On Efficient Markets and Practical Purposes

Eugene Fama continues to believe that the efficient markets hypothesis "provides a good view of the world for almost all practical purposes" and Robert Lucas seems to agree:

One thing we are not going to have, now or ever, is a set of models that forecasts sudden falls in the value of financial assets, like the declines that followed the failure of Lehman Brothers in September. This is nothing new. It has been known for more than 40 years and is one of the main implications of Eugene Fama’s “efficient-market hypothesis” (EMH), which states that the price of a financial asset reflects all relevant, generally available information. If an economist had a formula that could reliably forecast crises a week in advance, say, then that formula would become part of generally available information and prices would fall a week earlier.

It is surely true that if a crash could reliably be predicted to occur a week from today, then it would occur at once. But what if it were widely believed that stock prices were well above fundamental values, and that barring any major changes in fundamentals, a crash could reliably be predicted to occur at some point over the next couple of years? Since the timing of the crash remains uncertain, any fund manager who attacks the bubble too soon stands to lose a substantial sum. For instance, many major market players entered large short positions in technology stocks in 1999 but were unable or unwilling to meet margin calls as the Nasdaq continued to rise. Some were wiped out entirely, while others survived but took heavly losses because they called an end to the bubble too soon:

Quantum, the flagship fund of the world's biggest hedge fund investment group, is suffering its worst ever year after a wrong call that the "internet bubble" was about to burst... Quantum bet heavily that shares in internet companies would fall. Instead, companies such as Amazon.com, the online retailer, and Yahoo, the website search group, rose to all-time highs in April. Although these shares have fallen recently, it was too late for Quantum, which was down by almost 20%, or $1.5bn (£937m), before making up some ground in the past month. Shawn Pattison, a group spokesman, said yesterday: "We called the bursting of the internet bubble too early."

Note that this was written in August 1999, several months before the Nasdaq peaked at above 5000, and therefore cannot be said to reflect what Kenneth French might call the false precision of hindsight.

Along similar lines, a 1986 paper by Frankel and Froot contained survey evidence on expectations suggesting that investors believed both that the dollar was overvalued at the time, and that it would appreciate further in the short term. They were unwilling, therefore, to short the dollar despite believing that it would decline substantially sooner or later.

A crash will occur when there is coordinated selling by many investors making independent decentralized decisions, and a bubble may continue to grow until such coordination arises endogenously. In his response to Lucas, Markus Brunnermeier sums up this view as follows:

Of course, as Bob Lucas points out, when it is commonly known among all investors that a bubble will burst next week, then they will prick it already today. However, in practice each individual investor does not know when other investors will start trading against the bubble. This uncertainty makes each individual investors nervous about whether he can be out of (or short) the market sufficiently long until the bubble finally bursts. Consequently, each investor is reluctant to lean against the wind. Indeed, investors may in fact prefer to ride a bubble for a long time such that price corrections only occur after a long delay, and often abruptly. Empirical research on stock price predictability supports this view. Furthermore, since funding frictions limit arbitrage activity, the fact that you can’t make money does not imply that the “price is right”.

This way of thinking suggests a radically different approach for the future financial architecture. Central banks and financial regulators have to be vigilant and look out for bubbles, and should help investors to synchronize their effort to lean against asset price bubbles. As the current episode has shown, it is not sufficient to clean up after the bubble bursts, but essential to lean against the formation of the bubble in the first place.

This argument is made with a great deal of care and technical detail in a 2003 Econometrica paper by Abreu and Brunnermeier. If true, then clearly there are some terribly important practical purposes for which the EMH does not provide a good view of the world.