JP Bouchaud - EMH
Fama’s Efficient Market Hypothesis (EMH) was awarded a Nobel Prize in economics in 2013. Admittedly, Robert Shiller, one of its most persuasive opponent, got it as well the same year. It sounded a bit like giving the Nobel Prize simultaneously to Galileo and to the Church. In my opinion, EMH is a great example what Richard Feynman called “Cargo Cult Science” (one of the most inspiring – and fun ! – text on the nature of scientific theories).
EMH offers no explanation whatsoever for the slew of interesting and non-trivial phenomena happening in financial markets. In fact, these phenomena are waved away as “anomalies”, even when they reveal the deep nature of the underlying mechanisms driving price changes.
Is EMH-bashing like flogging a dead horse? Until EMH ceases to be taught as the pillar of modern financial economics, I think it is worth keeping pummeling it with empirical facts and arguments. Imagine the theory of epicycles still being taught to physics freshmen.
With this in mind, I’d like to advertise here a very nice piece of work by Klaus Adam, Albert Marcet and Johannes Beutel: “Stock Price Booms and Expected Capital Gains”, published in 2017 in the American Economic Review
Whereas market peaks (troughs) should be associated to low (high) expectations about future, the authors formally show, using sophisticated econometric tests, that survey measures of these expectations display excessive optimism (pessimism) at market peaks (troughs), i.e. when the price to dividend ratio is high (low).
In other words, and perhaps not surprisingly for those who have not been intoxicated by the EMH lore, people are trend followers. This is perhaps one of the most persistent and universal trait of humans as investors, and explains why trend following strategies have actually been making money for more than 200 years, see e.g.
Based on these observations, Adam, Marcet & Beutel develop a learning model that predicts that booms are followed by busts (or vice versa) as realized returns fail to conform to expectations. In spirit, their theory is very close to models where medium term trend following is interrupted by long term mean reversion, as in the model proposed by Carl Chiarella in 1992 and recently revisited by Adam Majewski et al. in
The phenomenology of financial markets is incredibly rich and complex, and EMH is only, at best, a medieval `flat earth’ approximation.