THE EFFICIENT MARKET HYPOTHESIS: THEORY AND PRACTICE
The Efficient Market Hypothesis or EMH rose to academic prominence in the 1960s through the work of Cootner (1964), Samuelson (1965), Fama (1965-70), Roberts (1967) and many others. Given a market and a set of information about that market and the securities traded in it, the EMH asserts that market prices are properly priced relative to that information. The key consequence is that there is no way to use that information to “beat the market,” i.e. no way to achieve excess risk adjusted expected return. Any future realized “superior” performance would be wholly due to unpredictable chance fluctuations.
After almost five decades of academic research and debate, financial economists have not reached a consensus about the EMH. As Martin Sewell on his website quotes from Lo (1997), “…what can we conclude about EMH? Amazingly, there is still no consensus among financial economists. Despite the many advances in the statistical analysis, databases and theoretical models surrounding the EMH, the main effect that the large number of empirical studies have had on this debate is to harden the resolve of the proponents on each side.” Haugen (1999) reports the following interaction with Fama, who is perhaps the most important architect of the EMH: “On April 16, 1998, at the UCLA conference, ‘The Market Efficiency Debate: A Break from Tradition,’ while delivering a paper on market efficiency, Fama pointed to me in the audience and called me a criminal. He then said that he believed that Godknew that the stock market was efficient. He added that the closer one came to behavioral finance, the hotter one could feel the fires of Hell on one’s feet.”
Opposing the EMF are a varied group of academics, advice sellers, practitioners, and hedge fund managers. Perhaps the best known is Warren Buffett, who stated that having so many distinguished minds believing in the efficient market hypothesis had the benefit of getting rid of a lot of potential competition. These varied group of academics, advice sellers, practitioners, and hedge fund managers argue that the EMH question has not been properly posed, and that when it is, “all becomes clear.” They show how securities markets are inefficient, and one can identify these inefficiencies, exploit them and make abnormal returns from them.
Some fund managers believe that the EMH is substantially wrong but, ironically, most investors can’t exploit this and so should act as though it is correct. The corner stone of market inefficiency is the behavioral aspect of individual investor.
Assume for instance in a given market, at a given instant in time, on each security (including all combinations or portfolios of individual securities; i.e. “bets” an investor will hold one of the following views (category):
1a. The investor believes the security (or bet) is properly priced based on the information available to him. An investor who believes this for all the securities in a market believes the EMH is true for that market.
1b. If an investor holds no view on a given security, he has no case for mispricing, so we take that as equivalent to his assuming it is properly priced.
2. The investor believes the security is not properly priced, but he is wrong.
3. The investor believes the security is not properly priced and he is correct.
Categories 2 and 3 are limiting cases of a more general situation: The investor has a belief about the direction and extent of mispricing for a given security (always understood: it’s based on his information set). The validity of this belief is to be compared with what is rationally ascertainable. It can be possible to establish that the investor is wholly wrong (category 2), wholly right (category 3), or more generally partly right, partly wrong, and partly not possible to determine.
Here is an example to illustrate these points. Academics who believe in market efficiency can rationalize this example
The Inefficient Market in Action – 3Com Spins Off Palm Pilot
The year 2000 gave us this outstandingly clear example of market inefficiency. To see what happened, first picture two car dealers with side by side stores. The first dealer offers new Ford sedans for $9,000, plus a $2,000 rebate payable in six months. The second dealer offers the identical new Ford sedans for $14,850. Every sighted person who drives up can see both dealer’s prices on huge signs. The higher priced dealer has balloons flying over his lot and a band playing. The lower priced dealer does a brisk business but the higher priced dealer is mobbed. Most of our “rational” investors prefer to pay the higher price. Crazy? Not possible? It happens often. For instance, in the next example the $9,000 Ford plus a $2,000 rebate corresponds to the price of 100 shares of 3Com and the identical Ford for $14,850 corresponds to the price of 135 shares of Palm Pilot. Here are the details.
3Com, ticker COMS, a company famous for its Palm Pilot hand held personal organizer, announced that it was spinning off its Palm Pilot division as a separate company. Some 6% of Palm Pilot, ticker PALM, was offered to the public in an initial public offering, or IPO, at a price of $38 per share on Thursday, March 2, 2000. By the end of the day the 23 million shares which had been sold traded more than one and a half times, for a one day volume of 37.9 million shares. The price peaked at $165 before closing at $95 and one sixteenth. The portion of Palm Pilot sold in the IPO was deliberately set well below demand and led to a price spurt typical of the then current tech stock IPO buying frenzy. So far, this just repeated what we had often seen during the previous eighteen months of the tech stock boom.
But now for the market inefficiency; at Thursday’s closing prices the market valued Palm Pilot at $53.4 billion, yet it valued 3Com, which still owned 94% of Palm Pilot at “only” $28 billion. But that means the market valued 3Com’s 94% of Palm Pilot at $50 billion so it valued the rest of 3Com at negative $22 billion! Analysts, however, estimated the value of the rest of 3Com at between $5 billion and $8.5 billion. And within six months or so, 3Com intended to distribute these Palm Pilot shares to its shareholders. You could buy PALM directly in the IPO (to get IPO stock you had to be “connected”) or at wildly gyrating much higher prices in the “aftermarket,” when it began trading. Or you could buy PALM indirectly by buying COMS and waiting a few months to get 1.35 shares of PALM for each share of COMS that you owned. Moreover, you would also have a share in the post spin-off business of 3Com, which was profitable and would have $8 cash per share. The stub and the cash together had a value estimated at between $15 and $25 per share.
Analysts’ note: The estimate of 135 shares of PALM to be distributed for each 100 shares of COMS is deliberately conservative – a “worst case” choice – compared with the typical “street” estimate of 150 shares. Thus the street’s estimate makes the disparity look even wider than what we indicate. A reason for the uncertainty: all the remaining PALM shares, some 94% of them, were to be distributed but the number to go to each share of COMS would depend on how many shares of COMS were outstanding at the time of distribution, and that in turn would depend on how much dilution occurred in the interim from, e.g., outstanding options.
At one point when we were discussing strategy on the first day, the prices were $90 per share for 3Com and $110 per share for Palm Pilot. If you bought 135 shares of Palm Pilot outright you paid $14,850, but if you bought 100 shares of 3Com you got not only the 135 shares of Palm Pilot but 100 shares of the 3Com “stub” company. (Think of each 100 3Com shares as a ticket having two parts, one labelled “135 shares of Palm Pilot” and the other piece or “stub” labelled “100 shares of 3Com post spin-off.”) If you buy the 100 shares of 3Com you pay $9,000 and get $14,850 worth of Palm Pilot and a 3Com stub with a current estimated value of between $1,500 and $2,500. Sell this for, say, $2,000 and the 135 Palm Pilot shares only have a net cost to you of $7,000.
A Challenge to Efficient Market Theorists
Why were people willing to pay $14,850 for 135 shares of PALM when they could have paid $7,000, and why were some investors buying PALM stock at a price of $53 billion for the company instead of acquiring it at a price of less than $25 billion for the company by buying it via 3Com stock? It’s not a question of information. The terms were simple, public, and known in advance.
How could one exploit this? One approach was to buy 3Com, wait six months or so, and then sell off both the Palm Pilot shares we would get from 3Com and the 3Com stub. But what if 3Com and Palm Pilot were both substantially overpriced and their prices both fell too much by then? There was ample reason to believe this might happen. First, COMS had run from about $50 two months earlier to over $100 just before the IPO, in anticipation of the spin-off. Secondly, tech stocks had been in what many felt was a speculative bubble driven by a large pool of irrational investors, many of them in the new day trading “casinos.”
What we could do for an almost sure profit was borrow and sell short 135 shares of PALM at 110 for proceeds of $14,850 which is placed in escrow until we return the borrowed shares. We also buy 100 shares of COMS at 90 for a cost of $9,000, selling up a nearly riskless hedge. In six months or so we get 135 shares of PALM from our 100 shares of COMS and deliver it to clear our short position. Then the $14,850 short sale proceeds comes out of escrow and belongs to us, netting us a profit of $5,850 over our cost. We still have 100 shares of the 3Com stub and if this is currently priced at, say, $15 per share we have an additional $1,500 profit for a total gain of $7,350 or about 82% on a $9,000 investment, in six months or so. Note: we have avoided obscuring our story with secondary details such as how the actual cash required for the investment might vary from the $9,000 of the example because of the interaction of margin regulations with the investor’s pre-existing portfolio, and also because of time-varying marks to the market on the short position.
A fund manager who was running a $2.7 billion dollar convertible hedge fund at that time was able to short 200,000 shares of PALM and had previously bought COMS at a much lower price, anticipating the pre-IPO run-up. Note that buying the COMS side of the hedge before the IPO, rather than concurrently, was not essential to locking in the profit. Think of it as a separate gamble, based on experience and judgment, that the price change in COMS would have positive expectation prior to the IPO.
On march the 3rd 2000 the Wall Street Journalpointed out that, in a few days when arbitrageurs (hedgers) could borrow more shares of PALM, they might be able to reduce the disparity as they sold short PALM and bought 3Com as in our example. Here we see clearly a mechanism of market inefficiency, namely the different behavior of the “dumb” or irrational PALM buyers and the savvy arbitrageurs. The Journal went on to point out that a similar pricing disparity arose in mid-February when IXnet Inc. was spun off from IPC Communications Inc. Even though IPC still owned 73% of IXnet, it was valued by the “efficient” market at less than half of IXnet. We hedged this one too and locked in a few hundred thousand dollars in profits there as well.
A PORTRAIT OF IDEAL EFFICIENT MARKET THAT ONE CANNOT BEAT
For a perfectly efficient market, one you can’t beat, we can ask ideally that:
1. All information is instantly available to all participants. In the case of COMS/PALM, we had an extreme, where the information was front page news for weeks. Any EMH that needs to exclude this from the information set holds no interest for anyone.
2. All participants are financially rational, for example they always prefer more money to less money, other things being equal.
3. All participants can and do instantly evaluate all available relevant information and determine the current fair price of every security.
4. New information causes prices to immediately “gap” to the new fair price, preventing anyone from gaining an excess market return by trading at intermediate prices during the transition.
Note: Supporters of this theory realize, in varying degree, that some or all of these conditions are unrealistic, but claim that the conditions still hold well enough to make the theory a good approximation. The COM/PALMS example rebuts each of these assumptions.
The investors who held PALM could have sold it and bought COMS, thereby increasing their payoff for virtually every future outcome. It appears as though the PALM investors, if they were aware, either were betting they could wait and resell to a “greater fool,” or that they did not prefer more money to less money! Prast (2003) cites Fama as acknowledging that “individual behavior may be affected by biases, but the market is efficient thanks to arbitrage by a few rational individuals.”
Suppose that rational investors were willing to arbitrage the spread, the question is why did the disparity persist? It was because, although the safe way to profit required a hedge via selling PALM short, buying COMS, and waiting to capture the spread, only small amounts of COMS were available to be lent to short sellers, so the arbitrageurs were unable to trade enough to correct the relative mispricing. Note, however, that investors who were long PALM could buy the hedge by swapping their PALM for COMS, according to the equation where the last term is the hedge that an arbitrageur would like to own. Any swap has this same structure, so the same ideas and arguments apply to any relative mispricing situation which arbitrageurs can’t fully exploit because there aren’t enough shares available to sell short.