Inefficient Markets: Should We Blame the Professors?

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 |  Includes: DIA, QQQ, SPY
by: Cullen Roche

Excellent paper here from the CFA Institute regarding the efficient market and the theorist’s role in contributing to the recent market turmoil. The paper asks whether professors have substantially contributed to what appears like an increasingly inefficient market:

Finance professors have certainly changed their definition of what they mean by market efficiency through the years. In the late 1970s and early 1980s, they basically believed that they had proven that prices in transparent, liquid markets (such as large-cap stocks in the United States) were in line with fundamentals.

In 1985, Robert Merton—a product of Massachusetts Institute of Technology and one of the cocreators of what is now generally called the Black–Scholes–Merton option-pricing model—made a fascinating statement:

“If, however, the rationality hypothesis is sustained [and he is assuming it will be] then instead of asking the question “Why are stock prices so much more volatile than (measured) consumption, dividends, and replacement costs?” perhaps general economists will begin to ask questions like “Why do (measured) consumption, dividends, and replacement costs exhibit so little volatility when compared with rational stock prices?”

Merton is saying that financial markets are right, so something must be wrong with all our measurements of reality.”

So are the professors to blame?

“So, are finance professors and their theories to blame for the financial crisis? They just cannot be because we have been having financial crises for a long time, and furthermore, so many other things were going on at the same time (e.g., massive political support for home ownership, almost beyond all reason; new technologies and financial innovations; the strange role of China in its very unbalanced trade and financial relationship with the United States). But have those theories been partly discredited by the financial crisis? Yes, I would say so, although it depends somewhat. If academics are just saying that the efficient market hypothesis means the market is hard to outsmart, then, no, it has not been discredited at all. But if academics are saying that the efficient market hypothesis means markets behave rationally, then they do not have good explanations for what went on the past couple of years.”

Good conclusion. Blaming the professors is not entirely accurate, however, they have misinterpreted markets for years by assuming the math can accurately reflect irrational decision making. In my opinion, this has cost investors countless dollars as strategies have been built around this inherent faith in the markets.

The Q&A section has the most vital question, however, when they differentiate between the long-term and the short-term. It has always been my opinion that markets are quite inefficient in the short-term for various reasons, however, are quite efficient over the long-term. It simply takes time for markets to digest and price-in information. The instantaneous and accurate reflection of price is simply not realistic. I would use the BP case as exhibit A. It’s simply impossible for market participants to know what the potential liability is. Therefore, it is nearly impossible to apply the proper price to its equity:

Question: Is it possible that markets are truly efficient in the long term, which could be an infinite period of time, but that, unfortunately, in the short term, they are irrational?

Fox: That’s what a lot of the disagreement in finance has come down to. We all agree that over some period, the efficient market hypothesis is right—that prices on average are right. But if you are talking about that over a 100-year period, it is not useful to
anybody in making investment decisions or regulatory decisions. That’s the problem.

Read the full piece here.