Market efficiency is a central issue in asset pricing and investment management, but while the level of efficiency is often debated, changes in that level are relatively absent from the discussion. I argue that over the past 30+ years markets have become less informationally efficient in the relative pricing of common stocks, particularly over medium horizons. I offer three hypotheses for why this has occurred, arguing that technologies such as social media are likely the biggest culprit. Looking ahead, investors willing to take the other side of these inefficiencies should rationally be rewarded with higher expected returns, but also greater risks. I conclude with some ideas to make rational, diversifying strategies easier to stick with amid a less-efficient market.
Stock prices should accurately reflect reality. That’s important, not just to investors and those who make their living from markets, but to society at large. A well-functioning free enterprise system needs a well-functioning capital market. Why? Because the prices accorded to enterprises, be they very high or very low, provide direct incentives for how society allocates its resources. Enterprises raising capital from, and then distributing capital back to, investors, and at what prices this occurs is the circulatory system of the economy. The more efficiently that system operates, the more efficiently the economy functions, allocating resources to their best uses. Hence, if those prices don’t reflect reality, there are real consequences to long-term productivity and growth. Paraphrasing what Churchill said about democracy, I believe our market system is the worst way to carry this out, excepting for all others that have ever been conceived of or tried. That is, I’m a fan, but not a Panglossian one. Furthermore, over the span of my career – almost 35 years – I believe markets have gotten less effective at this central task of accurate pricing, and I think it matters.
The “efficient market hypothesis,” or EMH, is at the core of the debate over how well-functioning is the stock market. EMH has always resisted easy testing. Its basic formation is “prices reflect all information,” which is pretty intuitive. But the rub comes in the next step – how do you test that? Here, we run smack dab into the joint hypothesis problem. “Reflecting all information” is intuitively what an efficient, or simply well-functioning, market should do. But to determine if it’s occurring, one also needs a model, formal or informal, of what and how information should be incorporated into prices. Then you can only test whether the “joint hypothesis” – prices reflect all information and abide by your model of what and how information should be incorporated – holds. If that hypothesis is rejected by the data, you generally don’t know which one, or both, were at fault.
But all is not lost. For instance, I, along with coauthors, have occasionally tried to inject some non-technical common sense into the discussion. In Institutional Investor, John Liew and I made the modest proposal to inject the word “reasonable” into the process. Just as in law a reasonable man standard is common, so it should be in what models are reasonable to pair with EMH. Yes, it is subjective. But if your finding is that companies with blue logos strongly statistically outperform all others, and your model for how prices and expected returns are set is “people hate blue logos so those companies trade cheap and then outperform” you, in our view, are not being reasonable. Barring some other nuance, we’d call such a finding an inefficiency. More realistically, if your reason some stocks underperform is “people like to talk about these kinds of stocks at cocktail parties, so they overpay for them” then yes, in some grand meta sense it’s “rational” considering the enjoyment they get from their party chatter. But I’d argue if that’s what you mean by an efficient market you, again, ain’t being reasonable or useful. While it may be true that “de gustibus non est disputandum,” at some point we have to call some tastes irrational, or the word irrational has no meaning.
Similarly, I have argued that bubbles, the mortal enemy of EMH, are rare, and the word is used far too promiscuously. But rare does not mean never. I argued the standard should be very high. It shouldn’t be “this small stock is expensive so it’s in a bubble” as you often see in market commentary, but rather “I have tried hard and I cannot come up with any reasonable set of expectations about the future that justifies the price today under any reasonable model.” Furthermore, to be a bubble it should affect a large swath of the market (I think one stock, even if you think it grossly overvalued, doesn’t constitute a bubble of one). I have only seen a few instances that I believe qualify. I think Japanese stock prices in the late 1980s were a bubble. I think US stock prices in general, and the difference in prices between high multiple and low multiple stocks, were a bubble in 1999-2000 and again for high versus low multiple stocks in 2019-2020. I don’t see many other clear ones.
In Gene Fama’s Finance class in the 1980s (and presumably before and after as he taught it for a while!), somewhere in the first few weeks after introducing the basic idea of EMH, he shocks the class by announcing that “markets are almost assuredly not perfectly efficient.” He elicits a mild gasp from the class.8 Of course, only in Gene Fama’s class at the University of Chicago would this elicit a gasp! To most of the world the idea that markets aren’t perfect would seem rather obvious. But Gene’s point is a simple and obvious one — and Gene is nothing if not intellectually honest about such things — perfect efficiency is an extreme and unrealistic hypothesis.
Accepting that markets are not perfect leads to some obvious questions and possibilities. Once the market is not perfectly efficient, the question of how efficient it actually is becomes legitimate to ask. Furthermore, the notion that this level of efficiency is constant through time becomes unlikely. Why would it be? Thus “how efficient?” and “Has this changed through time?” become legitimate questions.
It is, again, my contention that, for the relative pricing of different common stocks, the market has gotten less efficient over my career.
Finally, I should mention that I am aware this may all be the harrumphing of an old man! Tests of the EMH have always been both difficult and controversial in their interpretation. Tests of how much it’s changed are only going to be harder. Thus, it’s fair to say that, old man whinging or not, this piece is as much an op-ed as it is quantitative research. I just think it’s an accurate op-ed!
Read the full paper here.