Andrew Smithers is an economist and founder of Smithers & Co. This discussion can be followed in its entirety here.
In his article in The Economist, Professor Lucas claims that the Efficient Market Hypothesis (“EMH”) has proved robust under testing. This is, however, only true when the tests are applied to the pricing of individual shares relative to one another, not the pricing of the stock market in aggregate. When the EMH was first enunciated it was assumed, as a corollary, that aggregate stock prices behaved in a random way. When tested, however, the EMH failed, as real equity returns do not follow a “random walk with drift” but exhibit negative serial correlation. This meant that sustained periods of real returns, which were above the very long-term average, were followed by below average returns and vice versa.
This evidence obviously meant that the EMH, as applied to the stock market in aggregate, must be discarded or modified. Attempts at modification have failed. No one has yet produced a version of the EMH which can be tested and fits the evidence. Thus, the EMH must logically be discarded, as a valid hypothesis must be testable. The simplest explanation of the observed behaviour of returns is that equity markets are moderately or imperfectly rather than perfectly efficient, and rotate around fair value. As the simple and obvious explanation, this hypothesis accords with the principle of parsimony (aka Occam’s Razor). It is also, unlike the EMH, a valid hypothesis, as it is testable and robust under testing. For example, the ratio of the value placed by investors on non-financial companies in America to their inflation adjusted net worth (“the q ratio”) is mean reverting, as is the cyclically adjusted PE of all listed companies i.e. the PE based on an average of past earnings, also cyclically adjusted (“CAPE”.) Furthermore, the degree to which the American equity market has been misvalued in the past is extremely similar when measured either by q by or CAPE.
It is therefore possible, contrary to the EMH, to know whether markets are overvalued. It is not, however, possible to know when they will crash as, if this could be done, arbitrage would ensure that markets never became misvalued. It is, however, essential that central banks seek to prevent large misvaluations of asset prices, including the stock market. This is because asset prices provide a key transmission mechanism, whereby changes in short-term interest rates affect the real economy. While there is no long-term value relationship between interest rates and the stock market (the equity risk premium is not stable), the equity market responds in an ephemeral way to changes in interest rates and, like other asset prices, these changes affect the real economy, partly through changes in savings’ rates. But, if equities and other asset prices become overpriced, then they will fall, despite cuts in interest rates, and central banks will then, as recent events have underlined, lose control of the economy. It is not correct to claim that no one forecast the financial crisis, as I and others did so. What we did not and could not do is forecast its timing.
Economics needs defending, but not as Professor Lucas seeks to do, by defending the attachment of some economists to an invalid hypothesis in the form of the EMH. In defence of economics it needs to be pointed out that the unwillingness of many economists to discard outworn models is typical of science in general not just economics. The process of discarding the EMH involves a paradigm shift and these, as T.S Kuhn has explained (1), are commonly resisted. It has been remarked, with more truth and wit than charity, that “science advances obituary by obituary”.
As is common, when such paradigm shifts are under way, there is a danger that the robust and sensible parts of economics will be attacked and seem to be discredited, as well as the parts that need to be discarded. A current example is the tendency to react to the evidence of market imperfections by assuming that markets are irrational. A new working paper (2) shows how it is possible to explain momentum, bubbles and crashes, including subsequent reversion to fair value whilst retaining the assumption of rationality. This is done by recognising the agency problems arising when investors delegate responsibility for their affairs to financial intermediaries. This extremely valuable paper will, I hope, contribute to a greater understanding among economists that discarding the EMH need not involve embracing the irrational.