Robert Shiller deserves enormous credit for enhancing our understanding of how both investor sentiment and fundamental information about individual companies and the economy influence stock prices. He correctly elucidates how some investors make consistent and predictable errors in the processing of information and how the propagation of narratives about the stock market can become self-fulfilling. He uses the extraordinary volatility of the market in response to the COVID-19 pandemic as an example of the market’s apparent irrationality. In my judgment, however, none of this insightful work implies that markets are inefficient.
The Efficient Market Hypothesis incorporates two fundamental tenets. It first asserts that public information gets reflected in asset prices without delay. If a pharmaceutical company now selling at $20 per share receives approval for a new drug that will give the company a value of $40 tomorrow, the price will move to $40 without delay, not slowly over time.
It is, of course, possible that the full effect of the new information is not immediately obvious to market participants. Some participants may vastly underestimate the significance of the drug, but others may greatly overestimate it. Therefore markets could underreact or overreact to news. The COVID-19 pandemic presents an excellent example of how investor sentiment and the difficulty of predicting the extent and severity of the resulting economic disruption can intensify market volatility. But it is far from clear that systematic underreaction or overreaction to news presents an arbitrage opportunity promising traders extraordinary gains. It is this aspect of EMH that implies a second, and in my view the most fundamental, tenet of the hypothesis: In an efficient market, no arbitrage opportunities exist.
EMH does not imply that prices will always be “correct” or that all market participants are always rational. There is abundant evidence that many (perhaps even most) market participants are far from rational. But even if price setting was always determined by rational profit-maximizing investors, prices (which depend on imperfect forecasts) can never be “correct.” They are “wrong” all the time. EMH implies that we can never be sure whether they are too high or too low. And any profits attributable to judgments that are more accurate than the market consensus will not represent unexploited arbitrage possibilities.
In my view the most compelling evidence that our stock markets are extremely efficient is that they are extraordinarily hard to beat. If market prices were generally determined by irrational investors and if it were easy to identify predictable patterns in security returns or exploitable anomalies in security prices, then professional investment managers should be able to beat the market. There is abundant evidence that they do not. Direct tests of the actual returns earned by professionals, who are compensated with strong incentives to outperform, should represent the most compelling evidence of market efficiency.
A true market inefficiency ought to be an exploitable opportunity. If there’s nothing investors can exploit in a systematic way, then it’s very hard to say that information is not being properly incorporated into stock prices and that our stock markets are not remarkably efficient.