Collective Brain

Testing Market Efficiency

Collective Brain

During this turbulent period, certain pundits have questioned the validity of Efficient Market Hypothesis. There is nothing new about this, as these questions have arisen in every bear market since the formulation of the Efficient Market Hypothesis approximately forty years ago. As a specific example, the author of this article cites the magnitude of the drop as evidence that market prices were previously incorrect, but now, of course, they have been corrected. Furthermore, if the market was so obviously inefficient then, why should anyone believe that it is efficient now? Like so many others, the author of that article has confused hindsight with foresight.  

     In an interview seen here, Professor Eugene Fama, the father of the Efficient Market Hypothesis, describes a simple test for determining whether or not the market does a good job of setting prices. In order to understand this test, it is necessary to visualize what an inefficient market looks like. Such a market would be dominated by what we refer to as “noise traders” – people who place trades without any rational basis. Examples of noise traders include buyers who snap up a stock because they heard Jim Cramer recommend it and sellers who dump a stock simply because they need cash and harbor no opinion concerning where the stock price will go after they sell it. In an inefficient market, we would see one group of informed traders consistently making money at the expense of the noise traders, and there is simply no evidence that this is occurring.

     The second attribute of a market dominated by noise traders is daily price swings that eventually are corrected by the “smart traders” who take advantage of those poor ignorant noise traders. Specifically, daily volatility would be substantially higher than annual volatility because the latter would correct for the wild price fluctuations produced by the noise traders. The daily S&P 500 data from Yahoo! Finance for the last fifty years, however, suggests otherwise. Specifically, the standard deviation of annual returns is 17.2% while the annualized standard deviation of daily return is 15.5% (The latter is calculated as the standard deviation of daily returns (0.98%) multiplied by the square root of 250 (the approximate number of trading days in a year). 

    Given that the fifty year data shows no indication of market inefficiency, one may argue that the market over time has become progressively more efficient due to increased availability of information about companies or that it has become less efficient due to wider accessibility to uninformed traders. Breaking up the fifty year period into five consecutive ten year periods gives no indication of either increasing or decreasing efficiency. In fact the only ten year period where the annual volatility was substantially lower than the daily volatility was the middle period (1/1/1979 to 12/31/1988), as seen below: 

                                                Std. Dev. of                          Annualized Std. Dev. of

Period                                    Annual Returns                  Daily Returns         

1/1/1959 to 12/31/1968                   13.1%                                     11.6%

1/1/1969 to 12/31/1978                   19.4%                                     15.9%

1/1/1979 to 12/31/1988                   11.8%                                     16.5%

1/1/1989 to 12/31/1998                   14.7%                                     13.4%

1/1/1999 to 12/31/2008                   20.5%                                     21.2% 

1/1/1959 to 12/31/2008                   17.2%                                     15.5%

       Even if the market is filled with noise traders, all that is needed for market efficiency are many intelligent participants with access to information. These intelligent participants compete to trade at a profit, and the price they strike is the consensus of their opinions of the stock’s value. The market does its job of setting prices so that buyers can expect to receive a return that compensates them for the risk they take (Marlena Lee). As pointed out by Gene Fama, Jr. in May of 2001, the very fact that the Efficient Market Hypothesis still comes under assault is stronger testimony to its deep relevance. Furthermore, it is important to remember that asserting market efficiency is not equivalent to asserting that the market is right, just that it is more likely to be right than any single market participant. Also, even if markets are not perfectly efficient, they are efficient enough that the time and resources spent in attempting to uncover inefficiencies is usually wasted. Those who believe they can prosper by taking advantage of a market that they perceive as inefficient would do well to remember the thought expressed by John Maynard Keynes well before Professor Fama articulated Efficient Market Hypothesis: “Markets can remain irrational longer than you can remain solvent.”