Efficient Market Hypothesis: Current State of Belief
The Efficient Market Hypothesis continues to impede understanding of how capital markets work.
The front-page article in the WSJ of June 12, 2020, announcing record levels of stock buybacks, continued to promote a common misperception that stock repurchases enhance equity prices by the following mechanism:
By reducing the number of shares outstanding through buybacks, earnings per share increase;
Investors, noting this increase in earnings per share, are willing to pay higher prices;
Therefore, buybacks. by increasing earnings per share, cause prices to rise.
This, of course, is in line with the Efficient Market Hypothesis, and depends upon the assumption that increasing earnings per share improves intrinsic value and that a crowd of rational, competing, profit-maximizers will therefore force prices upwards.
Ignoring the Evidence
The popular line of reasoning of the WSJ ignored Federal Reserve flow of funds accounts that showed that something far removed from the Efficient Market Hypothesis was driving the market in Q1 2006:
- Corporations were spending vast sums (more than $146.7 billion) to take stocks off the market with the intent of directly manipulating prices upwards;
- Individual, sophisticated investors, dealing in specific stocks, were not bidding up prices because of enhanced earnings-per-share, but rather were selling out on a grand scale ($216.6 billion) — cashing in their stock options;
- Unsophisticated investors (according to surveys by the Investment Company Institute) were naively buying ’stocks for the long run’ through automatic payroll deductions channeled to tax-deferred mutual funds, with no perception, whatsoever, of changes in earnings-per-share of individual securities.
The WSJ interpretation of the record level of buybacks, supported by the Efficient Market Hypothesis, puts a spin on events that is far kinder to corporate executives, stock brokers, and option exercisers, than the unvarnished truth that prices were supported not by improved earnings per share and crowds of rational investors seeking ‘intrinsic value’, but rather by the brute force of $146.7 billion in corporate cash being applied to take stocks off the market from option holders, many of whom were the same executives ordering the buybacks.
Furthermore, what was going on in Q1 2006 was not some random event — mere noise in the market — but rather the continuation of a long-standing pattern of behavior involving corporations, option-holders, and mutual fund investors that has been going on for many, many years.
The Efficient Market Hypothesis Examined
Ever since Professor Eugene F. Fama proposed the Efficient Market Hypothesis in 1965, world capital markets have been seen by many as guided by crowds of rational, competing, profit-maximizers, each trying to predict future market values of individual securities.
Forty years ago, Professor Fama, then a student of economics without experience in investment markets, proclaimed, without experimentation or surveying the behavior of real people, that, “in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value”.
The Efficient Market Hypothesis has never been proven. Indeed, no serious attempt has even been made to examine this hypothesis in the real world or to verify the fundamental, easily-disproved, assumptions that:
In fact, there are large numbers of rational, competing, profit-maximizers each trying to predict future market values of individual securities and that these profit-maximizers determine price;
In fact, important current information is almost freely available to all participants;
In fact, the actual price of a security is a good estimate of its intrinsic value.
An Unproven Hypothesis
So-called ‘proofs’ of the efficient market hypothesis are based on the claim that, supposedly, almost no one has been able to consistently outperform the market indices and therefore prices must reflect intrinsic value.
If prices reflect intrinsic value, so the reasoning goes, then the premises of the Efficient Market Hypothesis must be true.
This ‘proof’ of the Efficient Market Hypothesis, going beyond being unsubstantiated, demonstrates marvelously fuzzy thinking and the double logical fallacy of ‘affirming the consequence‘:
If markets are efficient, then prices reflect intrinsic value;
Prices reflect intrinsic value;
Therefore, markets are efficient.
And, as to ‘intrinsic value’:
If prices reflect intrinsic value, then no one can beat the market;
No one can beat the market;
Therefore, prices reflect intrinsic value.
Please note that in these discussions, no one bothers to define ‘intrinsic value’, other than the tautology: ‘the value justified by the facts’.
So as to present a patina of scientific credibility to the Efficient Market Hypothesis, advocates ramble on about ‘random walks’ of prices, spewing forth pages of mathematical formulae, graphs, and reasoning that is extraneous to the central question:
How does the behavior of real people in real markets actually match the assumptions on which the Efficient Market Hypothesis is based?
The Efficient Market Today
In a long article on the editorial page of the Wall Street Journal (June 14, 2020), Professor Jeremy Siegel writes of the current status of the Efficient Market Hypothesis:
” … the ‘efficient market hypothesis’ … assumes that the price of each stock at every point of time represents the best, unbiased estimate of the true value of the firm.”
” … the efficient market hypothesis does not say a stock’s price is always equal to its fundamental value. But the theory implies it is impossible to tell which stocks are undervalued and which are overvalued without either costly analysis or an innate skill possessed only by a chosen few, such as Warren Buffett, Peter Lynch, or Bill Miller.”
“Efficient-market believers still dominate the field of financial research, but many practitioners, including moonlighting academics, recommend that investors overweight value and small stocks in their portfolios.”
“[A] new paradigm claims that the prices of securities are not always the best estimate of the true underlying value of the firm. It claims that prices can be influenced by speculators and momentum traders, as well as by insiders and institutions that often buy and sell stocks for reasons unrelated to fundamental value, such as diversification, liquidity, and taxes.”
“To distinguish this paradigm from the reigning efficient market hypothesis, I call it the ‘noisy market hypothesis.”
Now, Professor Jeremy Siegel is Professor of Finance at Wharton, high in the list of academics that influence the thinking of Wall Street, and not a visceral enemy of the Efficient Market Hypothesis.
From his comments, it is clear that the Efficient Market Hypothesis has drifted far from the base principles established by Professor Eugene Fama in 1965, without having achieved any improvement as to its scientific basis or clarity of thought.
Unfortunately, the cloud of confusion emanating from the remaining tatters of the Efficient Market Hypothesis, continues to befuddle the interpretation of market events, as observed in the WSJ story mentioned at the opening of this article.
This is relevant to Capital Flow Analysis because confused thinking about market mechanics shields the extraordinary short-term price manipulation of the buyback-option players and works against the interests of unsophisticated, long-term investors, saving for retirement, and the general economic welfare of the nation.
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