Sunday, December 27, 2009

Efficient Market Hypothesis (EMH)

EMH has been the Holy Grail of financial engineering ever since the late Paul Samuelson as a lowly graduate student of economics at MIT discovered Louis Bachelier, a French mathematician who wrote about speculation in his 1900 PhD thesis in Paris. Eugene Fama at Chicago later refined the theory making the Hypothesis famous establishing as more an axiom than a hypothesis as the theory itself is called. Burton Malkiel at Princeton popularized EMH for the lay reader in his best selling book: Random Walk Down Wall Street making him a millionaire several times over.

Briefly stated EMH posits that active fund management is futile to gain advantage over market moves because the "efficient" stock market prices incorporate, absorb, digest and, therefore, reflect all known information about them instantaneously. No human brain can possibly match that giant discounting machine. Ergo, no fund manager can possibly outperform the market.

Very few professional fund managers who have lived through at least one business cycle ever believed EMH was anything but an interesting idea whose time is yet to come.

However, it was the reigning ideology under the Bush administration where the market fundamentalists such as Greenspan and Christopher Cox, deliberately turning the other way "running" SEC, simply allowed the "market" do whatever it wanted to do, to a not very happy ending for which Greenspan and Cox both later apologized.

Most of the "high power" equity research is done by global sell-side firms -- the Goldman Sachs and the Morgan Stanley's of the world -- hence, there is negligible time delay between the hour of the publication of research and the time investors get it.

The largest investors, institutional or individual, usually even get a phone call as soon as a piece of important research is released informing them of new information that would go with a recommendation to act: sell, buy more or just hold.

Now, this study here suggests that the market does not discount all the information, even the most relevant one -- phone calls or no phone calls. Ergo, the idea that the all mighty "Market" is efficient leaves much to be fantasized by future generations of academics who can only think in obtuse mathematical equations.

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