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The Inefficiency of the Efficient Market Theory


Defending the Fundamental Approach



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Editor’s note: The writer, a longtime author of books on financial topics, offers his view of the efficient market theory. The subject is hotly debated by supporters and critics and in recent years has come under increasing scrutiny.

 The problem with theories is that they often don’t work in the real world. The efficient market theory, or EMT (also called the efficient market hypothesis), is a comforting idea to many people who seek order. But the truth is that the market is chaotic, irrational and, at times, downright inefficient.

The EMT is a belief that markets are efficient because the prices of stocks have been adjusted for all known information and that price changes instantly as the information is updated. Consequently, the theory goes on to claim that it’s impossible to outperform the market based on any information already known publicly. This is a fatalistic belief, one that strives for a perfect and orderly world while warning that you cannot beat the market. 
    
The truth, as most experienced investors know, is just the opposite. Markets are highly irrational and the predominant emotions — greed and fear — work to drive prices up too high on good news and too low on bad news. This is why you often see prices spike only to correct in the sessions immediately following.
    
A good example was the Oct. 15, 2009, announcement by IBM of quarterly earnings of $2.40 per share. Analysts had predicted $2.38, so the announcement was 2 cents better than estimates. IBM’s stock rose that day by $3.58. On the very next day, however, IBM led a market retreat by falling $6.34. What happened?
    
The market overreacted to the positive earnings news accompanied by a revised full-year earnings estimate. But the next day, the market collectively reconsidered its enthusiasm and sold off the stock. This two-day swing in activity is far from efficient and, in fact, is illogical and chaotic in the extreme. The net effect makes even less sense. The two-day change in IBM’s value was down $2.76 despite quarterly earnings ahead of estimates and an upward revision in full-year earnings projections.
    
All this market action is short-term, of course, but it aptly demonstrates why the efficient market theory is believed primarily by academics who have no money invested in the market. It is, indeed, a comforting idea but simply doesn’t work.

Theory Background

The theory itself is usually credited to Eugene Fama of the University of Chicago School of Business. In the 1960s, he wrote his Ph.D. thesis introducing this concept and claiming proof of its validity. His thesis cited the price-earnings ratio as the means for determining value, but this claim ignored the fact that low-P/E stocks outperform high-P/E ones. According to the EMT, the opposite should be true.
    
Like the related random-walk theory, which claims price movement is entirely random, the EMT falls apart under long-term analysis. The way I see it, these theories are quite cynical in explaining that it’s impossible to beat the market. EMT bases this conclusion on the belief that all prices are fair based on known data; and the random-walk theory claims that price movement is simply arbitrary and the outcome of upward or downward movement is a 50-50 proposition.
    
Fama expanded his original theory by defining three forms of market efficiency: weak, semistrong and strong. These distinctions are counterintuitive, since “efficiency” is an absolute. 
    
Even so, the distinction was a way to explain why apparent inefficiencies were experienced at times. So a “weak” form of efficiency was explained as being caused by outside influences such as a nation’s weak economy. When market prices move to what analysts consider a “correct price” quite rapidly, that is called a strong form of efficiency.
    
Many analysts have criticized this belief, however. They point out that instant price response isn’t always efficient. Experience shows, in fact, that fast response often is the most inefficient form of price movement. The October 2009 volatility in IBM stock is an excellent example of this.

Explaining Away Market Behavior

The technicians who believe in EMT fight a losing battle. But they use rationale to explain irrational behavior in the market. For example, everyone knows that individual investors tend to overreact or underreact to news. EMT supporters believe these tendencies offset one another, so that the result is still efficient. So you and dozens of other investors may be overreacting to today’s news, but EMT believers say an equal number of other investors underreact at the same time. As a result, the overall market reacts efficiently. Intuitively, most people understand at once that this very idea is irrational, especially those who have observed short-term price movement that contradicts the company’s fundamentals.
    
A more reasonable belief is that people in the market tend to move with the majority. So when the mood is enthusiastic about a stock, the market’s herd mentality drives prices upward. The buying volume tends to reach a peak as prices top, meaning more people buy at the high than at the low. The same happens when the majority panics. Prices are driven down so that most sellers take action at the bottom. This creates a tendency to buy high and sell low instead of the wiser opposite action. 
    
The inefficiency of the markets often is caused by the inefficiency of investors and traders. The desire for efficiency is understandable and even works well in theory. But the real market is much more chaotic.

Efficiency and Bubbles

If markets were truly efficient, they should never have price bubbles. In 2008, when prices tumbled, many well-managed companies lost value in their stock because of fear and panic. There was no efficiency in the bubble or in the resulting selloff. Even so, the many obvious bargain stocks remained low because everyone was afraid. How low would the market go?
    
An “efficient” market would have been rational. Stock prices would have fallen only for those equities that were overpriced and not in the entire market. Then again, there would never be any overpriced stocks in an efficient market, so even that belief is flawed. When all the prices were low and at bargain prices, an efficient market would have driven those prices up to a fair price, but that didn’t happen, either.
    
Efficient markets can exist only if every investor is also efficient in how they think and act. The emotional investor dominates the market, which is why short-term prices are erratic, why bubbles occur and why trends last longer than they should and then correct more than they should.
    
As long as speculators are active in the market, seeking high returns with high-risk and very-short-term positions, economic and market bubbles are going to persist. Another behavioral reality is that speculators and traders tend to operate on a series of flawed beliefs. These include the belief that they’re adept at timing both entry into and exit from positions. In fact, they are neither. Speculators tend to lose more often than gain because they have a blind spot that’s often termed irrational exuberance. This is a belief that a decision is going to be profitable, even when there’s no evidence to support that conviction. When Alan Greenspan used the term, he was referring to marketwide problems and a failure of investors to see that the market might be overvalued. 
    
How can the market be overvalued if markets are efficient? The point here is that speculative bubbles come and go specifically because of inefficiency in pricing of individual stocks and of the market as a whole. The tendency toward irrational exuberance describes the real world’s inefficient market.
    
The only rational conclusion is to dismiss EMT as an unrealistic belief and to recognize that prices change for a range of reasons. Most important among these are a range of fundamental indicators, which are the only reliable ways to identify and measure bargain prices for value investments. Prices are affected by the short-term inefficiency of the markets, but high-quality stocks are going to work out in the long term. Even high short-term volatility after earnings announcements doesn’t change a company’s financial attributes; they affect the price only for the short term.
    
Theories such as EMT are comforting to those who desire order in the universe. Investors, however, cannot rely on efficiency or order for their portfolios. You might have heard the expression, “If you want love, buy a dog.” By the same logic, if you want certainty, buy a certificate of deposit. The return is dismal but guaranteed. If you want to place money in the market, though, you cannot rely on efficiency to protect your positions.
    
Wise investing should be based on acknowledgment of the short-term chaos in pricing of stocks, coupled with a more important belief in long-term value based on fundamental analysis. The efficient market theory demonstrates how technical analysis can lead traders astray by presenting ideas that make no sense and then citing them as evidence to support the theory. If the concept of efficiency seems out of place to you and you know, intuitively, that it’s simply impossible, you’re wise to trust your intuition.


Michael C. Thomsett is the author of more than 70 published books. Among these are Getting Started in Stock Investing and Trading (Wiley), which includes practical suggestions for picking stocks based on fundamental analysis. He is also the author of Annual Reports 101 (Amacom Books), Getting Started in Fundamental Analysis (Wiley) and Investment and Securities Dictionary (McFarland). He lives in Nashville, Tenn., and writes full time.


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