Are Markets Efficient?

Muhammet Furkan Guven

Spring,2020

English for Argumentative Writing

Term Paper

For decades it has been discussed whether markets are efficient or not. The discussion of market efficiency is not only a quest for knowledge: it has ideological and political implications. In the past, neoliberal politicians have defended the efficient market hypothesis theory because they also defended deregulation and restricted government. To support their agendas, they also claimed that the market is efficient, and we should let the market find its equilibrium. However, in the past the world  has experienced many crises and these crises indicated that markets cannot always find their equilibrium, so they are inefficient. Luiz Carlos Bresser-Pereira (2010) in his seminal paper examines historical process towards neoliberalism and struggle of legitimization of neoliberalism by its proposers. Bresser-Pereira argues that even though neoliberals try to legitimize themselves with mathematical and scientific tools, new and more democratic system will emerge after the crisis caused by neoliberal policies. In an evolutionary perspective, it can be said that it is inevitable that people and policymakers admit market failures exist and affect our daily lives negatively and markets must be regulated so that people have more stable and efficient governance because the neoliberal propositions about the market efficiency have collapsed in the past many times and it was proved that market inefficiencies subsist with long standing existence of the economical and financial crises. 

The theory of market efficiency is one of the most controversial  subjects in the academia and any single view on this theory is considered to be senior the other. Several influential academicians discussed this topic in their works.  In 2013, Nobel Economics Prize was given to three economists: Eugene Fama, Peter Hansen, and Robert Shiller. All of them have different views about the market efficiency. Firstly, Fama is the proposer and the most known defender of the market efficiency. Secondly, it can be said that Hansen is in the middle ground between Fama and Shiller. Hansen (2014) applies econometric methods to explore actions of rational agents while considering behavioral explanations. Lastly, Shiller is one of the biggest opponents of the theory of efficient markets. Shiller (2002) argues that prices do not reflect all available information and it is possible to beat the market consistently. Shiller tries to explain these inefficiencies with behavioral models.

 The efficient market hypothesis implies that stock prices reflect all available information (Fama,1970). However, due to the following reasons stock prices do not reflect all available information and they do not  always reflect fair stock  prices: limits to arbitrage, different assessment of stock’s fair market value, existence of investors who consistently beat the market, and rational agents who are believed to correct effects of irrational agents are not independent from their cognitive and behavioral bias.

The biggest impediment to correction of stock prices in the markets is that there are certain limits investors have when they do arbitrage. Firstly, investors have budget constraint while selling short and if the market reversion or correction of the prices do not happen before they default, they can go bankrupt and be no longer able to sell short.  As Keynes puts it in a quote attributed to him: “Markets can stay irrational longer than you stay solvent.”. Keynes or another person who made this statement tries to explain that even though markets can correct themselves in an unknown moment in the future investors may not be able to bet against market fallacies because long-lasting market inefficiencies that investors think exist may sweep all of the liquidity of investors so that most investors avoid betting against market inefficiencies. As a game theoretical consideration, if investors have not enough incentive to bet against market inefficiencies, they do not short-sell securities that they think overvalued. Short-selling strategies are usually executed when expected gains from short-selling exceed expected costs from short-selling. Another dimension of short-selling is that theoretically you can lose every penny you invested in short-selling. This probability of losing all of their investment also scare rational risk averse investors and they avoid short selling. As a result, investors shun short-selling and do not correct prices when market inefficiencies exist and because of this type of behaviors, inefficiencies in the market continue to exist.

Another impediment to short selling is some legal restrictions on institutional investors. Institutional investors like pension funds are legally prohibited from short-selling activities in most countries of the world. These legal restrictions are designed so that institutional investors like pension funds avoid taking high risks and engaging risky trading activities like short selling. Pension funds are important institutions because they transform our labor or efforts to future benefits. However, if these institutions engage in highly risky trading activities, clients of these funds also bear high risks that they are not even aware of. So, in terms of legal perspective restricting highly risky trading activities of pension funds is appropriate measure for the sake of society. Notwithstanding legal perspective, these restrictions lead to market inefficiencies because these institutional investors, who mostly manage billion dollars portfolios, may have highly profitable short-selling ideas and they are legally prohibited to execute these ideas and exploit market inefficiency and correct market prices.

The last obstacle about short selling is prohibition or restriction of short selling in times of crisis. Authorities restrict or totally prohibit short selling during crisis times to prevent fall of the market. The reason behind why short selling accelerates the fall of the prices is that it enables investors to make profit without buying the stock and only paying the premium needed to sell short the stock.So, if prices are falling it is very intuitive to sell short the market index or stocks. If investors are not be able to sell short stocks, it is very unlikely that the prices will be corrected. Restriction on the short selling leads to overvaluation of the stocks because investors are not able to bet against overvalued prices. Overvalued prices are one of the biggest evidences of the market inefficiency and these restrictions make the price discovery process slower. Simon Grima and Stephen Sammut (2017) argue that prohibition of the short selling during times of crisis leads higher volatility and it slows the price discovery process. Sluggish price discovery process and higher volatility exacerbate existing market inefficiencies.

Another reason why market inefficiencies occur is that valuation of the market or stocks is not a complete scientific process or a calculation based on scientific facts. The valuation of stocks is mostly depends on expectations and personal views of analysts or investors so that the valuation can not be considered as an objective process. In such circumstances, different investors and analysts value stocks differently and these various valuations lead market inefficiencies. Most of the essential finance theories suggest that fair price of a stock is sum of all discounted future cash flows. It is thought that fair price of an asset should be discounted sum of all future cash flows. Some assets have finite cash flows like 10 years government bonds and some assets like stocks traded in exchanges are thought to have infinite cash flows in the form of capital gains and dividends. It is specified in the issuance of fixed income assets what will be the future cash flows that valuation of these financial instruments will be based on exact cash flows unlike expected cash flows in the stock valuation and the certainty in cash flows the investors receive make the valuation of the asset more universal. However, even in fixed income assets there are some risks that can endanger the future cash flows. For example, bond issuer may default on his or her debt. Another risk related to fixed income assets is the risk of inflation. You may receive your cash flows, but the real value of these cash flows might not be as high as you expect. There are many theories or works study markets related to fixed income products, but the domain will be restricted to the stock market for the sake of making the analysis more concrete. Although, some firms or conglomerates can buy their shares in the stock market back and end the cash flow you will get in the future. They must pay the market price of stock. If the price of the stock is correct, as an investor you will not lose money. However, the market price of the stock may be undervalued. Further, most of the time the reason why the owners of the firm want to buy back their stock share is they think their share is undervalued. To sum up, it is possible that you will not have infinite future cash flows and lose money. But this possibility will be ignored here to restrict the domain for the sake of argument. Nonetheless, even if we assume that we will have infinite cash flows from the stock we bought, it is still open to discussion how much profit we will make from the stock we bought. In conventional finance, future cash flows are predicted by the financial analysts. However, there are many schisms between these analysts. Many different predictions are made by these analysts and no one can prove that his or her prediction is the best prediction. Most probably, this is because of the complex structure of the valuation. There are many factors that affect future cash flows but to what extent they affect is always open to discussion. Furthermore, it is believed to that there are many other factors which are not discovered affect future cash flows. In such an uncertain environment, expectations and valuations differ considerably. Some analysts use statistical and mathematical models to predict future cash flows but the results you get from the statistical and mathematical methods are most of the time are not so precise. It also renders the prediction process more burdensome. In such circumstances, predicting future cash flows should not be considered as a science but kind of art. What analysts do is predict future cash flows, but the process is bound with their cognitive bias and limits of the tools they use. To sum up, without specifying exact or precise future cash flows it is not possible to find fair value of a stock. If we can not find the fair value of the stock, we can not know if it is undervalued, overvalued, or fair priced. Impossibility of finding exact or precise price of a stock makes the test of market efficiency impracticable. In an environment where the efficient market hypothesis cannot be tested, it is not reasonable to claim that markets work properly.

Second component of the discounted cash flow method is a discount rate besides future cash flow predictions. Discount rate is the rate you discount the future cash flows. Valuation of a stock will change when the discount rate increases or decreases.Discount rate for valuation is set according to future expectations and risk perception in line with future expectations.In conventional finance, 10 years government bond yield is usually considered the most basic discount rate. Most investors and analysts incorporate riskiness of the stock subject to valuation. The more a stock is thought to be risky, the higher discount rate analysts and investors use while doing calculation about the fair price the stock. The riskiness or so called “beta” of the stocks is usually considered response of the price of a stock to market movements. However, there are so many risk measures besides beta of a stock. Industry related or firm specific, so called idiosyncratic, risks are other popular risk measures. Investors or analysts choose their appropriate discount rates according to such type of considerations. Further, some investors take loans to invest in the stock market and these investors also think that their discount rate should be greater than the rate of interest which they pay to creditors. Different type of investors requires different rate of returns and adjust their discount rates accordingly. There are not any consensus mandates investors to choose specific discount rate. In such an environment, no one can determine what the fair discount rate is and decide what is the fair value of a stock. Pablo Fernandez (2019) examines in his work different price calculation methods based on the discounted cash flow analysis. Fernandez argues that valuation process is made more intricate with different methods to calculate discount rates and these different methods include many errors within the calculations.As a consequence, valuations differ immensely from investor to investor. Different valuations make markets more volatile and less efficient.

Without knowing what the fair price of a stock is, it is meaningless to claim that price of this stock reflects all available information. Lack of generally accepted valuation tools and existence of personal bias and different risk appetites of investors and analysts make things more complex. In such a chaotic environment, claiming that markets work properly needs concrete evidences. However, boom and bust cycles of global economy proves that markets may fail against the theory. Invention of very complex financial tools also contributes to fluctuations in economies. In 2008 crisis, new financial tools like CDO (“Collateralized Debt Obligation”) made some valuations more complex and, also facilitated frauds because these are new tools and people were not aware of the dangers these tools entail. Damodaran and Cornell (2014) examine Tesla’s stock market price in their paper. Damodaran and Cornell argue that discounted cash flow method based on company fundamentals cannot explain investor reaction to announcements from the company. Damodaran and Cornell claim that the price of the stock may not be corrected for a long period of time due to the investor behavior. Within this frame, it can be said that there are not enough rational agents in the markets both in terms of quantity and quality to correct the actions of irrational agents.

Lastly, consistent winners in the market conflicts with the efficient market hypothesis. The theory of market efficiency implies that stock prices reflect all available information so that there are not any undervalued or overvalued stocks that you can buy or sell short to make profit. Efficient market hypothesis argues that prices move randomly in markets. If prices move randomly, no single investor can beat the market consistently with predicting the market movements and gaining profits like Warren Buffet. However, there are many successful investors in the market who beat the market consistently. To be able to beat the market over 20 years like Warren Buffet, you must have some brilliant strategies. Existence of such strategies contradicts with the efficient market theory. Eugene Fama and Ken French (1998) in their seminal work argue that behind such successful long run strategies there is a risk-return trade-off. Fama and French claim that small cap and value stocks make higher return because of their high risk level. However, after Fama and French published this paper it is seen that returns of these type stocks decreased and become less attractive. Robert Shiller examines this issue in his best seller book Irrational Exuberance (2000) and claims that these are market inefficiencies and triggered by the cognitive bias of human beings and was exploited by the market makers when it was discovered. To sum up, consistent winners exist and the fact that they exist totally contradicts with the efficient market hypothesis. The idea that markets move randomly is rejected by the existence of consistent winners in the market.

Many influential academicians and researchers defend the efficient market hypothesis. In this section, some of their arguments will be analyzed. Eugene Fama is considered to be the most well known defender of the efficient market hypothesis as a proposer of the theory. The theory was first stated in “Efficient Capital Markets: A Review of Theory and Empirical Work” by Fama (1970). After his seminal paper, many other people have contributed to the theory. Burton Malkiel (2003) classifies the market efficiency into three form: weak, semi-strong, and strong. Weak form implies that it is impossible to make profit with only analyzing historical price patterns. Semi-strong form suggests that stock prices include all public information. Lastly, strong form indicates that stock prices reflect all information including insider news from the company who issued the stock. In general, people who endorse the theory only base their claims on the weak form and state that it is impossible to find a profitable strategy with patterns inferred from historical prices. However, there exists many successful trader who only base their strategy to historical price patterns and make profits. Park and Irwin (2004) analyze papers written about the profitability of the technical analysis which is a method based on the historical price patterns and concludes that technical analysis is a successful method for making profits. Due to the fact that semi-strong and strong forms of the market efficiency includes the weak form of the market efficiency, it can be said that the other two forms are also disproved when the weak form of the market efficiency is not valid.

Markets do not work efficiently because of certain factors. Firstly, there are some regulations like restraints on short selling do not let investors to invest according to their optimal strategies. Secondly, valuation is not a science and differs from investor to investor. Lastly, if markets would be efficient no investor could be able to beat markets. However, there are many investors who have beaten the market for long periods. Provided that markets may fail, regulation of markets and government interventions in the market are essential for more stable and efficient markets. Regulations and government interventions may mitigate adverse effects of market inefficiencies.

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Fama, E.F. and French, K.R. (1998), Value versus Growth: The International Evidence.

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