On Jul 12, 2008, at 7:20 AM, Carrol Cox wrote:
> This too is incoherent. It is theory that determines what data is
> data.
>
> According to my coputer, the current temperature outside is 70. Is
> that
> data relevant to efficient market theory. I say it is. Prove me wrong.
>
> You will have to articulate a theory to prove that that data isn't
> data.
>
> That in a way is what the Theory people (who Doug is so anxious to
> defend) are all about: the overthrow of empiricism.
Apples, meet oranges. EM theory makes predictions about security prices that turn out to be wrong, and in interesting ways. That undermines its standing as a theory. It has nothing to say about the temperature in the cornfield outside your window.
I just happen to have the script of what I said that inspired Laibman's reaction 11 years ago. Here 'tis.
Doug
----
The other major financial theory I'd like to discuss is efficient market theory — EM. There are several versions of EM theory. In the 1970s, they were called the weak, semi-strong, and strong variants; they have fancier names now, but this is close enough for journalism. The weak form asserts that the past course of security prices says nothing about their future meanderings. The semi-strong form asserts that security prices adjust almost instantaneously to significant news (profits announcements, dividend changes, etc.). And the strong form asserts that there is no such thing as a hidden cadre of "smart money" investors who enjoy privileged access to information that isn't reflected in public market prices.
On its face, that sounds fairly sensible. But there's more to it than its surface sense. Start with the theory's name. To a financial economist, saying that prices are "efficient" means that they reflect all available information. But what information? Is it accurate, or is it noise? And information about what? Stock prices, the subject of most efficient market theory, are supposd to reflect the market's best judgment of the future course of corporate profits. But who knows the future? We estimate the future mainly by extrapolating from the present and recent past. That will work fine if tomorrow is much like yesterday and today. Quite often that's the case. But hardly always.
EM theory, like MM, had some important real-world fallout. It contributed greatly to the veneration of markets that has characterized our political culture for the last 15–20 years. The financial economist's sense of efficency got all mixed up with the more colloquial sense of efficiency, and in a vulgarized version, "fully reflect all available information" became "the market is always right." That's become barroom wisdom even among people who don't know what they're talking about.
Again, academic work published during the 1980s and early 1990s made it gradually clear that stock prices were partly predictable in at least two not unrelated ways (Fama 1991; Poterba and Summer 1988; Shiller 1991; Lander, Orphanides, and Douvogiannis 1997). First, it became clear that stocks that were "cheap" — that is, those with low price/earnings ratios — performed better over the long term than those that were expensive. If the markets were correctly pricing stocks, that shouldn't have been the case. And second, future prices are indeed partly predictable from past prices, because of systematic overreaction. That is — and once again it's amazing that it's taken 20 years for academics to come around to such sensible conclusions — speculative markets get caught up in waves of optimism and despair. When prices are driven to extremes of under- and over-valuation, it's only a matter of time — though uncertainty over just how much time is why I keep saying "partly" predictable — before they return to some sort of mean. But often, instead of merely reverting to a mean, they overshoot to the other extreme. This over-reaction helps explain why cheap stocks tend to outperform expensive ones.
So the market isn't always right; in fact, it can be quite spectacularly wrong. Unfortunately this discovery hasn't had quite the real-world fallout that it should. This ideological perimeter will be very strenuously guarded, for reasons made clear in this observation by two very conventional economists, Terry Marsh and Robert Merton (1986): "To reject the Efficient Market Hypothesis for the whole stock market…implies broadly that production decisions based on stock prices will lead to inefficient capital allocations. More generally, if the application of rational expectations theory to the virtually 'ideal' conditions provided by the stock market fails, then what confidence can economists have in its application to other areas of economics…?" It's become very chic to cite Hayek's metaphor for the price system as a signalling mechanism. It's clear, though, that there's at least as much noise as there is signal.