“When the price of a stock can be influenced by a “herd” on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rational…in fact market prices are frequently nonsensical.”
The Efficient Market Hypothesis has been praised by some security analysts as an enduring truth about financial markets. Ever since Eugene Fama coined the theory of the efficient markets in 1970, it has held a prominent position in investment theory. According to him, “in an efficient market any new information would be immediately and fully reflected in equity prices. Consequently, a financial market quickly, if not instantaneously, discounts all available information. Therefore, in an efficient market, investors should expect an asset price to reflect its true fundamental value at all times.” (Stanley & Samuelson, 2009, p.183)
Seeing the apparent logical soundness of the EMH, Michael Jensen had famously stated that “there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis.” (Stout, 2003, p.635) Looking back in retrospect, it is easy to see how popular the EMH had been during the middle of the century. In fact, not only did ‘market efficiency’ become a buzzword among financial analysts by the 1980s but the concept was recognized as fact even by regulators, judges and research scholars from other allied fields. (Shleifer & Summers, 1990, p.704) But the fad has faded over the last three decades.
In the article titled The Superinvestors of Graham and Doddsville, author Warren Buffett gives a classic rebuttal of the Efficient Market Hypothesis. Buffett employs wit and humour alongside statistical evidence to present arguments in support of market inefficiency. Buffett gathers the investment performance of some eminent pupils of Benjamin Graham’s school of value investing – all of whom have also worked under Graham during the 1950s. These include Walter Schloss, Tom Knapp, Ed Anderson, etc, not to mention Buffett himself. The funds conceived and run by these stalwarts is now part of investment folklore, as they managed to outperform the markets year in and year out for decades. When we compare the annual published reports of funds such as Walter J. Schloss (WJS) Ltd. Partners, Tweedy Browne Inc., Buffett Partnership Ltd, and Sequoia Fund Inc, there is compelling evidence that contradicts EMH. For example, the annualized return of WJS Ltd. Partners is an impressive 16.1%, which is double the return fetched by S&P’s Index Fund over the corresponding 28 year period. Similar anomalies to the EMH are evident in Tweedy, Browne (TBK) Inc’s returns between 1968 and 1983. In this period, TBK’s overall annual compounded rate of return stood at 16% compared to S&P’s rather modest returns of 7%. Similar divergences are seen between S&P’s annualized returns and those of funds run by Buffett Partnership Ltd., and Sequoia Fund Inc. (Buffett, 1984, p.3) Hence, it is fairly obvious to the discerning analyst that Michael Jensen’s famous 1978 proclamation doesn’t hold good anymore. The proponents of EMH have empirical evidence stacked up against them. Prominent examples are that of Warren Buffett and his guru Benjamin Graham, who have ‘beaten the market’ consistently enough to disprove the claims of the EMT.
The empirical evidence undermining EMH is growing by the year. For much of the history of financial markets, the idea of market efficiency has co-existed with a darker view that stock prices can at times disconnect from underlying economic reality. The events of the last three decades have only fed this sceptical view.
“The seeds of doubt were first sown widely on October 19, 1987, when the Dow Jones Index of industrial stocks mysteriously lost twenty three percent of its value in a single trading session. More recently we have seen the appearance and subsequent bursting of a remarkable price bubble in technology stocks that rivals the famous Dutch Tulip Bulb Craze of 1637. To some extent, the entire stock market seemed to have been caught in the turbulence: in the Spring of 2000, the Standard & Poors 500 Index of 500 leading companies topped 1,500.7 By October 2002, the S&P Index was hovering near 775, a nearly fifty percent decline in value.” (Stout, 2003, p.635)
In the light of such repetitive patterns, it is impossible for a discerning analyst to not suspect a breach in the Efficient Market Hypothesis. With powerful data repository systems and automated mathematical tools at the disposal of the analyst, it is possible today to look through the flawed assumptions and lack of rigor in the works of earlier generation of financial market experts who promoted EMH. As author Lynn A. Stout propounds in her journal article, the gaping holes of the EMH apparent to “anyone who cared to look for them within a few years after the theory was first developed and disseminated…one need not have waited several decades to develop this suspicion. Nor need we have suffered through the Crash of 1987 and the 1990s tech stock bubble to find enlightenment.” (Stout, 2003, p.636)
Gilson and Kraakman’s pioneering work on the financial markets was condensed and presented in their article The Mechanisms of Market Efficiency (published in 1984). This work went a long way in exposing the weaknesses inherent in EMH. For a minority of EMH contrarians, it offered a meticulous and detailed enquiry into the Achilles’ heel of efficient market theory, namely, ‘how exactly does information flow into prices’. The EMH is only valid when market prices fully account for all available information pertaining to a stock. But, as Gilson and Kraakman point out, information is expensive to obtain, process, and verify. Consequently, it is near impossible for all market participants to “actually acquire, understand, and validate all the available information that might be relevant to valuing securities. Efficient market theory nevertheless predicts that even though information is not immediately and costlessly available to all participants, the market will act as if it were.” (Stout, 2003, p.635) This assertion is not true because arbitrageurs can ‘correct’ market prices only to a certain extent. In other words, arbitrageurs are not a homogenous lot, but instead comprised of distinct groups with different priorities and goals. In this context, as Gilson and Kraakman observe, “the answer could be found in the complex interaction of at least four imperfect price-moving market mechanisms: “universally informed trading;” “professionally informed trading;” “derivatively informed trading” (including both “trade decoding” and “price decoding”); and “uninformed trading.” (Stout, 2003, p.637) The fact that market transactions are carried out today in fast digital networks with an abundance of relevant information has not altered this arrangement in any significant way.