Challenging the Efficient Market Hypothesis and Fundamentals Analysis

It is widely held that financial asset markets fully reflect all available and relevant information, and that any adjustment to new information is virtually instantaneous. (For a review and critique of the relevant literature, see E.C. Pasour, Jr., “The Efficient-Market Hypothesis and Entrepreneurship,” Review of Austrian Economics 3 [1989].) This way of thinking is also known as the Efficient Market Hypothesis (EMH), and is closely linked to the Rational Expectations Hypothesis (REH), which postulates that market participants are at least as good at asset price forecasting as is any model that a financial market scholar can come up with, given the available information.

The view that everyone is as good a forecaster as any model implies that their forecasts do not display systematic biases. In other words, their forecasts are right on average. According to the EMH, by using available information, all market participants arrive at “rational expectations” forecasts of future security returns, and these forecasts become fully reflected in the prices that are observed in financial markets. Changes in asset prices occur on account of news which cannot be predicted in any systematic manner. Asset prices respond only to the unexpected part of any news, since the expected part of the news is already embedded in prices.

The efficiency of the market means that the individual investor cannot outsmart the market by trading on the basis of the available information. The implication of the EMH is destructive for fundamental analysis, for this means that the analysis of past data is of little help since whatever information this analysis will reveal is already contained in asset prices.

Does the EMH Framework Make Sense?

Now, the EMH assumes that all market participants arrive at rationally-expected forecasts. This means that all market participants have the same expectations about future securities returns. Yet, if participants are alike in the sense of having homogeneous expectations, then why should there be trade?

After all, trade emerges because of heterogeneous expectations. This is what bulls and bears are all about. A buyer expects a rise in the asset price while the seller expects a fall in the price. The EMH framework also implies that market participants have the same knowledge. Even if we were to accept that modern technology enables all market participants equal access to news, there is still the issue of interpreting the news. According to the EMH, forecasts of asset prices by market participants are clustered around the true value, with deviations from the true value randomly distributed, implying that profits or losses are random phenomena.

The EMH framework also gives the impression that the stock market can exist separately from the real world. However, the stock market doesn’t have a “life of its own.” That is why an investment in stocks should be regarded as an investment in business as such, and not just as an investment in stocks. This means that, for an entrepreneur, the ultimate criteria for investing his capital is to employ it in those activities which will produce goods and services that are demanded by consumers. Underpriced goods could be rearranged in ways that satisfy consumers more which, when done so successfully, is what produces profits.

Is it valid to hold that past information is completely embedded in prices and therefore of no consequence? For instance, the market-anticipated lowering of interest rates by the central bank—while being regarded as old news and therefore not supposed to have any effect—will in fact set in motion the process of the boom-bust cycle. Even if a particular cause was anticipated by the market, that doesn’t mean that it was understood and therefore discounted.

It is hard to imagine that the effect of a particular cause which begins with a few individuals and then spreads over time across many individuals can be assessed and understood instantaneously. For this to be so, it would mean that market participants could immediately assess consumers’ future responses and counter-responses to a given cause. This, of course, means that market participants not only must know consumers’ preferences but also how these preferences will change.

According to EMH, past information is in the market and does not have an effect on the future. According to Hoppe, it is past knowledge of individuals that shapes and constrains individuals’ future values and knowledge, thereby influencing future actions. If it were otherwise, and the past didn’t have any effect on the future a world of chaos would exist, where the accumulation of knowledge would not be undertaken and economic advancement could not take place. If one were to accept the EMH framework, then there is no room left for investment advisory services. The very existence of the consulting industry is a tacit denial of the EMH.

Are Profits Random Phenomena?

The proponents of the EMH claim that the main message of their framework is that excessive profits cannot be secured out of public information. Now, profits as such can never be a sustainable phenomenon. Profit emerges once an entrepreneur discovers that the prices of certain factors are undervalued relative to the potential value of the products that these factors, once employed, could produce. By recognizing the discrepancy and doing something about it, an entrepreneur removes the discrepancy (i.e., eliminates the potential for a further profit).

For an entrepreneur to make profits, he must engage in planning and correctly anticipate consumer preferences. Consequently, those entrepreneurs who excel in their forecasting of consumers’ future preferences will make profits.

Planning and research never guarantee that profit will be secured. Various unforeseen events can upset entrepreneurial forecasts. Errors which lead to losses in the market economy are an essential part of the navigational tools which direct the process of allocation of resources in an uncertain environment in line with what consumers dictate. Uncertainty is part of the human environment, and it forces individuals to adopt active positions, rather than resign to passivity, as implied by the EMH.

What is Behind Wild Swings in Asset Prices?

Some experts are of the view that the EMH does not adequately explain large price movements that can last for months or years and thus the need to employ new theories. The new theories offer amendments to the EMH, to allow for large price movements, which are labeled “bubbles.” Most of the bubble theories attribute large price fluctuations to abnormal investor behavior, also labeled as “irrational behavior.” The reason for this behavior, so they say, is psychological. Thus, according to these theories, changing fashions, fads, and erratic and capricious shifts in investor sentiment could set in motion a bubble. It is questionable that the psychological factors could explain wild swings in asset prices.

Following Mises, large fluctuations are set in motion by the central bank’s monetary policies. Trouble erupts whenever central bank officials try to improve on the working of the free-market economy. Once interest rates in financial markets are lowered artificially by the central bank, they cease to reflect consumers’ time preferences. This, in turn, means that entrepreneurs—once they are reacting to interest rates in financial markets—are committing errors.

As long as the artificially low interest-rate policy remains in force, there are no ways or means for entrepreneurs to know that they are committing errors. On the contrary, as the policy of artificially lowering interest rates via credit expansion intensifies, it generates a sense of apparent prosperity. The longer the period is, the more widespread the errors. The discovery that entrepreneurs didn’t abide by consumers’ instructions occurs once the central bank tightens its monetary stance.

The severity of the bust is dictated by the magnitude of the preceding boom. Thus, the longer the artificial bull market, the more widespread the errors will be, and therefore, the more severe the bust (i.e., the bear market). If voluntary savings are expanding, the severity of the bust will be cushioned. If, however, the savings are shrinking, then the bear market could be more protracted and severe.

Conclusion

The EMH gives the impression that there is a difference between investing in the stock market and investing in a business. However, the stock market doesn’t have a life of its own. The success or a failure of investing in stocks depends ultimately on the same factors that determine success or a failure of any business.