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131

A Leap of Faith

Even if the studies pu Orting that markets are efficient were not problematical, there is a much more serious question about them that was initially raised in chapter 4. The scientific findings were far too modest to justify the researchers all-encompassing and revolutionary conclusions. What proof did the researchers have that the markets respond not only immediately but correctiy to new information? None. They accepted market reaction to uncomplicated information as proof positive, not simply of reaction, but of the correct price reaction to the event. The investigators never attempted to test investors ability to 1 1 1 far more complicated information, such as weve viewed throughout the text.

The pattem is common not only to EMH studies, but to most areas of mathematical economics. The researchers are very rigorous in their statistical analysis, but extremely liberal, if not specious, in their 1 1 -tation of broader issues. We saw this in their presentation of the studies that attempted to prove markets are efficient. The work looked at obvious examples that news affects markets. These findings, which one could call "slivers of efficiency," lead the researchers by quantum leaps to much broader conclusions. If markets can be impacted by news of mergers or secondary offerings, the reasoning goes, they must be

perform and unde e form die market respectively for periods up to nine years.

These findings then appear to shoot another arrow through EMH.

Finally, Robert Shiller, a leading behavioral economist, argues that if markets were efficient, then looldng back at history, stock market prices at a given time should be related to prices that we can say are "rational."* To find out if this is true, he looked back at prices that would be considered rational in light of dividends subsequendy paid. The study covers the 1871 to 1979 period.

Shiller found the rational index he created after the fact follows a smooth and stable path, whereas the actual market index veers sha ly above or below it for extended periods, displaying substantial volatility in doing so.

Shiller concludes: "[S]tock price volatility over the past century ap-pear[s] to be far too high ... to be attributed to new information about future real dividends." In other words, markets over this long term did not respond accurately to information, but rather moved far higher or lower than was warranted by it.



The Problem of Interpreting Information

The obvious next question is, how good are investors inte retive capabilities? Even if the EMH studies are correct, do they prove markets are efficient?

The 1 1 1 11 of information, as we have seen, is anything but easy. It is influenced by the psychological mood of the time, the response of market experts, the complexity of the data, and a host of other inputs. Examining the effects of a stock split is far simpler than deciding die proper level for bank shares in the midst of the 1990 financial crisis.

Let us examine the seemingly simple statement that enough buyers and sellers are aware of the meaning of all public information to keep prices in line with value. This statement subsumes two complex premises. If either can be shown to be inaccurate, the hypothesis can be dismissed on yet another count.

The first premise assumes investors not only have complete knowledge but can correctly 1 1 1 all information, past and present.

The second premise assumes that the sophisticated investors in the marketplace are rational in the classic economic sense of excluding all behavioral influences but one, the maximization of gain or the minimization of loss. Given new information, then, decision-making is as routine, automatic, and mechanical as the changing of a traffic light.

We have seen how difficuh inte retation of information actually is. Perhaps this is why analysts so often project current trends to arrive at eamings forecasts or investors bet heavily on trendy stocks.

Although there is often a consensus by many sophisticated investors

equally capable of gathering and inte reting complex data about companies and industries, economic, monetary, and financial condidons, and the market itself."

One must marvel at the boldness of these scholars, to build an all-encompassing theory on such flimsy evidence. It is an enormous leap of faith from these simple findings to the conclusion that the market correctly 1 1 18 all information, no matter how complex, almost instantaneously.

This is like saying that if my then six-year-old daughter could count to 100 without difficulty, she should also be able to comprehend the theory of relativity. While Im sure that, if asked, she would have readily given me an answer to this, as she did to anything else, somehow I think it would miss the mark.



on the course of the market or the value of individual stocks, die difficulty of 1 1 1 alone can push them far off the mark.

That investors obtain and correcdy 1 1 1 not hundreds, but thousands, perhaps millions, of recondite facts is bedrock to die theory. This immensely complex undertaking, never subjected to testing, must be seriously questioned.

Summing It All Up

Unfortunately when put to die test, the tenets of EMH ring like a string of stunning military defeats. None of the risk measurements that die academics credit to rational investors have stood the test of time. The two key predictions of the theory, that investors cannot consistently beat the market and diat markets respond to new information quickly or accurately, have both been discredited.

Finally, there is the major problem widi the EMH assumption diat investors can 1 1 1 vast amounts of data. Findings in cognitive psychology and other psychological disciplines demonstrate that diis assumption is not accurate. To carry die chess analogy one step further, aldiough millions play chess, there is only a score of Grand Masters, and only one Gary Kasparov (or to date one "Deep Blue"). If people are not equally adept at inte reting die complex world of the chessboard, can diey be any better at inte reting the more complex and significandy more emotional world of markets? The simple EMH tests discussed previously showed that markets respond to new information; they did not demonstrate they responded correctly.

Towers Built in Sand

The history of science teaches us that, given capable, intelligent people, large errors normally do not occur in die development of a case, but radier in die assumptions upon which the work is based. Powerful statistical techniques without realistic assumptions take on a life of their own. As bad currency drives out good, three decades of bad constructs in finance and economics have driven out good science, leaving few useful contributions for the enormous effort expended.

To be fair, the concept of efficient markets has come under attack even by financial academics. Edward Saunders, using the work of Karl Popper, one of the important theorists on scientific method in the last half of the twentieth century, criticizes the scientific approach of EMH. Popper stated in a famous analogy that to prove the dieory that



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