Financial Markets Are Still Efficient (Approximately).

A brilliant post by guest blogger Scott Sumner on Econlog (Econolog.econolib.org, April 21, 2014) : "Why the EMH is truer than supply and demand."

It is well worth reproducing it in full: 

"My previous post discussed the strangeness of the efficient markets hypothesis. Here I'll defend its utility.

In the field of economics, all models represent simplifications of reality. Thus when we consider whether the EMH is true, it makes no sense to compare it to something like Newtonian physics. Yes, even Newtonian physics is only approximately true, but the approximation is much better than almost anything we observe in economics. So let's compare apples with apples.

Supply and demand has become the archetype model of economics. It's a workhorse widely used to explain the behavior in all sorts of markets, from haircuts and dry clearers to automakers and PC producers. Of course if you read the fine print the model is, strictly speaking, only applicable to a very restricted set of markets, essential grain producers. But almost all economists use it in a much wider range of applications, with justification. It's really, really useful.

But is it true? One of the most important implications of S&D is that producers are price takers. This assumption is what underlies the existence of a supply curve. If firms are not price takers then no supply curve exists. You can't have a supply and demand model without the assumption of firms being price takers.

But are they price takers? Not really. The vast majority of firms, even in highly competitive industries such as laundromats, dry cleaners and pizza shops, could raise prices by 5% and still hold on to a substantial share of their customers. Exxon might not be able to do so, but most small businesses could. This means the supply and demand model is not literally "true."

Fortunately, S&D is incredibly useful, even if not strictly true.

I would argue the EMH is truer that the S&D model. And by EMH I am actually only talking about the assumption that asset price deviations from trend are essentially unforecastable. Specific versions such as the CAPM may be flawed in other ways. However I believe the random walk model is truer than S&D, and also quite useful. But how can we test the EMH?

Many academics look for "anomalies." This is asking both too much and too little. Contrary to widespread belief, the EMH does not claim that a search of 20 million statistical patterns would fail to identify 1 million anomalies that show non-random price movements at the 5% level, or 200,000 at the 1% level. On the other hand, I'd also argue that it's asking too much of academics to suggest they need to find get-rich-schemes that violate the EMH, it should be enough to prove that at least someone has done so (say Warren Buffett.)

As an analogy, an economist looking for signs that the most famous secret in alchemy--turning lead into gold--had been discovered should not have to identify the magic formula, but rather merely show that gold prices are behaving in a way consistent with the fact that someone had discovered this sort of chemical process.

Eugene Fama understood that the only meaningful test of the random walk was to look for evidence that others had found anomalies. The initial tests showed no evidence; mutual funds excess returns were serially uncorrelated, whereas they would be correlated if a subset of investors had found the magic formula. Later work with Kenneth French slightly modified that conclusion. There was some evidence of stock picking ability, but too small to overcome the expense ratios of mutual funds. So now the EMH is only approximately true. But since it's a part of economics, we should have known that all along. No economic model is precisely true.

OK, but is it useful? I see three uses:

1. For ordinary investors, it suggests you'd want to stick to indexed funds.

2. For academics, it suggests that asset prices contain the optimal forecasts, and hence you should use something like TIPS spreads rather than the output of VAR models when trying to identify the optimal forecast of inflation. And you should use the response of asset markets to monetary policy announcements to evaluate the effectiveness of programs like QE, not subsequent movements in the economy.

3. For policymakers, it suggests that central banks and/or bank regulators should not try to identify bubbles. And that central banks should create and subsidize NGDP future markets. And that SEC officials should actually pay attention when whistleblowers bring in evidence that hedge fund returns are inconsistent with the predictions of the EMH (i.e. the Madoff case.)

To conclude, the EMH is a very useful model. It's also more true than the S&D model, as the pricing power of firms in so-called "competitive industries" where S&D is widely applied is actually much greater than the excess returns identified by Fama and French.

From now on any commenter who tells me the EMH is not true, should also tell me whether they think S&D is true, and if so, why it's true."