An Update on the Efficient Markets Hypothesis

The revolution in understanding how the discount rate affects market efficiency is only half over, but another revolution is on the horizon, said John Cochrane, Myron S. Scholes Professor of Finance. “I’m not sure how we’re going to understand information-based trading or its effects on prices, if there are any,” Cochrane during a panel at the 2007 Conference on Chicago Economics presented by the Becker Center on Chicago Price Theory at the Charles M. Harper Center November 10. “We don’t have good models yet.”

That challenge makes today an exciting time to examine efficient markets, especially at Chicago, he said. “The data are pushing us to think harder about it,” Cochrane said. “If we get somewhere, this will nicely tie up the one loose end of market efficiency. The proposition that information is quickly reflected in market prices is with us in the way Darwin lies over the modern explosion of genetic research. It’s not a biblical, final statement of the last grain of truth. It’s not even the focus of that much useful debate. That’s good. The science moves on.”

A future challenge for macroeconomists is disentangling investor beliefs from preferences, said Lars Hansen, Homer J. Livingston Distinguished Service Professor of Finance. “We write down a utility function,” Hansen said. “We write down a set of beliefs for investors. We waive our hands and get some rational expectations, and then we go forward. I think that paradigm has been kind of pushed to its limit.”

Among the issues for exploration are intriguing links between measurements of risk return relations and of discrimination, the role of the dynamics of learning by investors, the extent to which rational expectation models can be used and improved, and the value of recent advances in decision-theoretic models, he said.

With a complicated mathematical theory, Eugene Fama, Robert McCormick Distinguished Service Professor of Finance, has helped develop a statistical model of risk factors that better explains why value and small cap stocks tend to perform better than the market as a whole. Asset pricing models incorrectly suggest growth stocks are riskier than value stocks, Fama said.

“To me it makes sense that the distressed stocks have higher cost of capital than the growth stocks, but you may not believe that,” he said. “Another story mixes consumption and investment decisions. It says people just don’t like to hold distressed stocks. As a consequence, they’re priced lower than growth stocks, which people do like to hold. Now that story can persist, whereas the overreaction story of the behaviorists basically requires that every generation is stupid, never learns from the previous generation, and nobody can educate them.”

From the panel PhD student Hugo Garduno said he learned great work remains in the study of efficient markets. “So far we have just put in the basement of the building and we have two more stories to work on still,” Garduno said. “There is much that needs to be done to understand risk premium and how the markets behave and the returns of the markets. The work of all three panelists has been groundbreaking in different respects.”

- Phil Rockrohr