Efficient markets hypothesis… really?

The thing about humans is we often search for reason where there is none. Economists are notorious for it. So enamoured was the profession in the 1970s with the concept of rationality, economists developed the idea of the “efficient markets hypothesis”.

It states that, at any point, financial market pricing reflects all available information, and hence is the best possible guide to the value of economic assets. Some particularly ardent advocates take it a step further, arguing that, because share traders also take into account future developments, the present share price of a company must also be the best estimate of its future value.

Information being free, and market participants entirely rational, economists concluded market bubbles were impossible and that governments should not intervene to regulate financial markets.

The global financial crisis cast this theory asunder. Asset bubbles do indeed happen and where governments fail to regulate financial markets, lies, distortions and misinformation prosper.

But while most economists have fallen out of love with the idea that financial markets are efficient, we in the media still seem in the thrall. When shares fall suddenly, we immediately search for deeper meaning. “Shares tumble as likelihood of US recession rises,” we conclude. Two minutes later, as shares rise, we conclude the opposite: “Shares soar as recession risks recede”.

If we’re more investigative, we call share traders to try to figure out which particular rumour is preoccupying their mind. “Shares rise amid rumours of QE3,” we conclude. (QE3 meaning quantitative easing round three, or another round of the US Federal Reserve printing money to stimulate growth.)

But let’s face it, in the short term at least, the real reason share prices rise or fall is more mechanical. When there are more buyers in the market willing to pay a higher price, prices rise. When there are more sellers in the market, willing to sell at a lower price, prices fall.

Of course, for every seller there must be a buyer, and vice versa. So the term “sell off” is a bit misleading, implying that only selling is occurring. Who buys shares when prices are falling? Mainly, strategic bargain hunters or large institutional investors, such as super funds.

Unfortunately, the headline “Shares soar as more people willing to buy” isn’t very exciting, nor does it satisfy our deep yearning for meaning.

Because, while in the short term share price fluctuations display all the orderly progression of a stampeding herd, in the long run shares should reflect some more fundamental information about likely profit growth.

So where next for shares? In a recent speech, the Reserve Bank governor, Glenn Stevens, observed that real asset prices per capita (housing and super) grew 6.7 per cent a year in the decade between 1995 and 2005. Between 1960 and 1995 private wealth per capita had grown just 2.6 per cent a year.

“Had we really found a powerful, hitherto unknown route to genuine wealth? Or was this period unusual? Looking back, it appears the latter was the case,” he concluded.

Amid this week’s sharemarket volatility, one thing is clear: it is unlikely we will be returning to the extraordinary days of double digit annual share price gains any time soon.

The world economy is in the grips of a painful period of de-leveraging and it is going to take some time for growth to return.

THE IRVINE INDEX

$5 billion
Average daily value of shares changing hands on the Australian stock exchange.

8th
Global ranking of Australia’s share market by market capitalisation.

15.3%
Largest one-day percentage gain on the US Dow Jones Industrial Average on March 15,1933, after the Emergency Bank Act was passed.

$1.3trillion
Total market capitalisation (number of shares times their price) of the Australian share market as at July 31.

1861
Year Australia’s first stock exchange was founded in Melbourne during the gold rush.

2241
Number of companies listed on the Australian Securities Exchange.

1937
Year the state-based stock exchanges came together as the Australian Associated Stock Exchanges.

22.6%
Largest ever one-day percentage fall on the US Dow Jones Industrial average on October 19, 1987, dubbed “Black Monday”.

1987
Year the Australian Stock Exchange Limited (ASX) was formed. Three years later automated trading was introduced.

Sources: asx.com.au; wsj.com

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This entry was posted in Behavioural Economics, Global Financial Crisis. Bookmark the permalink.

One Response to Efficient markets hypothesis… really?

  1. harry mahoney says:

    harry is cool, not really

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