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.