Friday, November 13, 2009
Jeremy Siegel on the EMH
"Financial journalist and best-selling author Roger Lowenstein didn't mince any words in a piece for the Washington Post this summer, 'The upside of the current Great Recession is that is could drive a stake through the heart of the academic nostrum known as the efficient-market hypothesis.' ... But is the Efficient Market Hypothesis (EMH) really responsible for the current crisis? The answer is no. The EMH, originally put forth by Eugene Fama of the University of Chicago in the 1960s, states that the prices of securities reflect all known information that impacts their value. The hypothesis does not claim that the market price is always right. ... The fact that the best and the brightest on Wall Street made so many mistakes shows how hard it is to beat the market. ... Regulators wrongly believed that financial firms were offsetting their credit risks, while the banks and credit rating agencies were fooled by the faulty models that underestimated the risk in real estate. ... From 2000 through 2006, national home prices rose by 88.7%, far more than the 17.5% gain in the consumer price index or the paltry 1% rise in median household income. Never before have home prices jumped that far ahead of prices and incomes. This should have sent up red flags and cast doubts on using models that looked only at historical declines to judge future risk. But these flags were ignored as Wall Street was reaping large profits bundling and selling the securities while Congress was happy that more Americans could enjoy the 'American Dream' of home ownership. Indeed, through government-sponsored enterprises such as Fannie Mae and Freddie Mac, Washington helped fuel the subprime boom. ... With few exceptions (Goldman Sachs being one), financial firms ignored these warnings. CEOs failed to exercise their authority to monitor overall risk of the firm and instead put their faith in technicians whose narrow models could not capture the big picture. One can only wonder if the large investment banks would have taken on such risks when they were all partnerships and the lead partner had all his wealth in the firm, as they were just a few decades ago", my emphasis, Jeremy Siegel (JS) at the WSJ, 28 October 2009, link: http://online.wsj.com/article/SB10001424052748703573604574491261905165886.html.
JS is a Wharton professor, (boo), Fama is a Chicago professor (yay). I agree with JS. The models fail the EMH's "weak form", i.e., in relying on "historical information" they were a form of "technical stock market analysis". No Chicago grad since 1972 should have been fooled by this. For that matter, no: Wharton, Stanford, Tuck or ... grad since 1972 should have been fooled the rating agencies models. Well, maybe a Tuck grad. If Wall Street's "best and brightest" were fooled by what was covered in Finance 301 (1972 Chicago house number), how smart are they? Are they worth tens of millions a year? I mention JS on 29 April 2008 and 11 March 2009: