The efficient market hypothesis, which was developed in the 1960’s, states that an efficient market for equities, or indeed any other market is one where, given the available information, actual prices represent a very good estimate of intrinsic values.  Prices are always changing as new information is coming to the market.  This information may relate to specific shares or the economy more generally.  But when news does become available, prices react rapidly.

Given the sharp movements in the stock markets of late people have questioned whether or not stockmarkets are still efficient at valuing equity prices.  This is not the first time that questions have been raised – it seems to be a recurring debate whenever share prices fall.  This was raised both in 2000 – 2003 as well as the 1987 stock market crash.

When new information hits the market, prices change rapidly to reflect that information.  So, for example, when there is bad news on the economy, share prices tend to fall as investors downgrade their expectations of future profits.  Often, private investors looking on the sideline may see a news headline showing poor economic data (so bad it has made it to the evening news!) but share prices rise.  This is generally because of market relief that the data was actually better than economists and analysts had previously predicted or expected.

Given that the collapse of Lehman Brothers was more or less a year ago, it is worth revisiting that episode.  At the time, investors were worried that there would be a complete collapse in the global financial system.  Listening to interviews now from many of the key characters involved at the time, it seems that such fears were justified.  There was a real prospect that the global economy was going to enter a Depression with long periods of substantially reduced earnings.  It is hardly surprising that share prices around the world collapsed.

However, as events panned out and central banks took the actions they deemed necessary, expectations were revised again and markets have since recovered, albeit by no means fully, as risk appetite has increased.  This does not mean that previous prices were wrong, as they reflected the information at the time, but as new information came to the market the expectations changed. Maybe there was going to be no Depression at all, and possibly within 12-18 months most of the world would be through the worst of any recession.

Eugene Fama is one of the names most commonly associated with the creation of the Efficient Markets Hypothesis.  He believes that markets have behaved rationally and as you would expect throughout the credit crunch.  He says, in a recent podcast, “The market can only know what is knowable.  It cannot resolve uncertainties that are not resolvable.  So when there is a large amount of economic uncertainty out there, there’s going to be a large amount of volatility in prices.  And that’s what we’ve been through.  As far as I am concerned that is exactly what you would expect an efficient market to look like.”

What this means is what we repeatedly tell clients – unless you are very lucky, it is extremely hard to do better than the markets on a regular basis.

Having said all that, Fama is always aware of challenges to the theory and he acknowledges the fact that it is just a theory – it is not fact and therefore does not claim to be perfect.  If it was it would not just be a theory.

There are two issues around the Efficient Market Hypothesis that concern Fama.  One is the fact that insider trading (legal trading by senior executives in their own companies, not to be confused with insider dealing) seems to offer higher returns. The other is that returns following earnings announcements seem to persist for longer than one would anticipate.  However, he believes that the excess returns from these sources are so small that they are not possible to exploit.  The costs of doing so would erode the benefit.

So what does all of this tell us?  Simply, that it makes sense to have diversified portfolios to remove avoidable risk and that the only sure way of varying returns over the long run is by changing your risk appetite.  If you want big returns you need to take the risk. Markets may not be perfectly efficient, but they are pretty close.