Crises show markets do not actually know best

• The efficient market hypothesis was never meant to be taken literally

As Justin Fox recounts in The Myth of the Rational Market: On the fourth Thursday of October in 2008, 82-year-old Alan Greenspan paid a visit to Capitol Hill to admit that he had misunderstood how the world works. The chairman of the house committee on government oversight and reform summed up Greenspan’s explanation by saying, “In other words, you found that your view of the world was incorrect, that your ideology, was not right. It was not working.”

“Precisely,” replied Greenspan, “That’s precisely the reason I was shocked, because I had been going for 40 years or more with very considerable evidence that it was working exceptionally well.”

What was that ideology? Simply put, that financial markets knew best. They moved capital from those who had it to those who needed it. They spread risk. They gathered and dispersed information. They regulated global economic affairs with a swiftness and decisiveness that governments couldn’t match.

But then suddenly they didn’t. “The whole intellectual edifice collapsed in the summer of last year,” Greenspan admitted.

What he was referring to was efficient market theory. Its best known element is the efficient market hypothesis, formulated at the University of Chicago in the 1960s with reference to the US stock market: the belief that financial markets possess a wisdom that individuals, companies and governments do not.

Most of the scholars who backed the hypothesis early on did not mean for it to be taken as a literal description of reality. It was a scientific construct, a model for understanding, for testing and engineering new tools. But much of it was lost, most importantly the understanding — common among successful investors but absent from several decades of finance scholarship — that the market is a devilish thing.

“Far too devilish to be captured by a single simple theory of behaviour,” says Fox, “and certainly not by a theory that allowed for nothing but calm rationality as far as the eye could see.”

“Unfortunately,” wrote David Dreman in Forbes magazine, “a muddled notion called the efficient market hypothesis refuses to go away. This absurd thesis holds that nobody can beat the market, that stocks are correctly priced according to what’s publicly known about them and mispricings are chimeras. Such blind faith in the market’s omniscient rationality led to investor losses of a trillion dollars in the 1987 crash and several trillion dollars in the 2000-2002 postbubble slump. It ignores the effects of fads and manias.”

A challenge to the efficient market hypothesis is the existence of stock market anomalies — reliable and inexplicable patterns in returns. There are also the supposed indicators of undervalued stocks used by value investors, such as low price-to-earnings ratios and high dividend yields. And further challenges come from the study of behavioural finance, which examines the psychology underlying investors’ decisions.

Burton Malkiel has a different take on the efficient market hypothesis. “What efficient markets are often taken to mean is that prices are always right, but prices are seldom right,” says Malkiel. “In fact, prices may always be wrong. The problem is that no-one knows with any certainty whether they are too high or too low. It’s not that the prices are always right, it’s that it’s never clear the extent to which they are wrong.”

One thing is certain: recognising stocks whose prospects are significantly better or worse than indicated by the current stock price is extremely difficult. Almost any relevant factor that you can identify has most likely been incorporated into the price. This is a key insight of the efficient market hypothesis. And this aspect of it is virtually indisputable.

Robert Litterman at Kepos Capital says he’s not worried that markets are fully efficient — not yet. “But they are becoming more efficient all the time, and fast. The world is going quant, and there are no secrets. Alpha is in limited supply and hard to find.”

“[But] if one day the markets did reach full equilibrium because all alpha opportunities were exhausted, they couldn’t stay that way,” says Peter Bernstein, “as no-one would have any incentive to trade since prices would remain unchanged.”

Whereas the world beyond the markets is always in a state of change and disequilibrium. “The bizarre result of static markets in a dynamic world is obvious,” says Bernstein. “If the fundamentals are shifting while asset prices are constant, thousands of trading opportunities would open up … the markets would instantly come back alive, and the scene would be much as it is today.

“The miraculous vitality of markets is impossible to suppress as the great theories nurture and guide the development of today’s markets to a much greater extent than most of the participants stop to realise. In the most vivid manner, Adam Smith’s Invisible Hand is always in play, while Joseph Schumpeter’s perennial gale of creative destruction blows to a point where profit is temporary by nature: it will vanish in the subsequent process of competition and adaptation.”

That being the case, what does it matter whether markets are efficient or not if they’re always going to behave more or less the way they do now?