The Efficient Market Hypothesis shows us that financial markets are 100% informationally efficient, or that prices on traded assets already reflect all known information, and instantly change to reflect new information. Basically prices recalibrate with regards to all information. Ultimately it is impossible to consistently outperform the market by using any information that the market already knows. Doing so just requires luck. It can be naturally called the Rational Market Theory.
In theory prices truly reflect the information out there. There is no fear and no greed anywhere. Thus the market has no emotion or panic.
EMH was the one singular idea that stated the cottage industry that is Modern Day Risk Management.
I have noted before that markets are not always rational, they uncoil and the resulting quakes are painful.
http://tradersutra.blogspot.com/2009/07/markets-evolve-uncoilget-used-to-it.html
There was a duel over EMH this week.
In one corner their was Martin Wolf from FT.com who is an opponent of EMH.
http://www.ft.com/cms/s/0/38164e12-c330-11de-8eca-00144feab49a.html
"The era when central banks could target inflation and assume that what was happening in asset and credit markets was no concern of theirs is over. Not only can asset prices be valued; they have to be. “Leaning against the wind” requires judgment and will always prove controversial. Monetary and credit policies will also lose their simplicity. But it is better to be roughly right than precisely wrong. Pure inflation targeting and a belief in efficient markets proved wrong. These beliefs must be abandoned."
The other side has Professor Jeremy Siegel from the Wharton School.
Mr. Siegel makes a lot of good points, but lets be honest here, he is part of the academic elite, he is not about to tear down his gold standard. The single most important point that he doesn't understand is that all of the risk models failed because they were all based on rational pricing.
Its quite unnerving that the academic community still holds on to beliefs that simply don't work. That is why MBA programs should be marginalized and rendered useless going forward.
http://tradersutra.blogspot.com/2009/04/what-needs-to-happen-now.html
http://online.wsj.com/article/SB10001424052748703573604574491261905165886.html
"According to data collected by Prof. Robert Shiller of Yale University, in the 61 years from 1945 through 2006 the maximum cumulative decline in the average price of homes was 2.84% in 1991. If this low volatility of home prices persisted into the future, a mortgage security composed of a nationally diversified portfolio of loans comprising the first 80% of a home's value would have never come close to defaulting. The credit quality of home buyers was secondary because it was thought that underlying collateral—the home—could always cover the principal in the event the homeowner defaulted. These models led credit agencies to rate these subprime mortgages as "investment grade."
But this assessment was faulty. From 2000 through 2006, national home prices rose by 88.7%, far more than the 17.5% gain in the consumer price index or the paltry 1% rise in median household income. Never before have home prices jumped that far ahead of prices and incomes.
This should have sent up red flags and cast doubts on using models that looked only at historical declines to judge future risk. But these flags were ignored as Wall Street was reaping large profits bundling and selling the securities while Congress was happy that more Americans could enjoy the "American Dream" of home ownership. Indeed, through government-sponsored enterprises such as Fannie Mae and Freddie Mac, Washington helped fuel the subprime boom."
Of course someone should have noticed! But all of the bankers models never predicted down home prices. If fact AIG's CDS Model never factored in negative assumptions year over year for home prices. It wasn't sub prime/CDO/CDL/CDS that eventually killed AIG. That obviously helped and would have leveled them eventually. It was the collateral they had to pay off their counter parties because when housing took a header, the were not modeling collateral payments. I can pretty much guess that the AIG models had some sort of EMH schema behind them. Another thing that is lost here is all of these models have huge leverage tied to them.
The models that were built by rocket scientists simply couldn't have been wrong. Too many smart people worked on them everyday. How in the world can bank executives go against Nobel Prize winning economists and their financial models? Everyone was getting drunk rich off the cool aid.
Siegel makes the point that someone should have known. That it was obvious. He makes Mr. Wolf's retort easy. EMH says don't argue with the prices. They always adjust for new information. Well they did eventually.
"Our crisis wasn't due to blind faith in the Efficient Market Hypothesis. The fact that risk premiums were low does not mean they were nonexistent and that market prices were right. Despite the recent recession, the Great Moderation is real and our economy is inherently more stable."
No Mr. Siegel. You Are Wrong! EMH along with free market University Of Chicago style economic thought always taught us that we should be seduced by models. We should let markets do what ever they want, because at the end of the day prices are always right. We never learned from LTCM, it should have ended there
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