What does the efficient market hypothesis have to say

about asset bubbles?

9 Answers

Burton Malkiel, author of "A Random Walk Down Wall Street," Wealthfront CIO
34.6k Views Featured in Forbes Upvoted by Jon Levin, Professor of Economics, Stanford
University and John Hegeman, Former PhD student in Economics, Stanford University

What does the efficient market hypothesis have to say about asset bubbles?
Lets first define the Efficient Market Hypothesis (EMH), then address the implications for
asset bubbles, and conclude with a discussion of what it really means for the capital markets
to be efficient.

Image source: http://StockCharts.com

What is the Efficient Market Hypothesis (EMH)?
Two fundamental tenets make up the Efficient Market Hypothesis. EMH first asserts
thatpublic information gets reflected in asset prices immediately. Information that should
affect the future price of any financial instrument will be reflected in the assets price today.

If a pharmaceutical company now selling at $20 per share receives approval for a new drug
that will give the company a value of $40 tomorrow, the price will move to $40
immediately, not slowly over time. Because any purchase of the stock at a price below $40
will yield an immediate profit, we can expect market participants to bid the price up to $40
without delay.
It is, of course, possible that the full effect of the new information is not immediately
obvious to all market participants. It is also likely that the estimated sales and profits
cannot be predicted with any precision and that the value of the discovery is amenable to a
wide variety of estimates. Some market participants may vastly underestimate the
significance of the newly approved drug but others may greatly overestimate its value.
Therefore, in some cases, the market may underreact to a favorable piece of news. But in
other cases, the market might overreact, and it is far from clear that systematic
underreaction or overreaction to news presents an arbitrage opportunity promising traders
easy, risk-adjusted, extraordinary gains.
It is this aspect of EMH that implies the second, and more fundamental, tenet of the
hypothesis: In an efficient market, it is not possible to earn above average returns without
taking on above average risk.
This lack of opportunities for extraordinary profits is often explained by a joke popular with
professors of finance. A professor who espouses EMH is walking along the street with a
graduate student. The student spots a $100 bill lying on the ground and stoops to pick it
up. Dont bother trying to pick it up, says the professor. If it was really a $100 bill it
wouldnt be there.
Perhaps a less extreme telling of the story would have the professor telling the student to
pick the bill up right away because it will not be lying around very long. In an efficient
market, competition will ensure that opportunities for extraordinary risk-adjusted gain will
not persist.
EMH does not imply that prices will always be correct or that all market participants are
always rational. There is abundant evidence that many (perhaps even most) market
participants are far from rational and suffer from systematic biases in their processing of
information and their trading proclivities. But even if price setting were always determined
by rational profit-maximizing investors, prices can never be correct.
Suppose that stock prices are rationally determined as the discounted present value of all
future cash flows. Future cash flows can only be estimated and are never known with
certainty. There will always be errors in the forecasts of future sales and earnings.

Moreover, equity risk premiums are unlikely to be stable over time. Prices are therefore
likely to be wrong all the time!
What EMH implies is that we never can be sure whether prices are too high or too low at
any given time. Some portfolio managers may correctly determine when some prices are
too high and others too low. But other times such judgments will be in error. And, in any
event, the profits that will be attributable to correct judgments will not represent
unexploited extraordinary returns.
What does the EMH say about Asset Bubbles?
From March 2000 to October 2002, the NASDAQ index of high-tech stocks declined by 70
percent. During the twelve-month period from March 2008 through March 2009, the stock
market declined by almost 50 percent.
Did the stock market accurately reflect all relevant information about stocks and the
economy in March 2000 or March 2008? Were firms such as Bear Stearns and Lehman
Brothers making rational assessments of the value of the mortgage-backed securities in
their portfolios before the financial crisis that forced both firms into liquidation and
threatened to blow up the world economy in 2009?
Critics believe that such events stretch the credibility of the EMH beyond the breaking
point. The financial press has been unambiguous in its judgment. The Wall Street
Journal opined that the EMH was a remarkable error. Business Week described the
theory as a failure, and Justin Fox of Time, author of The Myth of the Rational Market,
claimed that the EMH has deluded investors and played a major role in the worldwide credit
crisis of 2008-09.
Certainly the behavioral theorists are highly skeptical that markets are efficient. The
behaviorists chide their efficient-market brethren for blindly accepting that the stock
market behaves rationally. Robert Shiller, the Nobel prize winning behavioral economist,
concluded from a longer history of stock-market fluctuations that stock prices show far too
much variability to be explained by an EMH of pricing, and that one must look to
behavioral considerations and to crowd psychology to explain the actual process of price
determination in the stock market. Shiller has called the EMH the most remarkable error
in the history of economic thought.
If, in fact, the stock market systematically makes errors, and if overpriced stocks can be
identified in advance, then it should be possible to beat the market. The strategy that I have
recommended for the last 40 years in A Random Walk Down Wall Street and that we
implement at Wealthfrontbuy and hold low-cost broad-based index fundswill not be

optimal. A far better strategy would involve holding different portfolios designed to produce
higher returns.
In retrospect we know that Internet stocks sold at bubble levels in early 2000 and that home
prices were unsustainably high in 2007. But at the time no one knew for sure. Indeed,
some analysts believed that the stock market was in a bubble in the early 1990s, just before
one of the best decades in history for equity investing.
In December of 1996, former Federal Reserve Chairman Alan Greenspan gave his famous
Irrational Exuberance speech. From the date of his speech through December 2013, the
stock market returned 9 percent per year, even after withstanding two sharp bear markets.
It is only in retrospect that we know that stock prices were too high at their peaks in 1999
and early 2000 during the Dot.com bubble and again in 2007 and early 2008 in the real
estate bubble. No one can time the markets effectively to help you avoid being invested at
temporary highs.
My conclusion is that obituaries for EMH are greatly exaggerated and that the extent to
which the stock market is usefully predictable has been vastly overstated. Following the
tenets of the EMHthat is, buying and holding a portfolio of broad-based low-cost market
index fundsis still the best game in town. Although the market may not always be rational
in the short run, it always is over the long haul.
What does it really mean to say markets are efficient?
As long as there are stock markets, mistakes will be made by the collective judgment of
investors. And undoubtedly, some market participants are demonstrably less than rational.
As a result, pricing irregularities and predictable patterns in stock returns can appear over
time and even persist for short periods.
Andrew Lo from MIT* has argued that no engineer would ever devise a test to determine if a
particular motor was perfectly efficient. But they would attempt to measure the efficiency of
that engine relative to a frictionless ideal.
Similarly, it is unrealistic to require our financial markets to be perfectly efficient to accept
the basic tenets of EMH. Indeed, as Sanford Grossman and Joseph Stiglitz have argued, the
perfect efficiency of our financial markets is an unrealizable ideal. Those traders who
ensure that information is quickly reflected in market prices must be able at least to cover
their costs.
But it is reasonable to ask if our financial markets are relatively efficient, and I believe that
the evidence is very powerful that our markets come very close to the EMH ideal.

Information does get reflected rapidly in security prices. To return to our analogy of the
$100 bill lying on the ground, it is highly unlikely that it will continue to stay there.
The EMHs basic underlying notion that if there are obvious opportunities to earn excess
risk-adjusted returns, people will flock to exploit them until they disappear, is as reasonable
and commonsense as anything put forward by the EMHs critics.Systematically beating the
market remains really hard, and the EMH remains an extremely useful working
hypothesis.
Updated Jun 12, 2014