Monthly Discussion



NYSE and the Efficient Market Hypothesis


Two-and-half years ago the market was booming and investors' greatest fear was whether it would crash or not. There was justification for such a fear. The equities market had been steadily growing for almost ten years outperforming by far all other types of investment. Such market behavior had been associated with a crash. In September 1999 The Economist published a graph pointing out similar behaviors during the decade that preceded the 1929 crash and the 1989 crash of the Japanese stock market, see Exhibit 3.




Exhibit 3.  Share prices rising and leading into a crash, as reported in The Economist on September 25, 1999, (trimesterly data normalized to the dates shown in the graph legend). These markets grew by more than a factor of 4 in less than 10 years. The red circles represent recent data.


But the market did not crash. Instead it embarked on a rather flat (with downward overtones) trend. This stagnation has been going on for 10 trimesters now. Impatient questions arise about how long it will continue. According to our long-term forecast in Exhibit 1 there is no end in sight. I am not saying that the market will stay flat forever. I am simply aware of the fact that for many of us "forever" translates to a modest number of years!

What has happened? The market has always been reliable for what concerns the long term. From grandfathers to shrewd market analysts the traditional advice has always been "Don't panic. If you hold out long enough, the market will reward you." In fact, the rule has been that during any 20-year period stocks will outperform bonds. Reliable data over the last 75 years confirm that rule for American markets. But there can only be three non-overlapping 20-year periods since 1926, which undermines the statistical validity of this confirmation. Moreover, there is evidence that in stock markets of other countries, and in older times of the American stock markets, there have been periods where 40 consecutive years were necessary for stock investments to outperform bond investments.*

          And there is a more intriguing and disturbing issue raised by The Economist: the ultimate application of the Efficient Market Hypothesis (EMH).

          EMH says that the market is very efficient in assimilating information. Following the observation of any financial pattern—that small company stock outperform those of large ones, that gains of winter seasons outperform those of summer seasons, that low-price/high-yield stocks outperform the DOW, and so forth—investors exploit the pattern promptly and eventually the pattern dies away. The corresponding rule or advice for investors becomes useless.

The pattern in question could simply be that stocks outperform bonds over 20 years; the corresponding advice is "if you hold out long enough, the market will reward you." Have investors exploited this pattern sufficiently to render it useless? There is some evidence in that direction. Record numbers of investors have rushed to the stock market during the last ten years and most of them are stubbornly holding out waiting for the market upturn.

EMH applied to the very concept of the stock market reminds me of the snake that eats its own tail. Even if the consequence is only that we'll have to wait more than 20 years for risk-free returns from stocks to become superior to those from bonds, there is reason to consider readapting our investment portfolios.

However, for the frequent trader there is good news. Low growth periods

are naturally accompanied with large fluctuations (see discussion of the "winter season" in Conquering Uncertainty). Strategies designed for either bull or bear markets need to be revamped so that they exploit the large and frequent up-and-down excursions that characterize flat markets. Betting in both directions could prove a profitable rule, until EMH catches up with this one too.


* See Triumph of the Optimists, by Elroy Dimson, Paul Marsh and Mike Staunton. Princeton University Press, 2002.