Basic Capital Flow Analysis: The Efficient Market Hypothesis and the Inefficient Market
The Efficient Market Hypothesis Rejected
The Non-Efficient Market
T he Irrationality Axiom and notions of market value varying from 'reasonable value' are contrary to principles of some economists and the so-called Efficient Market Hypothesis (EMH) that has ruled Wall Street for 30 years.
If the Efficient Market Hypothesis were true, Warren Buffett would be a failure.
This strange hypothesis states, in essence, that because market players are so smart and correct information so widely distributed, the price determined by 'supply and demand' in this efficient market must be the same as the intrinsic value of the securities traded.
If this is so, market value is always 'reasonable' and there can never be a shortage of equities or an opportunity for a smart security analyst to find under-valued stocks or bonds.
In the world of the Efficient Market, Warren Buffett would be a failure, because no matter how cleverly he examined financial statements, he never would be able to find an undervalued stock.
The Father of the Efficient Market
The Efficient Market Hypothesis is, in itself, evidence of the truth of The Irrationality Axiom.
The author of the hypothesis, Professor Eugene F. Fama, published his famous thesis in the Financial Analysts Journal of September-October 1965, under the title 'Random Walks in Stock Market Prices', as follows:
'An efficient market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants.
Professor Fama equated market price with intrinsic value.
In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future.
In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.'
Efficient Market theorists believe that no matter how low or high a stock is priced and no matter how unrelated this price is to the objective facts about the issuer, the price nevertheless is the intrinsic value.
Therefore, fundamental analysis is a waste of time since no advantage can be gained.
Index Funds and the EMH
The logical conclusion from the Efficient Market Hypothesis is that it is useless to conduct fundamental analysis since stock prices always reflect intrinsic value.
Billions of dollars have been invested in index funds, assuming that market price equals intrinsic value.
This leads directly to idea of the index_fund — a portfolio without professional guidance that mimics the behavior of stock price averages.
Billions of dollars have been invested in Index Funds — an exhibition of irrational conduct that disproves the Efficient Market Hypothesis.
This type of thinking is the opposite of the Greater Fool Theory since the assumption behind the Index Fund is that there are Lesser Fools who will do the necessary work to determine intrinsic value so that lazy people can ride on their coat tails.
The Trend Against Value Investing
The Efficient Market Hypothesis is anathema to old-school fundamental analysts.
It is also contrary to the principles of Capital Flow Analysis and easily refuted by commonsense.
The Efficient Market Hypothesis assumes that all players are playing the same game.
The basic assumption of the Efficient Market Hypothesis is that all investment decisions are based on a game in which players try to maximize gains over some uniform, but unspecified period.
The proponents of the Efficient Market Hypothesis presume the structure of the market to be that of similarly motivated, intelligent players, all with the same goals and the same understanding of intrinsic value.
The Efficient Market Hypothesis denies the existence of:
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millions of retirees who are forced to sell stocks, not to buy other shares with more favorable prospects, but only to pay living expenses in old age.
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the banker or broker who sells out a client’s margin account, irrespective of price, because the client did not meet a margin call.
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the fund manager whose motive to sell stocks is not to reinvest, but rather to pay investors who have redeemed their shares.
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the tycoon who buys up a company to gratify his ego and thirst for power, as well as corporate managers who aggressively repurchase company stock at ever-higher prices to increase the value of their options or to make their firm a less attractive target for takeover.
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the investor who might be saving for retirement twenty-years hence, while another hopes to make a profit before the end of the day.
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the investors that have different rules to follow, based on their own particular tax situation and individual perceptions of the market.
Not only is the Efficient Market Hypothesis flawed because of mistaken assumptions as to the motivation of investors, it also errs in assuming that there are objective facts available that lead to a precise measurement of intrinsic value.
Important Information Is Not Widely Available
In practice, professional portfolio managers place great importance on highly subjective issues, such as the quality of corporate management.
For a company to have honest and talented executives is considered to enhance the intrinsic value of a security.
However, where is the quality of management reported?
Certainly, auditor’s notes to the financial statement do not contain remarks such as,
'Management of this company is highly capable with high ethical standards.'
Where in the 'freely available information' about a company can one find statistics on the quality of management?
Accepted accounting principles produce reported profits that legitimately vary by thirty percent or more.
A fortunate investor who meets face to face with the CEO of a public company may come away with material information about the intelligence, honesty, and health of that executive, even though no 'inside information' is actually disclosed.
Generally Accepted Accounting Practices are sufficiently vague as to permit variances of thirty percent in reported earnings, without violation of law or accounting rules.
In large complex companies, an understanding of the intrinsic value of the company is difficult to come by, even for people on the 'inside'.
Where Are the Rational Investors?
The Efficient Market Hypothesis is based on the assumption that the market is made up of many rational investors competing for capital gain.
The Hypothesis states that because of their similar analysis of the plentiful information available about stocks, none will be able to outdo the other.
However, if everyone sits on the sidelines holding index funds, hoping that someone else will do the 'rational analysis', how can the market be efficient and why should prices approximate intrinsic value?
The Efficient Market Hypothesis is an example of the pseudo-scientific mumbo-jumbo that has come to dominate capital markets in the last half of the 20th century.
The Efficient Market Hypothesis and the Common Stock Legend supported the Great Bubble of the 1990s.
It is in the same category as the Common Stock Legend and the Fallacies of the Nobel Gods.
Changes in the sociology of the market come slowly; but when they occur, they are extremely important in Capital Flow Analysis.
The Efficient Market Hypothesis and the Common Stock Legend were instrumental in supporting the expansion of the Great Bubble of the 1990s.
For the purposes of Capital Flow Analysis, we can not view the market as the interaction of rational, well-informed people playing on a level field for common goals.
Instead, we look at the market as it really is, a diverse mass of people with different purposes, held in the grip of superstition, irrational beliefs and cultural mores, guided by the high priests of pseudo-science, the financial economists.
In analyzing this market, we have the difficult task of trying to stand outside of common belief and old professors' preachings (to which we ourselves have been subjected) in order to see the market and the players as they really are.
Before proceeding, check your progress:
Self-Test
The Irrationality Axiom contradicts:
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The author of the Efficient Market Hypothesis is:
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The idea of a stock index fund contradicts the Efficient Market Hypotheis because:
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learning module : continued >
Suggested Reading:
'A Random Walk Down Wall Street', 7th edition, Burton Gordon Malkiel First published in 1973, Professor Malkiel (Princeton University) recommends buying index funds, rather than trying to select stock based on fundamental analysis. |
'All About Index Funds', Paperback, Richard A. Ferri Explains how index funds work and the connection with the recommendations of Professors Malkiel and Fama. |
'Foundations of Finance: Portfolio Decisions and Securities Prices', Hardcover, Eugene F. Fama Required Text at University of Chicago Graduate School of Business (1998). Professor Fama used it as required reading in the course that he taught. |
'The Exchange-Traded Funds Manual', Hardcover, Gary L. Gastineau By 2003, investment in ETF, an efficient version of the index fund concept, had reached $150 billion. |
'The New Finance: The Case Against Efficient Markets', Paperback, Robert A. Haugen This book from academia has the courage to go against the establishment and criticize the Efficient Market Hypothesis. |
'The New Finance: Over-reaction, Complexity, and Uniqueness', Paperback, Robert A. Haugen Evidence contradicting efficient market theory. |
'Irrational Exuberance', Paperback, Robert J. Shiller Considered controversial by the establishment, this book is consistent with 'reasonable value' used in Capital Flow Analysis. |
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The truth about 13 widely touted investment strategies |
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Some economists suggests a 'weak form' for the Efficient Market Hypothesis. |
External Links
| Efficient Market Hypothesis : Economic discussion paper by economists at the Reserve Bank of Australia. [Return] |
| Warren Buffett : Forbes magazine information on this famous investor. [Return] |
| Fundamental Analysis : Introduction to fundamental analysis on Investopedia.com [Return] |
| Index Fund : Index Funds.com is a comprehensive resource on index funds investing, [Return] |
| Greater Fool Theory : Definition in Investopedia.com. [Return] |
| Intrinsic Value : Definition in Investor Words.com [Return] |
| Margin Account : Definition in Investopedia.com [Return] |
| Margin Call : Definition in Investopedia.com [Return] |
| Rational Investors 'Are Investors Rational? Choices Among Index Funds', Social Science Research Network. [Return] |
