There are a lot of poor arguments against the efficient markets hypothesis (EMH). I believe that “bubbles” are one of them. To refresh what exactly EMH states according to Eugene Fama’s 1970 paper “A market where prices always “fully reflect” available information is called efficient”.
In that there are three levels of market efficiency that Fama lays out:
Weak-Form: Historical prices have no impact on a stock’s price.
Semi-Strong-Form: All public information is accounted for in a stocks price.
Strong-Form: All information, public and private, is accounted for in a stocks price.
Are markets perfectly efficient? Of course not. Insider-trading does happen and can be benefited from, making strong-form efficient markets a poor model for actual markets. Semi-strong also fails such as when individuals trading Hertz stock traded a company going through bankruptcy publically that would make a stock worthless because they didn’t understand what happens to common stock in bankruptcy. Weak-form is also wrong. Momentum in all countries except Japan is a documented factor, stocks that have gone up, tend to keep going up, and stocks that go down, tend to keep going down. Efficient markets is simply a theory that in some forms, best explains asset pricing. It is not a law of markets like laws of physics, its simply the arguably best way to understand them.
“If markets are efficient then why do bubbles form and pop?”
What exactly is a bubble? Almost every day, since stocks began trading, there have been people calling everything a bubble, for each time there is a rapid decline in the price of an asset, the ones that made the claim proudly claim that they “called the bubble”, but lets investigate what it was that led to a couple recent “bubbles” and if they would contradict EMH.
The Financial Crisis
In 2007–2008, the housing “bubble” popped, leading to a rapid decline in prices after they rapidly acended. Why exactly did this happen? For one, the rating agencies responsible for rating the riskiness of Mortgage-Backed-Securities had fundamentally flawed models of how mortgages across geographies would correlate. They assumed that a bunch of shitty mortgages from different places would not fail all at once and therefore with enough diversification, they could be engineered into products that would be AAA or AA rated (the safest type of bond) and therefore would sell for the highest price for their clients. Mortgages were made under models that allowed them to be as bad as they were because of this percieved diversification which made them, in all ways, rational mortagages to make. There are plenty of stories of people getting 3 homes, never confirming their income, and taking on more liabilities than seemed rational, but the truth of the matter is that, under the assumptions of the models used, these mortgage-backed-securities were trading at fair value.
There was plenty of greed, fraud, and improper incentive structures that led to these circumstances, but for the matters of EMH, it wasn’t that people weren’t accounting for publicly available information and rationally pricing it, it was that the models, unfortunately failed, which was not a given. Additionally, there were many trading desks that thought the market was improperly pricing the riskiness of housing, but rather seeing it as an assult on EMH, I argue that this explains why housing prices climbed so much. The riskiness of the asset class made it susceptible to the shock of the financial crisis, and in that, the returns generated compensated investors for the risk they took, even as they were generally unaware of it. That is the reason why prices increase the most, before crashes, the crash was one of many potential results of the massive risk being taken and that risk is compensated. If prices had not crashed, either because there was no shock or because the models had held up.
This is not an excuse for the financial crisis, but rather an explanation that the fundemental reason for the crash was due to excessive risk taking rather than objectively stupid decisions. (Although there were plenty)
The Dot-Com Bubble
The internet is arguably one of the most revolutionary technologies in human history, yet we now mock the companies seeking to capitalize on its enormous potential in the late 90’s. The internet ended up being bigger and more fundamental to our lives than even the most optimistic projections from back then. The only reason the Dot-Com bubble is so mocked and forsaken as irrational exuberance, is because it popped. When those supporting behavioral explanations behind bubbles talk about how they knew that it was irrational when they overheard people at restaurants talking about investing, I wonder how they would explain someone today overhearing a conversation about Bitcoin in 2016 and how that outcome differed.
According to Pastor and Veronesi’s “Was There a NASDAQ Bubble in the Late 1990s?” they partly explain the high prices as a function of high uncertainty in future prospects for companies as uncertainty fundamentally increases the value of a corporation.* In that you can say, it is unfair that optimists fundamentally have a larger impact on stock prices, as a response I’d say, mathematics gives more power to optimists. The idea here is not that it was smart to jump on the tech bubble, but rather than jumping on the tech bubble was rationally rewarded with high returns until the riskiness caught up to it. In 1996 people were calling it asset prices a bubble, yet prices never fell so far as back to 1996 levels. High risks led to high returns, and high risk led to fat tails in returns that act like crashes, all of which support EMH.
On Bubbles as a Concept
I love stories, but the EMH framework better reflects what in my view is a better model for markerts. I also think that explaining perceived bubbles under EMH does not discount the idea of a bubble as nonsensical, but rather reframes bubbles as excessive, unknown to some parties, risk that is potentially disastrous. It doesn’t discount the behavioral finance explanations that might lead to individuals taking excessive risk and getting burned, but it does a better job of explaining asset prices than going up because people are unresonable and then collapsing as somehow people become either resonable or reconstrained by reality and cash-flows. On a logical basis, I do believe that EMH is the best model, not just relatively, but absolutely for explaining asset prices and how they move in the future, and that bubbles are a bad argument against EMH.
* “To further illustrate the convexity, suppose that firms A and B differ only in the future growth rates of their book equity, whose current value is $1m. While A is going to grow by 10 percent per year with certainty, B will grow either by 5 percent or by 15 percent with equal probabilities. Due to the convex nature of compounding, the difference between compounding the 15 percent and 10 percent growth rates over time is substantially higher than the differ- ence between compounding the 10 percent and 5 percent growth rates. Over 10 years, for ex- ample, $1m cumulates to $4.05m at the 15 percent rate, to $2.59m at the 10 percent rate, and to $1.63m at the 5 percent rate. Hence, firm B has a higher expected future book value of equity than firm A (because (4.05 + 1.63)/2 = 2.84 >” (Pastor, Veronesi, 2003)
