Understanding How Economists Use Efficient Market Hypothesis in The Analysis of The 2008 Global Financial Crisis

The Global Financial Crisis and the Efficient Market Hypothesis

The Global Financial Crisis of 2008 is considered the worst financial crisis since the Great Depression, a time of turmoil and sharp declines in the economies of the United States, Europe, and other parts of the world. For the next five years, the financial crisis caused a crippling global recession that saw a national decline of trillions in household wealth and prolonged mass unemployment. For years, economists have argued the cause and one particular argument put forward is the Efficient Market Hypothesis (EMH), the theory that in response to any new information, competitive markets quickly make price adjustments. Due to all publicly available information, the average investor is not likely to earn above-normal returns. The ideas of the efficient market are one of the most controversial economic theories, however, difficult to test. There is no quantifiable measure of market efficiency and the timing of a stock price decline cannot be predicted, as asserted by EMH. While EMH provides an intriguing insight, it is limited The Global Financial Crisis of 2008 demonstrates the theory is mainly false when applied to events of the global crisis. This paper seeks to disprove the EMH claims of responsibility for the Global Financial Crisis of 2008 by carefully examining the theory and presenting strongly supported arguments backed by research and knowledge of economic and behavioral theories.

Efficient Market Hypothesis (EMH) suggest that global financial crisis was caused by the continued reliance on all available information on stocks. Regulators and investors vastly underestimated the looming asset price bubbles from a result of not authenticating the actual values of publicly traded securities. Created by Eugene Fama (1970), EMH presents a plausible theory in which it suggest investors cannot sell inflated priced stocks or purchase undervalued stocks. This is as stocks will always trade at their fair value. Efficient Market Hypothesis is defined as “the definitional statement that in efficient markets prices “fully reflect” available information is so general that it has no empirically testable implications” (Fama, 1970, pg. 384). In this most straightforward definition, in an efficient market, investors cannot consistently beat the market, since market prices react to changes in discount rates and new information.

For markets to be efficient, it can be contrasted with the conditions necessary for defining a perfect capital market, which is informationally efficient and has perfect competition among participants and are frictionless. Efficient markets, however, are less restrictive. Efficient capital markets may still exist in a frictionless market when all relevant information is fully reflected. The three variants of EMH; weak or narrow, semi-strong and strong forms that demonstrate this type of information should be reflected in financial assets current prices. In the weak form, EMH asserts that current prices already reflect any information contained in historical trading volume or price series. Thus any future price movements predicted by any historical patterns would already be exploited. (Malkiel, 2009) The semi-strong variant form believes any information that is fundamental to the stock market or about individual companies will be without delay reflected in stock prices. “Thus, investors cannot profit from acting on some favorable piece of news concerning a company’s sales, earnings, dividends, etc., because all publicity available will have already been reflected in the company’s stock price” (Malkiel, 2003, pg. 9). The strong variant form suggests that any information that is knowable and known is already reflected in market prices. In this extreme view, investors cannot even benefit when conducting the illegal activity of insider information. (Malkiel, 2011) This form is never completely satisfied, but it does identify an extreme range of market efficiency.

Ray Ball (2009) examines that the EMH is composed of two insights. The first illustrates the correspondence between costs and revenues enforced by the competition of new entrants. This wipes out or reduces excessive profits. The second insight matches Fama’s view that the function of the flow of information to the marketplace changes asset prices. (Ball, 2009) Ball interprets EMH using these two insights that market participant competition is the cause of returns to commensurate with its costs from using the available information. (Ball, 2009) The hypothesis of efficient markets posits that; events such as news on initial public offerings, new exchange listings, mergers, dividend actions, stock splits, and earnings surprises cause stock prices to respond efficiently. (Malkiel, 2003) Accordingly, fundamental changes in value cannot be immediately or entirely reflected in market prices due to the inhibition of both uneven transaction costs and differences in investor awareness.

According to Malkiel, for EMH, anomalies in returns can arise only when the economist applies specific models in order to get them. These uncommon effects tend to disappear when different models are adjusted for risk and when measures are calculated using different statistical approaches, as they were not what the model was testing. (Malkiel, 2003). EMH follows the series of prices, where all subsequent price changes represent from their previous prices random departures, otherwise known as a “random walk”. “The logic of the random walk idea is that if the flow of information is unimpeded and information is immediately reflected in stock prices, then tomorrow’s price change will reflect only tomorrow’s news and will be independent of the price changes today” (Malkiel, 2003, pg. 59). The value of an information structure equation that equals the decision maker’s expected utility, which considers the factors of receiving the message, and the probability of an event, and the result from the action. : V (?) = Sm q (m) maxa S p (em) U (a, e) - V (?0). The value of information can be determined by a net of costs, transaction costs or costs undertook in transmitting and evaluating messages considered if the capital market is efficient.

Similar to Capital Asset Pricing Model (CAPM), E(ri) = Rf + ßi(E(rm) - Rf). Where E(rm) is the average return on the capital market, Bi is the beta value for the financial asset i, Rf is the risk-free rate of return and E(ri) is the return required on financial asset i. CAPM is used in predicting the expected asset return of the risk. It consists of the tradeoff of the return and the risk, where the higher the risk, the higher the return. It is too, an idealized illustration of expected returns on capital investments price securities in the market. Its intuitive appeal is based on various assumptions and low complexity, making it a popular tool for investors. However, it is impossible to predict the news. This illustrates the randomness and unpredictability of price changes, as well as the presence of asset market anomalies such as calendar effects, which sees higher than average returns in the first month of the year. IPO effects, high earnings/price ratio effect, and the size effect serves as evidence of inefficiencies in the market. EHM moves away from CAPM to Fama-French’s 3 Factor Model, a risk factor model, which uses the long-short portfolios to respond to the anomalies of EMH events. The model demonstrates that higher expected returns should be compensated due to undiversifiable systematic risk.

Criticism against Efficient Market Hypothesis argues how large behavioral theory plays in determining the reaction of new information and psychological feedback mechanisms. Economist Robert Shiller has long been a prominent criticizer of EMH, frequently writing about his skepticism of market efficiency. The perspective follows along behavioral theories of stock prices and it can be stressed that EMH could be supported when examining the late 90s Internet Bubble Crash which demonstrated an irrationality of the high-tech sectors of the market. (Malkiel, 2003) Largely due to the behavioral, psychological effects of short-run momentums, these patterns can cause investors to react with less eagerness to newly available information. Viewing through the lens of behavioral theory, the cause of the late 90s U.S. stock market rapid rise could be due to a bandwagon effect that draws individuals into the market when stock prices are rising. As Malkiel states, Shiller illustrated in Irrational Exuberance, the concept of “irrational exuberance” is caused by the result of psychological contagion. Looking behaviorally, the presence of the ongoing public information can lack significance over a period in which news of important information full impact cannot be grasped, resulting in investors finding a positive serial correlation of stock prices. (Malkiel, 2003) While these patterns tended to produce in the 90s positive returns, in the 2000s, it produces highly negative returns. Contradictory to EMH theories, excess volatility caused by discounted aggregate dividends. Overreaction to any new information can have adverse effects on stock market prices. While EMH, in hindsight, lines up with some factors of the Global Financial Crisis of 2008, the underlying causes of the crisis had largely to do with the amount of debt acquired. As well, credit and bank corporations that underestimated the bubble burst from the negative consequences of the rising house prices while taking the risk securing subprime mortgage loans. The “bubbles” were largely ignored due to lack of recognition, which does give credence to the belief of efficient markets. However, it is not always generally applicable to an entire stock market.

Efficient Market Hypothesis exists in a portrayal of a near perfect capital market, in which, market prices adequately reflect all publicly available information. However, this theory is mostly false in claiming the cause of the Global Financial Crisis; this is due to anomalies that abnormally impact stock prices, such as the January Effect. As well as the anomalies of overreaction to specific new information, price changes of smaller firms which are inconsistent with EMH's hypothesis of “random walk” behavior and a false reliance on taking risks in the market to get benefit from returns. These factors contradict much of EMH's theory in which believes that price changes in stock prices are random, but instead follow particular patterns that are affected by internal and external factors. While EMH can argue its presence in the global crisis due to investor behavior, it was still limited in its application. The risk undertook by banks and credit institutions carry a majority of the blame. Because they continue to invest in the subprime mortgage market, while accumulating debt, ignoring the asset price bubble and lack of varied information of stocks. EMH can still be valid in certain stock cases, however, for the global crisis, it is not the case.