Deficient Market Hypothesis (Archive)

First published on 17 Feb 2007

If there is something bigger than stock market crash or a meteor crashing down on earth, it’s the death of an economic theory. After all, if the economics is right, we can still detect and divert a catastrophe. Economics is why we think we live today and is what we think will be the reason generations will live tomorrow.


We at Orpheus believe good theories are for a generation after which they are thrashed or rehashed. Scientifically the unifying theory remains elusive and somewhere the construction and reconstruction attempts have pushed scientists to recreate the laboratory Big Bang. The new emerging theories we believe will unify science and emerging economic theories, which are much broader in their scope. By the way, did you know we have Econophysics? The subject ties up Economics and Physics.

So here we are with the young, ready to bury the old. Efficient Market Hypothesis is one such theory that has reached burial ground after nearly half a century of existence. And like always markets are ahead of the event. US markets have given many cues starting 2000 that Eugene Fama’s market hypothesis might be deficient.

But what is so important about this theory that even it’s marginalizing deserves such attention globally, in India and in other emerging markets. EMH makes many assumptions. First it says that supernormal returns are not possible. DOW Jones moving up by 1000% over the theories life trashes the first assumption. You can make supernormal returns in markets. Second it says, every news that matters is in the price. This also means that any thing which can affect the price is new information. This extrapolated assumption has justified the “Impact Analysis” industry i.e. how new news will effect prices. So first there is a multi billion dollar information industry and then another multi billion dollar industry that studies the impact of the news on the asset prices (popularly known now as stock market).

The latter industry, what we also call popularly as ‘Equity Research’ is under tremendous stress in America. There are studies written to revive the industry. The crash of 2000 has questioned the accountability of research and how to make Wall Street pay for research. The best Wall Street research firm gives an accuracy of 34% with two open recommendations a week. The stresses are building up especially with Sarbanes-Oxley 2002 corporate governance act tightening around the financial intermediaries.

Overall, the industry is figuring out a revenue model for the inaccurate, unaccountable work, which takes away a sizeable part of the already shrinking market commission. Order flows are moving to electronic systems, as clients don’t want research that does not work. There is also a joke about selling ‘Equity Research’ by passing it on with a 50 dollar note inside. “Some motivation”, they call it to open the glossy in consequential pages.

And if this internal struggle was not enough, we have questions being raised about huge bonuses, and bestsellers written, rightfully asking, “where are the customer yachts?” We also have the famous Jamie Oli case. An ex tax accountant with the Dynegy, an energy trading firm. The judge presiding over the case had to rework on his Economic after Oli’s lawyers proved that it was tough to quantify the impact of news released by Oli on the price fall. In crux, American law firms have proved in their recent published research that market prices are far from efficient and sentencing someone to 24 years of prison on a flawed economic hypothesis is harsh. Recent research papers have also gone ahead and proved that New York Stock Exchange prices are inefficient. Oli finally got a reduced sentence of 6 years on Sep 2006.

Speaking from a market psychology perspective, what market fancies is what outperforms. And outperformance is not a straight line, like the Sensex outperformance of Dow since 2003 reaching a two decade low. Straight line approach is also non acceptable to changes. Big changes are not introduced at a top, big changes find their footing at a bottom. Historically it has been seen that regulators just like market participants are complacent at a market top and get into activity at a low. The other graph is the DOW marking the signing of the Sarbanes-Oxley act, at a low. And this was also the time Daniel Kahneman, the only psychologist ever got the Nobel prize for economics. And global market meltdown does not only destruct wealth, it also creates and nurtures new. And meltdowns happen when people are the most complacent. And failing theories do sink multi billion dollar industries, overnight.


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