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business newsEfficient Market Hypothesis' False Reign Over Financial Markets
EMH is the cornerstone of modern finance, yet ironically, this slayer of technical analysis shares a philosophical base with it.
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EMH is the cornerstone of modern finance. Ironically, this slayer of technical analysis shares a philosophical base with it. Efficient Market Hypothesis asserts “that market prices fully reflect all information contained in the historical sequence of prices.” This sounds a lot like Dow’s basic tenet that price discounts everything.
Charles Dow organized stocks into indexes and provided tenets for interpreting the price movement of those indexes through a series of articles in the Wall Street Journal in the late 1800s to early 1900s. He believed the sum total of all causal factors, including “acts of God" were already included in the price of the market (market discounts everything) and a person could forecast business and the economy through observation of the indexes and application of his tenets. In addition to the belief that (1) the market discounts everything, the other tenets of Dow that remain the philosophical pillars of technical analysis today are (2) that prices move in trends and (3) market history repeats itself.
EMH concludes, however, “that past prices contain no information which can be used to predict next period values,” which is diametrically opposed to the second and third tenets of Dow’s theory that price trends and history repeats.
The Efficient Market Hypothesis is attributed to Professor Eugene Fama at the University of Chicago’s Booth School of Business, through his published Ph.D. thesis in the 1960s. The idea was first expressed by Louis Bachelier, a French mathematician, in his 1900 dissertation, "The Theory of Speculation." (The timing of Bachelier’s paper with Dow’s published tenets in the Wall Street Journal is an interesting coincidence.)
EMH was combined with Random Walk Theory (or RWT), popularized in the 1973 book A Random Walk Down Wall Street, by Burton G. Malkiel, a Princeton economics professor. RWT postulated that stock prices exhibit randomness around intrinsic value as new information enters the market.
Malkiel’s Random Walk Theory by itself concluded that stock-market prices were completely random, and debunked both fundamental and technical reasons for buying stocks. However, his sensationalized coin-flip test was more of a black eye to technical analysis. His students were given a hypothetical stock that was initially worth $50. The closing stock price for each day was determined by a coin flip. If the result was heads, the price would close a half point higher, but if the result was tails, it would close a half point lower. Over time, cycle and trend data were plotted from the test and taken to a technical analyst in chart form. The analyst told them they should buy the stock.
Technical analysis was further attacked by the scientific testing of mechanical “technical” systems that used volume, advance-decline, odd-lot statistics, and short interest data to forecast future market direction on the basis of historical data. The test results found no positive correlation. It was footnoted that the study wasn't conducted by practitioners.
The combined theory of EMH/RWT was latched onto by academia as groundbreaking “hard science” for finance. It was heavily hyped and spread like wildfire. Backed by “empirical” statistical studies, it grew unchecked as the scientific basis for the quadrillion dollars of financial derivatives now circling the globe, as well as the Black-Scholes option pricing formula.
Over the course of the next decade, subsequent academic studies revealed numerous statistical anomalies in the EMH hypothesis but were largely dismissed as small and inconsequential. 1980s price volatility was a wake-up call however, and couldn't be explained by efficient market hypothesis or dismissed as trivial. Academics shuffled the lens of optimism from stock prices, to dividends, to earnings, then back to stock prices in a frantic search for an efficient market hypothesis model that really worked.
One is reminded of the old joke about the boy who happened upon a giant pile of horse manure and began to dig through it excitedly. When someone asked him what he was doing covered in horse manure, the boy responded brightly, "There must be a pony in here somewhere!”
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