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Are Bubbles Efficient?

February 3, 2004

Many investors purchased absurdly overvalued stocks during the late '90s and have since suffered devastating losses. The explanation now given for this is that the stock market was in a "bubble" which has burst, but those buying stocks at the time were not able to identify the bubble.

What is clear in retrospect was a controversial proposition at the time. Many individual investors justified their own purchases of stocks at inflated values by the naïve belief that stocks at current prices are always a good investment. Their prices have been set in a competitive market and returns from the ownership of stocks will always be in line with historical averages, so the thinking goes.[1]

Individual investors could find intellectual support for their view in a 1999 speech by Fed governor Alan Greenspan. In this speech, he argued that a stock market bubble could not be distinguished (until after it had burst) from a rise in prices of stocks due to improvements in fundamentals:[2]

To anticipate a bubble about to burst requires the forecast of a plunge in the prices of assets previously set by the judgments of millions of investors, many of whom are highly knowledgeable about the prospects for the specific investments that make up our broad price indexes of stocks and other assets.[3]

Greenspan was expressing a form of what economists call the Efficient Markets Hypothesis (EMH) in rationalizing his inability to determine whether there was indeed a stock market bubble.[4]

The EMH has its roots in the development of academic finance theory since the 1960s. It is an extension of a theoretical construct from mainstream economics of a state in which no profit opportunities exist (and hence no serious possibilities of errors or losses, either). The extension of this model to securities pricing has created a widely accepted but perverse understanding of financial markets.

The Efficient Markets Hypothesis is the proposition that there are ultimately no profit opportunities in financial markets because the prices of securities already take into account all relevant information. This is equivalent to saying that no individual could systematically improve upon the financial forecasts already embedded in financial market prices.

The reasoning behind the EMH is that, should a security become momentarily under- or over-valued, the most alert and well-informed traders ("the smart money") will pounce on the opportunity and eliminate the price discrepancies before an investor of a more average situation could act. They will do this by a process known as arbitrage: either purchasing the security in sufficient quantity until its price rises to eliminate the discrepancy, or borrowing it and selling it short until the price declines to its fair value.

A well-known joke illustrating the EMH concerns two finance professors walking down the street. One spots a $100 bill lying on the pavement. He brings this to the attention of his colleague, who says, "That cannot be a $100 bill or someone would have already picked it up." And so they continue walking.[5]

According to the EMH, there is no point for the investor in doing research on companies, whether that means evaluating their financial statements, studying their business prospects, or examining the competitive structure of the industry. "The market" has already done this analysis and it is already priced into the stocks.[6]

Since the investor cannot beat the market, buying a broad-based market index is likely to earn as good a return with a lot less work. The EMH suggests that an investor picking stocks at random should do as well as the more analytical investor. According to a famous example (from before the days when most people got stock quotes from the internet), it is said that a blindfolded monkey throwing darts at the stock listings page of the newspaper could do as good a job picking stocks as a diligent analyst.[7]

Because current prices take into account all known information, price changes can only occur because new information becomes available. For example, a new invention has been discovered, or a fire has destroyed a factory. Such "information shocks" are assumed to arrive randomly, distributed according to a bell curve distribution.

This assumption of this type of statistical randomness allows stock prices to be modeled according to mathematical formulae devised by physicists in the 19th century who were studying the physics of gas particles. The physical description of the motion of a single particle in a gas is said to describe the fluctuations of a single stock price, a type of motion that is known as a "random walk."

Modern finance theory is founded on the proposition that future events can be divided into those that are known and those that can be described statistically. This classification omits a third category: uncertainty. "Uncertainty" describes our state of mind in relation to the future, when trying to anticipate changes that cannot be characterized by probability distributions. The distinction between risk and uncertainty is central to Austrian price theory.  

Although future events are unknown, some of these events can be characterized by statistics. As Rothbard has written:

"Risk" occurs when an event is a member of a class of a large number of homogeneous events and there is fairly certain knowledge of the frequency of occurrence of this class of events. Thus, a firm may produce bolts and know from long experience that a certain almost fixed proportion of these bolts will be defective, say one percent. It will not know whether any given bolt will be defective, but it will know the proportion of the total number defective.[8]

To properly characterize the statistics of a given risk, one already must know quite a lot about the situation—enough to gather statistics of similar classes. But in many situations that we face in the real world, we cannot be sure even how much we know and how much remains that we do not know. This is uncertainty.

As Rothbard wrote:

Most uncertainties . . . are unique cases facing each individual or business; they may bear resemblances to other cases, but are not homogeneous with them. Individual entrepreneurs know something about the outcome of the particular case, but not everything.[9]

In a market economy, entrepreneurs are people who voluntarily take on uncertainty. They do this by forming forecasts of future supply, demand, and prices, and then directing their capital to the particular sectors of the economy, industries, individual firms, even different countries, or new products that will be most profitable if their views about the future are correct. Entrepreneurs thus earn profits or suffer losses depending on how accurate their forecasts are: they get paid for correctly placing capital resources where they are most needed.[10]  

So far the advocate of the EMH might agree with the Austrian. But why, over time, would the more active and successful entrepreneurs not drive stock and other asset or commodity prices toward their intrinsic value, and then keep them there, until some change in data arrives?

Clearly there is a process behind the idea of the EMH that Austrians can embrace—the most talented traders and investors are indeed constantly seeking profit opportunities in markets and placing their bets when they believe that they have found them.   Indeed, many niches are found and exploited by the nimblest trades and the most far-sighted venture capitalists.

But the process does not converge in the way that the EMH suggests. The EMH misrepresents the nature of financial markets. Financial markets are a nexus for the exchange of claims on the future income of business firms. The value of these claims is ultimately derived from the income stream of the underlying business, and then by the assets of the company itself.

In his seminal paper on the economics of socialism, Mises argued that economically meaningful prices are necessary for the allocation of goods within the economy, and that such prices come about only as a result of multiple owners of private property bidding for capital goods:

Moreover, the mind of one man alone—be it ever so cunning, is too weak to grasp the importance of any single one among the countlessly many goods of a higher order. No single man can ever master all the possibilities of production, innumerable as they are, as to be in a position to make straightway evident judgments of value without the aid of some system of computation. The distribution among a number of individuals of administrative control over economic goods in a community of men who take part in the labor of producing them, and who are economically interested in them, entails a kind of intellectual division of labor, which would not be possible without some system of calculating production and without economy.[11]

The multiplicity of capital owners bringing their own knowledge, beliefs, and abilities that each potential buyer and seller brings to their job is what creates the "intellectual division of labor" that drives the formation of prices in financial markets. While it is true that smart and well-informed traders will profit at the expense of the uninformed and unsophisticated, this is not the whole story.

If the future values of each company’s income and assets could be known with certainty, then the prices of securities could be computed in a straightforward way. This unknown value is the "intrinsic value" or "fair value" of the security. Because the future values of the corporate accounting numbers are not known, the prices of securities represent mere forecasts of the future values of these numbers.

Securities prices are in a constant state of flux not only because of a changing world, but because the process by which entrepreneurs digest this information and act on it depends on the differential evaluations of many actors. Mises argues that the market economy does not ever reach a resting place: it is a dynamic process of adjustment to constant change that requires judgment and skill by participants. And, the progress of this adjustment process depends on the differing opinions held by the various players.  

The search by entrepreneurs for profit is a search for price differentials—the opportunity to "buy low" and "sell high." This price-driven search process is what Mises called "economic calculation."

The problem of economic calculation is a problem which arises in an economy which is perpetually subject to change, an economy which every day is confronted with new problems which have to be solved. Now in order to solve such problems it is above all necessary that capital should be withdrawn from particular lines of production, from particular undertakings and concerns. This is not a matter for the managers of joint stock companies, it is essentially a matter for the capitalists—the capitalists who buy and sell stocks and shares, who make loans and recover them, who make deposits in the bank and draw them out of the banks again, who speculate in all kinds of commodities. It is these operations of speculative capitalists which create those conditions of the money market, the stock exchanges and the wholesale markets which have been taken for granted by the manager of the joint stock company…[12]

In an uncertain world, people have different views about the future. Mises had the insight that prices are formed by these differences of opinion, belief, and information between competing entrepreneurs. To see the importance of difference of opinion, consider the following example: a stock trade has two parties: the seller who thinks that the stock is worth no more than the price at which it trades, and a buyer who thinks that it is worth no less. If everyone held the same beliefs about the future, there would be no trading at all.

Not only is it true that not everyone knows all relevant information, but knowing what is relevant information is itself a matter of judgment. People differ in how much they know, and in their abilities to perceive connections between one thing and another thing. As Mises wrote:

In an economic system in which every actor is in a position to recognize correctly the market situation with the same degree of insight, the adjustment of prices to every change in the data would be achieved at one stroke. It is impossible to imagine such uniformity in the correct cognition and appraisals of changes in data except by the intercession of superhuman agencies. . . . Certainly the market[ economy] is filled with people who are to different degrees aware of the changes in data and who, even if they have the same information, appraise it differently.[13]

The paradox of the EMH is that it assumes the existence of entrepreneurs seizing profit opportunities to prove that there are no profit opportunities for entrepreneurs. Economist Robert Shiller shows the contradictory nature of this view by raising the following questions: When did the smart money set the prices? Are they all done now? If they are all done, then did they leave the market and retire with their earnings? If the smart money is setting the prices who are they trading with? It cannot be other smart people because a smart person would not enter into a losing trade.[14] Economists Lo and MacKinlay ask, if there were no profit opportunities, then why would the smart money incur the expense of research and transaction costs?[15]

Companies that are listed on the stock market have been financed by entrepreneurs, been analyzed by financial analysts, and been bought and sold in the market by traders to establish their prices. The strategy of "buy and hold" of a market index works as well as it does because of the work already done by financial entrepreneurs such as analysts and traders.[16] As Austrian economist E.C. Pasour points out, putting the monkey in a position to select stocks with darts assumes that some competitive selection process has already taken place that reduces the selection of stocks to those that are now publicly traded.[17]

In financial markets, securities prices cannot be assumed to be at all times equal to the value a perfect forecasting machine would place on them. Opportunities for profit continually arise and some are spotted sooner than others. Individual investors are financial entrepreneurs as well, and as such are relieved neither of the burden of forecasting the uncertain future nor of helping to create it.

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Robert Blumen is an independent enterprise software consultant based in San Francisco. Send him mail at mailto:robert@RobertBlumen.com.



[1] Like the children of Lake Wobegon, many investors believed that stock market returns would always be above average.

[2] Transcripts of FOMC meetings released some years later show Greenspan discussing the existence of a stock market bubble, which in spite of his protestations of innocence, he did know about.

[4] It is impossible in a single article to deal with all of the problems in Greenspan’s statement. For one, there was the Fed’s responsibility for creating the bubble. In light of this, it should not be very reassuring that Greenspan denies the possibility of a housing bubble at this point in time. http://www.federalreserve.gov/boarddocs/testimony/2002/20020417/default.htm.

[5] I first heard this joke some years ago with a $10 bill. It would seem that fiat money inflation has eroded even the nominal value of jokes.

[6] Another similar joke goes: Q: How many economists does it take to change a lightbulb? A: None, the market will take care of it.

[7] The "smart monkey"?

[8] Rothbard, Man, Economy and State, p. 498.

[9] Rothbard, p. 499.

[10] The physicist Neils Bohr once said, "Prediction is very difficult, especially about the future".

[12] Socialism, p. 120.

[13] Mises, Human Action, p. 328.

[14] Schiller, p. 174.

[15] Lo, Andrew and MacKinlay, Craig, A Non-Random Walk Down Wall Street. Princeton University Press, 1999, p. 6.

[16] Pasour, ??.

[17] E. C. Pasour, The Efficient Markets Hypothesis and Entrepreneurship, Review of Austrian Economics vol 3, p. 102.


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