Efficient Market Hypothesis: Fama Vs Shiller

Today I will be looking at Eugene Fama and Robert Shiller’s view on Efficient Market Hypothesis (EMH). Both academics won the Nobel Prize in 2013 for the Science of Economics; however they have extremely contradicting opinions on EMH. EMH suggests that all information is incorporated into a stocks share price rapidly and rationally, thus implying that there is no opportunity available for traders to make abnormal returns (Arnold 2013).  Fama’s theory follows a neoclassical approach, which assumes people are fully rational. Whereas Shiller’s theory follows the behavioural approach, which recognizes that psychological imperfections cause people to act irrational.  Both academics are clearly contradicting one another, so how could both share the same award?

Eugene Fama
Fama (1970) identified three forms of efficiency: Weak form, Semi-strong from and strong-from efficiency.

Weak Form efficiency

Fama’s tests revealed that in weak form efficient markets, current share prices reflect all past movements and changes in the share price only occur when new information arrives on the market (Watson & Head 2013). This evidence supports Kendell’s Random Walks Hypothesis theory as it also agrees with the idea of share price movements being random (Kendell 1953).

Semi-Strong form efficiency

This level of efficiency suggests that share prices fully reflect all historic and publicly available information and react quickly and rationally to new information. Thus implying there is no advantage in analysing public information after it has been released (Arnold 2013). Similar findings were reached by Ball and Brown (1968) regarding earnings announcements and Kewon and Pinkerton regarding merger announcements. In fact mergers were found to be anticipated by the market up to three months prior to any announcement (Franks et al. 1997).

Strong form efficiency 

Strong form efficiency theory is based on the idea that share prices reflect all information, whether publicly available or not. This therefore assumed that no-one can make abnormal returns, including ‘insiders’. The tests used follow an indirect approach and examined how expert users of information perform when compared against a yardstick. It can be argued that capital markets are not strong form efficient.  In fact, Shiller’s work argues that that stock prices can be predicted over a longer period of time and concluded that markets were inefficient.

Robert Shiller 
Shiller’s research on behavioural finance stands in sharp contradiction to much of efficient market theory (Shiller 2003). Unlike Fama, Shiller’s research focuses on behavioural finances, which suggests that irrational investor behaviour can have significant and long-term lasting effects on share price movements.

Feedback theory

The feedback theory suggests that speculation increases stock prices and as a result could cause a speculative ‘bubble’.  These high prices are not sustainable as they are based on expectations, thus casuing the ‘bubble’ to burst, subsequently bringing down prices.  Shiffler, argues the natural self-limiting behaviour of bubbles and the possibility of negative feedback once the bubble has burst, could have a damaging effect on stock prices in the future.  Shefrin (2011) supports this view, acknowledging that bubbles challenge EMH. Furthermore, Krugman goes a step further; arguing the blame for the 2008 recession can be attributed to the commonly held belief that markets are somewhat efficient.  Is speculation in the market evidence of market inefficiency?

 EMH Anomalies

Fama discovered three anomalies: Time of the day effect, month effect and small companies. He claimed that these anomalies tended to appear to be as often under reaction by investors as overreaction. Secondly he stated that the anomalies tend to disappear either as time passed or the methodology improved.   What significance do these anomalies have on EMH? According to Fama’s research they don’t appear to be much of a concern.
Shiffler , however, is highly critical of Fama, arguing that his criticism reflect an incorrect view of the psychological underpinnings of behavioural finance. Furthermore, he argues the mere fact that anomalies disappear is no evidence that the markets are fully rational; in fact that is what you would expect to see happen in highly irrational markets.
Shiffler’s research emphasises that asset prices are far too volatile for markets to be efficient. Financial markets are vulnerable to asset pricing bubbles and that such bubbles are inconsistent with rational expectations. Is it therefore stupid to assume that all investors are rational? If so, are markets inefficient?

So, are stock markets efficient? 

If we adopt Fama’s approach and acknowledge that we are operating in efficient markets, those making returns will not be due to skill but by the randomness of price deviations from true economic value.  However there are a few stock pickers who seem to perform extraordinary well on a consistent basis over a long period of time, suggesting that there are some people who are able to exploit inefficiencies.  Warren Buffet has successfully outperformed the market for 40 years, some argue it is down to luck while others put it down to his superior stock picking.  Therefore there is evidence that stock markets exhibit inefficiency in some areas.   Buffet argues that there is much inefficiency in the market due to the fact that the price of a stock can be influenced by a ‘herd’ on Wall Street, supporting the idea of the feedback theory.  The assumption that people act rationally could altogether prove that markets aren't efficient.

We could argue that a weak form efficiency exists; Benjamin Graham supports this view, arguing that the one principal which is used by most technical approaches is that “one should buy because a stock or the market has gone up and should sell because it has declined… is the exact opposite of sound business sense everywhere else… We have not known a single person who has consistently or lastingly made money by just following the market.”  Maybe weak form has some credibility in practice?

There is evidence supporting the idea that there is some form of efficiency in markets, however, if it is true that returns are made by luck rather than skill, why are  there still fund managers and investment bankers with highly paid jobs claiming they have the right level of skills to outperform the market? It can therefore be concluded that markets are not strong form efficient.

Shareholder Vs Stakeholder Theory

As many of you are aware, there has been a constant debate on the Shareholder Vs Stakeholder theory. Various academics and professionals have joined this debate, however are these the only two options available? Today I will be analysing both theories and discussing the enlightened value maximisation view.

Shareholder Theory

Anglo –American companies are known to take a shareholder view.  In fact, over the last 200 years it has been argued that society is best served by businesses focusing on returns to the owner. Their assumed objective of corporate finance states that companies should make investment and financing decisions that maximise the wealth of its shareholders.   Adam Smith (1776) is a true supporter of this view. He submits that by acting in our own interests it will effectually benefit society.  Further support can be seen with Hayek and Friedman. Hayek argues the “only specific purpose corporations ought to serve is to secure the highest long term return.”  Friedman also supports this view, stating that companies do not have any moral obligations or social responsibilities other than to maximise their own profit. All three academics are in agreement; making shareholders’ interests the paramount objective will benefit both the firm and society .Why? Well, in practical terms how does this benefit companies? Firstly shareholders take on the most risk, it therefore seems reasonable that the owners should be entitled to any surplus returns.  Secondly, focusing solely on the benefits of shareholders allows a clear investment decisions to be made, making the decision making process easier and more efficient.  Finally, if they are unhappy with the way the company is being run, they have the right to sell their shares. This could cause a series of problems and could leave the company susceptible to a potential takeover. In practical terms you could argue that this is the way forward, should all companies adopt this view?

Stakeholder Theory

The stakeholder theory focuses on the importance of other stakeholders. The idea basis for this theory is the acknowledgement of a company’s responsibility to a number of interested parties. This not only includes shareholders but also customers, employees, suppliers, distributors, those concerned with the environment and the local community. Stemberg is a true believer stating that the business should be run to serve all of their stakeholders. Arguably, following this approach might lead to confusion and conflict with regards to the company’s objectives as each group of stakeholders have different needs. This could cause problems and as a result it could have negative effects on a company’s performance. However, Freeman argues that the groups and individuals who are affected by the company have legitimate interests that need to be taken into account. Furthermore, corporations who opt to place a strong emphasis on wealth maximisation risk upsetting stakeholders. Ignoring the needs of important stakeholders’ could have a detrimental effect on the business’ overall performance.  Is it beneficial to ignore the other stakeholders in order to achieve wealth maximisation?  . The case of General Motors (GM) demonstrates the impact that neglecting stakeholders can have.

General Motors: Case Study

In the 1970s GM discovered that the position of the fuel tanks in their cars caused an engineering failure which would result in the death of the passenger. GM calculated that repositioning the fuel tank would cost the company $8.59 per car, whereas paying compensation for those 500 casualties would cost the company $2.40 per car. Focusing on shareholder maximisation, GM went for the second option as it would reduce costs.  This information was made public and you can obviously imagine what those customers’ reactions would be.  The case was taken to court, however, surprisingly the court ruled in favour of GMs actions concluding that the company had acted in the interests of their shareholders.. Is this acceptable behaviour for such a large corporation?  If this were to occur today, it is likely that the negative press surrounding such a situation would have a devastating effect on the company’s share price and their customer base.

Maximisation Enlightenment Value

It is clear that both views have their advantages as well as their limitations, is it therefore possible to combine the two? Jensen brings an interesting view on both theories known as enlightened value maximisation.  This view is critical of both theories but acknowledges the importance of each one.  Jensen argues that shareholder value cannot be created if stakeholders are ignored.  However, Jensen then disputes this by saying that sometimes companies go too far in balancing all the stakeholder interests.  This theory recognises the importance of long-term value for the shareholders but utilizes much more of the structure of the stakeholder theory.   Is this the answer to the debate? It can be argued that most companies listed on the FTSE 100 follow this approach. Their mission statements and objectives focus on their stakeholders; however, they still aim to achieve long-term value.  An example of this can be seen with Xstrata plc objectives.

Xstrata plc

Xstrata plc is recognised as one of the best managed companies in the world. The reason behind this is due to its clear objectives:

We will grow and manage a diversified portfolio of metals and mining businesses with the single aim of delivering industry leading returns for our shareholders.”

We can achieve this only through genuine partnerships with employees, customers shareholders, local communities and other stakeholders, which are based on integrity, co-operation, transparency and mutual value-creation.

The example above supports Jensen’s theory; however it should by highlighted that a company’s objectives should be clear and not confused with their strategy. Companies who successfully implement this can achieve long-term value for its shareholders, whilst acting in the interest of its stakeholders. 

Corporate Finance: Problems associated with the Shareholder Theory,

Today,  as part of my trial blog I will be discussing the problems associated with the Shareholder Theory. I will begin by introducing the shareholder theory before moving on to an analysis of the issues surrounding this theory. 

The Anglo-American viewpoint argues that the ultimate objective of corporate finance should be to make investment and financing decisions that maximise the wealth of its shareholders.  Therefore, investment decisions will be based on those projects that deliver the highest return.  There are many academics who support this view by emphasising the importance of shareholders. Two examples can be seen with Hayek and Friedman. Hayek argues the “only specific purpose corporations ought to serve is to secure the highest long term return.”  Friedman also supports this view stating that companies do not have any moral obligations or social responsibilities other than maximise their own profit. Both acaedemics make it clear that wealth maximisation is the main priority.

Firstly, it is argued that the shareholder theory allows management to ignore the interests of other stakeholders, as its focus remains on delivering the highest return to its shareholders. The stakeholder theory can be used to support this view. The main problem is seen with the fact that stakeholders can have a significant impact on a companies’ performance. Freeman argues that the legitimate interests of these groups and individuals who are affected by the company need to be taken into account. Freedman stresses the importance of these groups; corporation's who opt to place a strong emphasis on wealth maximisation risk upsetting stakeholders such as employees or customers. Stemberg, takes this argument even further by stating that the business should be run to serve all of their stakeholders.  It is therefore clear that neglecting the needs of other stakeholders can have a negative impact on wealth maximisation; the Enron failure is a perfect example. The failure of this corporation strengthens the argument of a stakeholder theory and exposes the failures of the shareholder theory.

Furthermore, John Kay identifies another issue, where he argues that those directing focus on shareholder value may do worse for the shareholders in the long term. This mentality can be referred to as short-termism and has caused many problems. The 2008 recession is an example of the devastating effects that short-termism has on shareholder wealth maximisation.

Finally, Jensen & Meckling's Agency Theory highlights another problem. This theory identifies the gap between ownership and control. The theory argues that the agents (managers) may pursue objectives attractive to them at the expense of shareholders.  It shows the importance of employees in a company and how their actions can have a detrimental effect on shareholders wealth. Examples of this include the recent Tesco accounting scandal, where the £250m black hole in their accounts has resulted in a dramatic decrease in its share price, reducing its shareholders value.  Other examples can be seen with the former CEO of Merrill Lynch and the Directors at General Motors who would treat themselves with expensive perks at the cost of the shareholders.  These examples demonstrate the importance of employees in a corporation. Understanding this can help reduce the problems mentioned above and enable the company to generate long term value. 

In conclusion, the problems highlighted above give a clear indication of the effects this can have on shareholders wealth in the long term. It should be highlighted that shareholders are influential and can have an impact on the company, but solely focusing on the owners can cause many problems. In my next blog, I will be looking to discuss the problems associated with the stakeholder view and how companies can generate the long-term value in the most efficient manner.

Sources 

Hayek

Friedman 

Freenan 

John Kay

Jensen & Meckling 

Arnold