheers,

Marco

References

[1] Eugene F. Fama, Kenneth R. French. "The Capital Asset Pricing Model: Theory and Evidence". 2004.
CRSP Working Paper No. 550; Tuck Business School Working Paper No. 03-26
Working Paper Series.
http://papers.ssrn.com/sol3/cf_dev/AbsByAuth.cfm?per_id=998#hide440920

I understand a version of this paper was published in the Journal of Economic Perspectives, Volume 18 (2004) Pages 25-46.

[2] Milton Friedman. "The Methodology of Positive Economics"; in: Friedman, Milton: Essays in Positive Economics, University of Chicago Press, p. 3-43. 1953.

[3] Robert Lucas. "Economics focus. In defense of the dismal science".
From The Economist print edition. Aug 6th 2009.
http://www.economist.com/businessfinance/economicsfocus/displaystory.cfm?story_id=14165405

[4] Dirk J. Bezemer. "No One Saw This Coming: Understanding Financial Crisis Through Accounting Models".
Groningen University. 16 June 2009.
MPRA Paper No. 15892.
http://mpra.ub.uni-muenchen.de/15892/"

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