Efficient Market Hypothesis - EMH

[jiHymas]

As long as I get paid, I don't care what you call it.

That's a very weak argument against EMH, James.

It wasn't intended to be an argument against the strong-EMH as you have defined it. All your definition says is that the value of the work done to extract value from the market is equal to value extracted.

What's to argue with? Your statement makes no claims about the behaviour of securities markets. If I find money on the street while walking around, all you need to do to defend your thesis is divide the total money found by all participants and divide by the total number of hours walked in order to determine the amount that I should have found and ascribe the difference to luck. There's not an awful lot of meat in that sandwich.

My arguments against the strong-EMH depend upon the strong-EMH being defined in accordance with industry standards - e.g. The Efficient Market Hypothesis on Trial: A Survey

First, what do we mean by an Efficient Market Hypothesis? The simplest explanation would be that securities prices reflect information. Fama (1970) made a distinction between three forms of EMH: (a) the weak form, (b) the semi-strong form, and (c) the strong form. However, it is the semi-strong form of EMH that has formed the basis for most empirical research.

The strong form suggests that securities prices reflect all available information, even private information. Seyhun (1986, 1998) provides sufficient evidence that insiders profit from trading on information not already incorporated into prices. Hence the strong form does not hold in a world with an uneven playing field. The semi-strong form of EMH asserts that security prices reflect all publicly available information. There are no undervalued or overvalued securities and thus, trading rules are incapable of producing superior returns. When new information is released, it is fully incorporated into the price rather speedily. The availability of intraday data enabled tests which offer evidence of public information impacting stock prices within minutes (Patell and Wolfson, 1984, Gosnell, Keown and Pinkerton, 1996). The weak form of the hypothesis suggests that past prices or returns reflect future prices or returns. The inconsistent performance of technical analysts suggests this form holds. However, Fama (1991) expanded the concept of the weak form to include predicting future returns with the use of accounting or macroeconomic variables.

Or, to put it another way:

There are three forms of the efficient market hypothesis

The "Weak" form asserts that all past market prices and data are fully reflected in securities prices. In other words, technical analysis is of no use.
The "Semistrong" form asserts that all publicly available information is fully reflected in securities prices. In other words, fundamental analysis is of no use.
The "Strong" form asserts that all information is fully reflected in securities prices. In other words, even insider information is of no use.

So when I engage in a discussion of EMH I expect the battle lines to be drawn more in accordance with:

The accumulating evidence suggests that stock prices can be predicted with a fair degree of reliability. Two competing explanations have been offered for such behavior. Proponents of EMH (e.g. Fama and French [1995]) maintain that such predictability results from time-varying equilibrium expected returns generated by rational pricing in an efficient market that compensates for the level of risk undertaken. Critics of EMH (e.g. La Porta, Lakonishok, Shliefer, and Vishny [1997]) argue that the predictability of stock returns reflects the psychological factors, social movements, noise trading, and fashions or "fads" of irrational investors in a speculative market. The question about whether predictability of returns represents rational variations in expected returns or arises due to irrational speculative deviations from theoretical values has provided the impetus for fervent intellectual inquiries in the recent years.

[Norbert Schlenker]

That's a fine place to draw the line. I'll just reiterate two points from above.

1. Whether EMH is true or false, liquidity providers deserve to be paid for the valuable service they provide. In general terms, that they do get paid is not evidence for or against EMH. More specifically, that you get paid for making a market in preferred shares does not make that market inefficient.

2. There are now many documented (and refereed) anomalies that do not fit EMH. Using the semi-strong form for purposes of argument, i.e. fundamental analysis has no value, it's pretty hard to conclude that either EMH or ~EMH is true. For every one of the handful of success stories that believers in ~EMH trot out, there are a thousand failures that EMH believers produce. To be fair, statistics are indication and not confirmation, but most people should think very hard before they play what looks like a game rigged heavily against them.

[jiHymas]

1. Whether EMH is true or false, liquidity providers deserve to be paid for the valuable service they provide. In general terms, that they do get paid is not evidence for or against EMH. More specifically, that you get paid for making a market in preferred shares does not make that market inefficient.

The idea that I can get a buy order filled with a reasonable expectation of outperformance is contrary to the semi-strong form (as defined in my most recent post).

In fact, there some evidence contained within my analysis that indicates that not even the weak form (as defined in my most recent post) holds, but I'll settle for disproving semi-strong and advancing liquidity provision as the probable explanation.

[Shakespeare]

get a buy order filled with a reasonable expectation of outperformance

For the TSE, even a simple "Dogs" strategy has a reasonable expectation of outperformance, according to David Stanley's work.

contrary to the semi-strong form (as defined in my most recent post).

How do you reconcile the three-factor model - and particularly the value premium - with the semi-strong form?

[jiHymas]

get a buy order filled with a reasonable expectation of outperformance

For the TSE, even a simple "Dogs" strategy has a reasonable expectation of outperformance, according to David Stanley's work.

I'm not familiar with "Dogs" and therefore have no views on its efficiacy, but have never denied there's more than one way to skin a cat.

contrary to the semi-strong form (as defined in my most recent post).

How do you reconcile the three-factor model - and particularly the value premium - with the semi-strong form?

I don't personally see any need, or have any desire, to reconcile the three-factor model with the semi-strong form. Fama & French reconcile it simply by defining excess returns as risky (see also Asset Management: Engineering Portfolios for Better Returns, E. F. Fama, Jr. 1998).

[Shakespeare]

Fama & French reconcile it simply by defining excess returns as risky

I'm aware of that (and don't particularly agree).

I'm not familiar with "Dogs"

It's a Canadian variation of the "Dogs of the Dow". You buy the 10 highest yielders on a small blue-chip index, rebalancing yearly. The index used was initially the TSE 35 and is now the Dow Jones Canadian Titans.

[jiHymas]

I'm not familiar with "Dogs"

It's a Canadian variation of the "Dogs of the Dow". You buy the 10 highest yielders on a small blue-chip index, rebalancing yearly. The index used was initially the TSE 35 and is now the Dow Jones Canadian Titans.

Just off the top of my head, I see two opposing forces in this strategy:

(1) If we accept that securities trade within a range of their fair value and that securities prices will tend towards their fair value (in other words, not drunkard's walk, but drunkard's walk with a lamppost), then maximizing dividend yield will bias securities selection towards those securities trading at the bottom of their range. This is a good thing.

(2) If we accept that fundamental analysts sometimes get it right, a high dividend yield may imply that the dividend is about to be cut. This is a bad thing.

Just which force has proved dominant in the past is something in which some people other than myself might have an interest. As to myself, I simply would not adopt (or pay somebody to adopt for me) an equities strategy that examined two data points (last declared regular dividend amount and market price) and threw away all other publicly available information.

The strategy seems akin to trading prefs on the basis of current yield (which is not a good thing to do).

[Shakespeare]

two opposing forces

James, the point that you may have missed is that this strategy is applied to a small, select blue-chip index. The index selection committee will cull the losers, so 1) predominates.

Those who want to know more about this strategy and its success record can refer to David Stanley's articles at Canadian Moneysaver.

I would not apply this strategy to an index that held more than a modest number of stocks.

Added: Remember that 10 stocks are selected. You are not going to find 10 basket cases in a 35- or 40-stock blue-chip index. If a basket case makes the grade one year, the index committee will drop it one of the following years, so your annual reselection [not rebalancing; I used the wrong term] will eliminate the holding.

[Bylo Selhi]

<OT>

just like Newton's theory of gravity was superceded by Einstein's. Rather than saying Newton got it wrong, and Einstiein right, it's better to say Einstein got it less wrong.

Einstein's Theory 'Improved'?

A Chinese astronomer from the University of St Andrews has fine-tuned Einstein's groundbreaking theory of gravity, creating a 'simple' theory which could solve a dark mystery that has baffled astrophysicists for three-quarters of a century...

</OT>

[WishingWealth]

Talking 'bout Einstein.

Now that the worldwide celebrations marking Einstein's miraculous achievements of 1905 are over, let's take a moment to light a candle to the runners-up, those poor fellows who were hot on Einstein's heels, who almost got it right and perhaps would have, but who've been lost in the shadow of his great triumphs. It is true; Einstein was not the only person at the turn of the last century thinking about molecules and relativity. What's more, he was up on much of their work and, like any scientist, stood on the shoulders of his predecessors.

Tell Me It Ain't So

The central fixture of Einstein lore is that the lowly patent clerk conjured from pure thought not only his theories but also the questions they answered. Not quite: Einstein himself helped foster this myth (more through carelessness than design, one suspects) by being less than fastidious about providing references in his papers, and since then credulous scientists have equated absence of evidence with evidence of absence. Physicists are notorious for taking history on faith, but none is required to prove this point—the evidence is in plain sight if one cares to look. The papers of Einstein and his contemporaries, as well as Einstein's letters, are published. Anyone who reads them quickly realizes that Einstein had a very good sense of the currents of science swirling about him and once or twice relied on the insights of colleagues
......

WW

http://www.americanscientist.org/template/AssetDetail/assetid/49611?&print=yes

[George$]

I can't help myself commenting here.

<OT>

just like Newton's theory of gravity was superceded by Einstein's. Rather than saying Newton got it wrong, and Einstiein right, it's better to say Einstein got it less wrong.

Instead of saying "superceded" I would use the word "extended".

All theories are approximations in the strict sense of the word. They are approximations of the physical world we inhabit - but only for the experimental observations they claim to explain. At some point all approximations are bound to fail when they are tested for new observations that are outside their original framework.

There is nothing wrong with Newton's theory for the physical realm for which it was developed. It is an excellent approximation to the classical world.

When you have velocities approaching the speed of light it no longer works. It was not developed for that. Einstein's theory was.

Someday Einstein's theory will no doubt also be extended to new areas he never imagined. But I would not say Einstein's is "wrong". Neither was Newton's wrong.

My two cents as a physicist.

[couponstrip]

From the NYT:

As it turns out, Mr. Grantham was an early advocate of index funds, mainly for unsophisticated investors who have no hope of beating the market. But he also believes that professionals should do better precisely because, as he puts it, “the market is full of major league inefficiencies.”

“There are incredible aberrations,” he told me over lunch not long ago. “The U.S. housing market in 2007. Japan in the 1980s. Nasdaq. In 2000, growth stocks were three times their fair value. We were quoted in The Economist in 2000 saying that the Nasdaq would drop by 75 percent. In an efficient world, you wouldn’t have that in a lifetime. If the market were truly efficient, it would mean that growth stocks had become permanently more valuable.”

As Mr. Grantham sees it, if professional investors had been willing to acknowledge these aberrations — and trade on the fact that the market was out of whack — they should have been able to beat the market. But thanks to the efficient market hypothesis, no one was willing to call a bubble a bubble — because, after all, stock prices were rational.

“It helped mold the ‘this time it’s different’ mentality,” he said. Indeed, professional money managers who tried to buck the tide wound up losing their jobs — because everybody else was making money by riding the bubble for all it was worth. Meanwhile, government officials, starting with Alan Greenspan, were unwilling to burst the bubble precisely because they were unwilling to even judge that it was a bubble. “Our default reflex is that the world knows what it is doing, and that is extravagant nonsense,” Mr. Grantham said.

I thought this article was semi-interesting, and worthy of a post, although Grantham's opinions (on the tech bubbly particularly) seem to suffer from hindsight bias, IMO.

However, after searching for a place to put this article, I found yet another gem of a thread from the FWF golden era of 2005, and after reading the thread I realized that posting this NYT article pales in comparison to the interesting debate above. If you have not seen it before, this thread is definitely worth reading from the beginning.

[NormR]

Has there been a good EMH rebuttal to the momentum effect? Momentum appears to violate even the weak form of the EMH and has been spotted in markets worldwide.

[Taggart]

From the NYT:

As it turns out, Mr. Grantham was an early advocate of index funds, mainly for unsophisticated investors who have no hope of beating the market. But he also believes that professionals should do better precisely because, as he puts it, “the market is full of major league inefficiencies.”

“There are incredible aberrations,” he told me over lunch not long ago. “The U.S. housing market in 2007. Japan in the 1980s. Nasdaq. In 2000, growth stocks were three times their fair value. We were quoted in The Economist in 2000 saying that the Nasdaq would drop by 75 percent. In an efficient world, you wouldn’t have that in a lifetime. If the market were truly efficient, it would mean that growth stocks had become permanently more valuable.”

As Mr. Grantham sees it, if professional investors had been willing to acknowledge these aberrations — and trade on the fact that the market was out of whack — they should have been able to beat the market. But thanks to the efficient market hypothesis, no one was willing to call a bubble a bubble — because, after all, stock prices were rational.

“It helped mold the ‘this time it’s different’ mentality,” he said. Indeed, professional money managers who tried to buck the tide wound up losing their jobs — because everybody else was making money by riding the bubble for all it was worth. Meanwhile, government officials, starting with Alan Greenspan, were unwilling to burst the bubble precisely because they were unwilling to even judge that it was a bubble. “Our default reflex is that the world knows what it is doing, and that is extravagant nonsense,” Mr. Grantham said.

I thought this article was semi-interesting, and worthy of a post, although Grantham's opinions (on the tech bubbly particularly) seem to suffer from hindsight bias, IMO.

However, after searching for a place to put this article, I found yet another gem of a thread from the FWF golden era of 2005, and after reading the thread I realized that posting this NYT article pales in comparison to the interesting debate above. If you have not seen it before, this thread is definitely worth reading from the beginning.

Just after the world stock market meltdown in October 1987 (not mentioned in the NYT article), I read at least one or two commentaries in the newspapers questioning the Efficient Market Theory. Over 20 years later and the debate continues......

[Shakespeare]

I'm not familiar with "Dogs"

It's a Canadian variation of the "Dogs of the Dow". You buy the 10 highest yielders on a small blue-chip index, rebalancing yearly. The index used was initially the TSE 35 and is now the Dow Jones Canadian Titans.

Just off the top of my head, I see two opposing forces in this strategy:

(1) If we accept that securities trade within a range of their fair value and that securities prices will tend towards their fair value (in other words, not drunkard's walk, but drunkard's walk with a lamppost), then maximizing dividend yield will bias securities selection towards those securities trading at the bottom of their range. This is a good thing.

(2) If we accept that fundamental analysts sometimes get it right, a high dividend yield may imply that the dividend is about to be cut. This is a bad thing.

Just which force has proved dominant in the past is something in which some people other than myself might have an interest. As to myself, I simply would not adopt (or pay somebody to adopt for me) an equities strategy that examined two data points (last declared regular dividend amount and market price) and threw away all other publicly available information.

The strategy seems akin to trading prefs on the basis of current yield (which is not a good thing to do).

two opposing forces

James, the point that you may have missed is that this strategy is applied to a small, select blue-chip index. The index selection committee will cull the losers, so 1) predominates.

Those who want to know more about this strategy and its success record can refer to David Stanley's articles at Canadian Moneysaver.

I would not apply this strategy to an index that held more than a modest number of stocks.

Added: Remember that 10 stocks are selected. You are not going to find 10 basket cases in a 35- or 40-stock blue-chip index. If a basket case makes the grade one year, the index committee will drop it one of the following years, so your annual reselection [not rebalancing; I used the wrong term] will eliminate the holding.

hi shakes-furthur to your discussion with jim hymas, i did a quick check on 'btsx' vs 'dog of the dow' from dec 31 2008 to june 5 2009. during that period 6 of the dog stocks cut their dividend and the average return was -7.9%. none of the btsx stocks cut their dividend and the average return was 24.7%. yes, big-cap blue chip stocks can sometime cut their dividends but i would be much more worried if i was a u.s. investor. last year (from may 08 to may 09) 6 of the btsx stocks actually increased their dividends. the u.s. has had a worse time of it than we have had here (so far) and dividends (especially bank dividends) seem more sacred here. you are absolutely correct, this approach should only be attempted with an index consisting of a small number of blue-chip stocks. regards, dave stanley

Posted with permission.

[newguy]

Interview on EMH with author of new book. Not sure where to put this. Notable quote

It’s the same way with efficient market theory: As a very loose description of how the market works, it’s not totally wrong. But as soon as you start depending on prices being right, you get into trouble.

He's the author of a new book about the history of emh. I like history books, but not so much emh books, so I'm only considering this.
I believe in efficient markets, I just don't know when they'll believe in me. It's like the oil/ng ratio, if markets were efficient right away we'd never have this spread, but if I wait long enough I think everything has to equalize. You can see why I'm interested in that quote.

newguy

[tidal]

Oddly, this James Montier piece came to my attention via an ASPO article.

Six Impossible Things Before Breakfast

It's a behaviouralist's take on dismantling EMH. I wasn't particularly persuaded with his response on the EMH 'Nuclear Bomb'. I liked the data from the "beauty contest" experiment.

[Peculiar_Investor]

A new opinion piece in the WSJ by Jeremy Siegel, Efficient Market Theory and the Crisis. Notable from the article are the following:

But is the Efficient Market Hypothesis (EMH) really responsible for the current crisis? The answer is no. The EMH, originally put forth by Eugene Fama of the University of Chicago in the 1960s, states that the 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.

I've never seen this take on the meaning of EMH, but maybe he has a point.

One can only wonder if the large investment banks would have taken on such risks when they were all partnerships and the lead partner had all his wealth in the firm, as they were just a few decades ago

Another very interesting point. It is consistent with the creation of CDOs and their ilk, packaging out the risk and therefore reducing the requirement to fully study and understand the risk before loaning the funds in the first place. If you know in advance that you are going to pass the buck, do you really investigate the quality of the buck?

[Bylo Selhi]

One can only wonder if the large investment banks would have taken on such risks when they were all partnerships and the lead partner had all his wealth in the firm, as they were just a few decades ago

This also underscores a point I've made in the past regarding executive compensation. The CEO and senior VPs should all be required to have a significant percentage of their net wealth invested in stock of the company they lead. If necessary, they should borrow the money they need to buy this stock, paying market rates to borrow and market rates for the stock itself. No options. No zero-interest loans. No half price stock. No bonuses -- and especially not when your company performs poorly. If you believe you have what it takes to lead a large public company and you want the opportunity to earn a 7-figure salary for doing so, then put some of your own skin in the game. If they're half as good as they imagine they are, then they'll have no trouble paying themselves big bonuses by selling off some of the stock whose value they were instrumental in appreciating. And if not, "well ya pays yer money and ya takes yer chances" just like the rest of us shareholders.

[Peculiar_Investor]

One can only wonder if the large investment banks would have taken on such risks when they were all partnerships and the lead partner had all his wealth in the firm, as they were just a few decades ago

This also underscores a point I've made in the past regarding executive compensation. The CEO and senior VPs should all be required to have a significant percentage of their net wealth invested in stock of the company they lead. If necessary, they should borrow the money they need to buy this stock, paying market rates to borrow and market rates for the stock itself. No options. No zero-interest loans. No half price stock. No bonuses -- and especially not when your company performs poorly. If you believe you have what it takes to lead a large public company and you want the opportunity to earn a 7-figure salary for doing so, then put some of your own skin in the game. If they're half as good as they imagine they are, then they'll have no trouble paying themselves big bonuses by selling off some of the stock whose value they were instrumental in appreciating. And if not, "well ya pays yer money and ya takes yer chances" just like the rest of us shareholders.

I would wholeheartedly agree with you on that point. They sticking point would likely be in the definition of "significant portion". Would it be 10%, 25%, or 50% or more? The key would be no helping from the corporation through loan agreements that Joe Employee would not be able to get.

I've seen a number of companies that require their senior employees to acquire stock equal to 1x (VP Level) to 4x (CEO Level) their annual salary and they are given a number of years to reach that amount. At least that is a step in the right direction.

[newguy]

I posted upthread about this book, I'm reading it now.
A seeking Alpha article has some interesting comments.

But he’s right. Most market participants don’t think markets are so efficient that they can’t get some alpha out of it. So who does believe in market efficiency? Is there a group of people who believe it significantly more than Fama believes people that participate in markets believe it? Yes: Our regulators and our government.

There is also a comment about the Brooksley Born Frontline episode mentioned here at FWF. I'm not comfortable posting sexist comments so you'll have to read it for yourself.

newguy

[WishingWealth]

Daniel Gross @ Slate: http://www.slate.com/id/2238729/

The Myth of the "Typical" Investor
Who is Mrs. Cohen from Hadera, and should Israelis care where she puts her money?
By Daniel Gross

TEL AVIV, Israel—Amram Aharoni has a serious résumé, but he has the mien of a comedian. On Sunday at the Globes' Israel Business Conference, Aharoni, who teaches investment theory and finance at the Herzliya Interdisciplinary Center, ran through his many qualifications—degrees from Tel Aviv University, a doctorate in finance from New York University, many years of experience in the financial sector—before throwing up his hands. "I'm supposed to be a specialist in the capital markets, but I want to confess that many times I know nothing. How can I not foresee the future and any junior analyst can tell me what's going to happen?" In laying out the modern case against active asset management, Aharoni name-checked the efficient markets hypothesis, Nassim Nicholas Taleb's The Black Swan, and ran through a bunch of gems from the behavioralist playbook (like those surveys that show most people think they're above-average drivers). Aharoni assembled a series of analysts' quotes making foolish and wrong short-term market projections, and displayed a chart showing that out of a few dozen Israeli investment funds, only three beat their benchmark indices over eight years.

And then … he turned over the session to a panel of six Israeli economists and asset managers who offered opinions on what would happen next in the markets and where people should put their money.
...

MyBold: I was watching the news just last night and one biz analyst was telling the assembled believers about the future.
Pardner got a bit concerned when I started to talk/scream at the tube. when we could hear not a peep or question from the dumbass interviewer: Sir, how did you fare in your predictions from last year?
Pathetic porn.

WW

[Bylo Selhi]

Inefficient Markets Are Still Hard to Beat

Can't anyone here play this game?

With the market so erratic at pricing stocks, it is tempting to think you can do better.

Between the Dow Jones Industrial Average's record in October 2007 and the bear-market low in March 2009, Bank of America's stock fell 94%. Then, by year-end 2009, it went up 380%. It wasn't just financial stocks that acted like yo-yos: Over the same period, Alcoa's stock fell 87%, then more than tripled.

How can such crazy swings in price be "efficient"?

[Taggart]

Inefficient Markets Are Still Hard to Beat

Can't anyone here play this game?

With the market so erratic at pricing stocks, it is tempting to think you can do better.

Between the Dow Jones Industrial Average's record in October 2007 and the bear-market low in March 2009, Bank of America's stock fell 94%. Then, by year-end 2009, it went up 380%. It wasn't just financial stocks that acted like yo-yos: Over the same period, Alcoa's stock fell 87%, then more than tripled.

How can such crazy swings in price be "efficient"?

Quote from the article: "It takes superhuman courage to buy into a hurricane of selling."

It wasn't a problem for me. I had far more trouble buying into the 87 crash than I did last winter. Perhaps I'm a bit older and seen more. The only other thing was since I'm not a market timer, I started running out of ammunition.

[Bylo Selhi]

Efficiency Thoughts [CanadianMoneySaver, Jan09]

What I found interesting about Vanguard’s presentation was their take on the William F. Sharpe paper, The Arithmetic of Active Management that I have referenced previously. Vanguard pointed out that Sharpe says the expected return for both active and passive strategies is the market return minus the average cost of the strategies. They then added something so obvious that it amazed me that I had never connected the dots before. Vanguard noted that Sharpe’s logic is not only unassailable, but that the conclusion holds true irrespective of whether the market is highly efficient or not.