Defending the EMH

Continuing on my first post about the efficient market hypothesis (EMH), I believe in a semi-strong version of the hypothesis, which allows for some opportunities to make profit through a process called fundamental drift. It would seem that the EMH’s biggest opponent are from the ‘right’ of the political spectrum (zerOh3dge and Market Ticker type guys) who insist the market is ‘rigged’, which is a view that many on the left also share. In fact, it would seem the EMH has fallen out of favor from both sides of the ideological aisle, leaving only a handful of academics and myself to defend it. Of course, there are always the well-worn ‘violations’ of the EMH that are trotted out, with the sanctimonious belief that EMH doubters have somehow overturned the establishment, when in fact, such counter-evidence doesn’t necessarily refute the EMH. For reference, some violations include the infamous Palm Spinoff snafu, companies’ stock reacting ‘too much’ to the re-release of public information, and those ‘obvious’ bubbles such as the dotcom bubble. Irrational markets and behavior finance in popular now, but I think the EMH can be slightly modified to reconcile perceived ‘irrationality’ and still be consistent with an efficient market.

From The Wikipedia definition of the EMH,

The Efficient-market hypothesis (EMH) states that it is impossible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments.[1]

Borrowing from the no-arbitrage conditions of option pricing, I would modify this definition to say that the EMH doesn’t necessarily require that stock prices not be predictable, that all information be instantly reflected in the stock price, that bubbles cannot form, or that investors cannot act irrationally – violations of all of these things can happen in an efficient market – it’s just that the frequency and liquidity of such events isn’t consistent or deep enough to allow for a consistent, abnormally high profit. In a random walk, any pattern or outcomes is possible, but under the no-arbitrage condition the aggregate of traders cannot make an abnormally high profit/rate of return from these fluctuations. For every ‘obvious’ bubble where speculators profit betting against it, there are countless situations where traders lose their shirt as the ‘obvious’ bubble proves to be surprisingly resilient or isn’t a bubble at all. Then you have issues like low liquidity, short squeezes, and ‘hard to borrow’ working against the short seller. The same goes for re-release of public information. Yes, sometimes stocks move too much, but this doesn’t happen often enough to allow for abnormal profit. Same for arbitrage opportunities that are too small and too infrequent to allow firms to make an abnormally high rate of return.

Or as I wrote in my earlier article, Irrational Investors Don’t Exist:

Markets are nearly impossible to predict because in retrospect many bubbles like Facebook, for example, now seem rational. It is demonstrably impossible to exploit ‘bubbles’ to achieve excess returns, even during the late 90’s. For a couple reasons: liquidity and timing. It’s hard to find shares to short and if your timing is bad and the stock keeps rising, you’ll get a margin call and be forced out of the position at a large loss, even if your original thesis is correct. A notable example is the Manhattan Investment Fund that lost $400 million shorting tech stocks in the 90’s. He is the real wolf of Wall St., but you won’t be seeing a movie about him because the it makes the government look incompetent being that he got away with it. In 2007, Microsoft purchased a small stake in Facebook , valuing the social networking site at $15 billion. Everyone in the media and blogs (except me and some others) was convinced it was bubble. Fast forward to 2014 and Facebook is worth north of $130 billion. Anyone went on the opposite side of that trade (assuming Facebook was a public company) would have lost 500-700% of their money.

Make that $230 billion for Facebook. And now Uber is next in line to cross the $100 billion threshold, long after pundits were calling it a bubble at < $5 billion valuation. And this happens over and over again. The media and punditry goes to great lengths to tout their ‘bubble radar’, ignoring all the times they were wrong.