Scott Sumner Defends EMH

Last week I wrote about the sudden increase in stock market volatility as an illustration of why the efficient market hypothesis (EMH) is not entirely accurate. I focused on the empirical argument made by Robert Shiller that the observed volatility of stock prices is greater than the volatility implied by the proposition that stock prices reflect rational expectations of future dividends paid out by the listed corporations. I made two further points about EMH: a) empirical evidence cited in favor of EMH like the absence of simple trading rules that would generate excess profits and the lack of serial correlation in the returns earned by asset managers is also consistent with theories of asset pricing other than EMH such as Keynes’s casino (beauty contest) model, and b) the distinction between fundamentals and expectations that underlies the EMH model is not valid because expectations are themselves fundamental owing to the potential for expectations to be self-fulfilling.

Scott responded to my criticism by referencing two of his earlier posts — one criticizing the Keynesian beauty contest model, and another criticizing the Keynesian argument that the market can stay irrational longer than any trader seeking to exploit such irrationality can stay solvent – and by writing a new post describing what he called the self-awareness of markets.

Let me begin with Scott’s criticism of the beauty-contest model. I do so by registering my agreement with Scott that the beauty contest model is not a good description of how stocks are typically priced. As I have said, I don’t view EMH as being radically wrong, and in much applied work (including some of my own) it is an extremely useful assumption to make. But EMH describes a kind of equilibrium condition, and not all economic processes can be characterized or approximated by equilibrium conditions.

Perhaps the chief contribution of recent Austrian economics has been to explain how all entrepreneurial activity aims at exploiting latent disequilibrium relationships in the price system. We have no theoretical or empirical basis for assuming that deviations of prices whether for assets for services and whether prices are determined in auction markets or in imperfectly competitive markets that prices cannot deviate substantially from their equilibrium values.  We have no theoretical or empirical basis for assuming that substantial deviations of prices — whether for assets or for services, and whether prices are determined in auction markets or in imperfectly competitive markets — from their equilibrium values are immediately or even quickly eliminated. (Let me note parenthetically that vulgar Austrians who deny that prices voluntarily agreed upon are ever different from equilibrium values thereby undermine the Austrian theory of entrepreneurship based on the equilibrating activity of entrepreneurs which is the source of the profits they earn. The profits earned are ipso facto evidence of disequilibrium pricing. Austrians can’t have it both ways.)

So my disagreement with Scott about the beauty-contest theory of stock prices as an alternative to EMH is relatively small. My main reason for mentioning the beauty-contest theory was not to advocate it but to point out that the sort of empirical evidence that Scott cites in support of EMH is also consistent with the beauty-contest theory. As Scott emphasizes himself, it’s not easy to predict who judges will choose as the winner of the beauty contest. And Keynes also used a casino metaphor to describe stock pricing in same chapter (12) of the General Theory in which he developed the beauty-contest analogy. However, there do seem to be times when prices are rising or falling for extended periods of time, and enough people, observing the trends and guessing that the trends will continue long enough so that they can rely on continuation of the trend in making investment decisions, keep the trend going despite underlying forces that eventually cause a price collapse.

Let’s turn to Scott’s post about the ability of the market to stay irrational longer than any individual trader can stay solvent.

The markets can stay irrational for longer than you can stay solvent.

Thus people who felt that tech stocks were overvalued in 1996, or American real estate was overvalued in 2003, and who shorted tech stocks or MBSs, might go bankrupt before their accurate predictions were finally vindicated.

There are lots of problems with this argument. First of all, it’s not clear that stocks were overvalued in 1996, or that real estate was overvalued in 2003. Lots of people who made those claims later claimed that subsequent events had proven them correct, but it’s not obvious why they were justified in making this claim. If you claim X is overvalued at time t, is it vindication if X later rises much higher, and then falls back to the levels of time t?

I agree with Scott that the argument is problematic; it is almost impossible to specify when a suspected bubble is really a bubble. However, I don’t think that Scott fully comes to terms with the argument. The argument doesn’t depend on the time lag between the beginning of the run-up and the peak; it depends on the unwillingness of most speculators to buck a trend when there is no clear terminal point to the run-up. Scott continues:

The first thing to note is that the term ‘bubble’ implies asset mis-pricing that is easily observable. A positive bubble is when asset prices are clearly irrationally high, and a negative bubble is when asset price are clearly irrationally low. If these bubbles existed, then investors could earn excess returns in a highly diversified contra-bubble fund. At any given time there are many assets that pundits think are overpriced, and many others that are seen as underpriced. These asset classes include stocks, bonds, foreign exchange, REITs, commodities, etc. And even within stocks there are many different sectors, biotech might be booming while oil is plunging. And then you have dozens of markets around the world that respond to local factors. So if you think QE has led Japanese equity prices to be overvalued, and tight money has led Swiss stocks to be undervalued, the fund could take appropriate short positions in Japanese stocks and long positions in Swiss stocks.

A highly diversified mutual fund that takes advantage of bubble mis-pricing should clearly outperform other investments, such as index funds. Or at least it should if the EMH is not true. I happen to think the EMH is true, or at least roughly true, and hence I don’t actually expect to see the average contra-bubble fund do well. (Of course individual funds may do better or worse than average.)

I think that Scott is conflating a couple of questions here: a) is EMH a valid theory of asset prices? b) are asset prices frequently characterized by bubble-like behavior? Even if the answer to b) is no, the answer to a) need not be yes. Investors may be able, by identifying mis-priced assets, to earn excess returns even if the mis-pricing doesn’t meet a threshold level required for identifying a bubble. But the main point that Scott is making is that if there are a lot of examples of mis-pricing out there, it should be possible for astute investors capable of identifying mis-priced assets to diversify their portfolios sufficiently to avoid the problem of staying solvent longer than the market is irrational.

That is a very good point, worth taking into account. But it’s not dispositive and certainly doesn’t dispose of the objection that investors are unlikely to try to bet against a bubble, at least not in sufficient numbers to keep it from expanding. The reason is that the absence of proof is not proof of absence. That of course is a legal, not a scientific, principle, but it expresses a valid common-sense notion, you can’t make an evidentiary inference that something is not the case simply because you have not found evidence that it is the case. So you can’t infer from the non-implementatio of the plausible investment strategies listed by Scott that such strategies would not have generated excess returns if they were implemented. We simply don’t know whether they would be profitable or not.

In his new post Scott makes the following observation about what I had written in my post on excess volatility.

David Glasner seems to feel that it’s not rational for consumers to change their views on the economy after a stock crash. I will argue the reverse, that rationality requires them to do so. First, here’s David:

This seems an odd interpretation of what I had written because in the passage quoted by Scott I wrote the following:

I may hold a very optimistic view about the state of the economy today. But suppose that I wake up tomorrow and hear that the Shanghai stock market crashes, going down by 30% in one day. Will my expectations be completely independent of my observation of falling asset prices in China? Maybe, but what if I hear that S&P futures are down by 10%? If other people start revising their expectations, will it not become rational for me to change my own expectations at some point? How can it not be rational for me to change my expectations if I see that everyone else is changing theirs?

So, like Scott, I am saying that it is rational for people to revise their expectations based on new information that there has been a stock crash. I guess what Scott meant to say is that my argument, while valid, is not an argument against EMH, because the scenario I am describing is consistent with EMH. But that is not the case. Scott goes on to provide his own example.

All citizens are told there’s a jar with lots of jellybeans locked away in a room. That’s all they know. The average citizen guesstimates there are 453 jellybeans in this mysterious jar. Now 10,000 citizens are allowed in to look at the jar. They each guess the contents, and their average guess is 761 jellybeans. This information is reported to the other citizens. They revise their estimate accordingly.

But there’s a difference between my example and Scott’s. In my example, the future course of the economy depends on whether people are optimistic or pessimistic. In Scott’s example, the number of jellybeans in the jar is what it is regardless of what people expect it to be. The problem with EMH is that it presumes that there is some criterion of efficiency that is independent of expectations, just as in Scott’s example there is objective knowledge out there of the number of jellybeans in the jar. I claim that there is no criterion of market efficiency that is independent of expectations, even though some expectations may produce better outcomes than those produced by other expectations.

13 Responses to “Scott Sumner Defends EMH”


  1. 1 maynardGkeynes September 7, 2015 at 8:24 pm

    When you say: “I claim that there is no criterion of market efficiency that is independent of expectations…”

    Although you seem to state otherwise earlier in this post, this strikes me as a rather fundamental critique of EMH, close to an outright rejection. It’s a subtle argument, but worth making. Unlike physics, there is no fundamental particle of “demand,” nor is there a general theory of “tastes” as irreducibles (like quarks). Both are in significant part purely social phenomena, which I think is the basis of Shiller’s overall argument against EMH with regard to stock market valuation (although clearly, EMH does apply with regard to trading rules and arbitrage).

  2. 2 Unlearningecon September 8, 2015 at 2:17 am

    A couple of tangential points:

    “We have no theoretical or empirical basis for assuming that deviations of prices whether for assets for services and whether prices are determined in auction markets or in imperfectly competitive markets that prices cannot deviate substantially from their equilibrium values.”

    I’m finding this sentence quite confusing.

    “(Let me note parenthetically that vulgar Austrians who deny that prices voluntarily agreed upon are ever different from equilibrium values thereby undermine the Austrian theory of entrepreneurship based on the equilibrating activity of entrepreneurs which is the source of the profits they earn. The profits earned are ipso facto evidence of disequilibrium pricing. Austrians can’t have it both ways.)”

    This is, of course, also a valid argument against the perfectly competitive neoclassical model, where there is no room for entrepreneurship. Perhaps something similar could even be said about monopoly/oligopoly models, since they are static and opportunities cannot really be ‘created’ in the same way as they are in reality.

  3. 3 Michael September 8, 2015 at 3:01 am

    I think to reject the EMH (for some market) is to claim that the prices leave substantial scope for gain based on existing information. The conversation gets a bit muddled because in practice the use of EMH almost always involves two supplementary hypotheses: one, that there are a set of “fundamentals” that are causally prior to the market prices — no feedbacks; and two, the equilibrium corresponding to those fundamentals is unique. Your arguments attack those supplementary hypotheses. They don’t carry the implications that could sometimes be inferred from a true rejection of the EMH — for example, that central banks can usefully pop bubbles before they get too big.

  4. 4 JKH September 8, 2015 at 3:36 am

    Looking back at this link:

    https://uneasymoney.com/2011/07/19/whats-fundamentally-wrong-with-emh/

    I find the discussion around expectations to be quite confusing.

    Expectations are inherent to the ‘fundamental value’ and ‘fundamental analysis’ of stocks and bonds, for example. That valuation is all about expected cash flows. And that’s without considering any second order effect from how others may be doing the same thing in terms of determining value.

    But you also use expectations in the sense of Keynes’ beauty contest, where the judgements (expectations?) of other market actors are taken into account. (Expectations of expectations?)

    This latter effect is a factor in ‘technical analysis’ of markets, for example, as distinct from the ‘fundamental analysis’ of financial assets. Also, momentum and trend traders use the phrase “so long as the trade is working’ along with the imposition of “stop loss” strategies to crystallize their gain when the trade “stops working”. Isolated fundamental analysis is a lesser factor in such strategies. Yet all of this watching of what others are doing can be captured loosely in the idea of the beauty contest.

    Anyway, I’m seeing a sort of slippage in the use of the word ‘expectations’. It seems there is a compounding plus feedback effect working over top of the primitively true idea that expectations of future cash flow or value are fundamental to the present value of any financial asset, for example.

  5. 5 David Glasner September 8, 2015 at 9:28 am

    maynardGkeynes, I reject EMH in theory, but I believe that it is useful in practice if handled with care.

    Unlearningeconomics, Sorry, I was tired when I finished writing the post and didn’t read it carefully before posting. The sentence you quote was poorly written and doesn’t convey the point I was trying to make. Here’s the way it should have been written (which I am going to insert in the post in place of the original:

    “We have no theoretical or empirical basis for assuming that substantial deviations of prices — whether for assets or for services, and whether prices are determined in auction markets or in imperfectly competitive markets — from their equilibrium values are immediately or even quickly eliminated.”

    I agree that in a very different, but curiously parallel way, extreme neoclassical theoreticians — especially RBC types — cannot explain entrepreurial behavior, but those guys don’t make as a big deal about entrepreneurship as do the Austrians.

    Michael, I think that I agree with you. In any case, I absolutely am against using monetary policy as an instrument for popping bubbles.

    JKH, I haven’t looked at the post for a long time, but I thought it was pretty good when I wrote it. Was there a specific point in that post that you wanted me to comment on?

  6. 6 Jason Smith September 8, 2015 at 12:35 pm

    I was actually confused by Sumner’s reference to an “fundamental” number of jellybeans — his contention that QE doesn’t impact inflation because of expectations depends critically on the fundamental number of jellybeans not mattering.

    http://informationtransfereconomics.blogspot.com/2015/09/quantitative-jellybeans.html

  7. 7 M. September 8, 2015 at 2:29 pm

    “The problem with EMH is that it presumes that there is some criterion of efficiency that is independent of expectations, just as in Scott’s example there is objective knowledge out there of the number of jellybeans in the jar. I claim that there is no criterion of market efficiency that is independent of expectations, even though some expectations may produce better outcomes than those produced by other expectations.”

    Does the EMH really states that? Isn’t informational efficiency (price includes all relevant informations, expectations included) and not economic efficiency (price = NPV)?

    The way I understand it, EMH says you cannot form better expectations that the market — which does not imply that the price is equal to the fundamental value.

    Am I wrong somewhere?

  8. 8 Benjamin Cole September 9, 2015 at 9:58 pm

    I think Sumner’s argument for an anti-bubble ETF is very strong. Wall Street has gobs of money and has invented any number of ETFs. To my knowledge, there is not a single ETF functioning successfully as a bubble-popper.

    I think EMH holds an awful lot of water.

  9. 9 maynardGkeynes September 10, 2015 at 6:56 am

    I hope it works better than the last anti-bubble strategy, laying off the risk on AIG. The counter-party risk on such an ETF would be huge, wouldn’t it?

  10. 10 sumnerbentley September 10, 2015 at 5:54 pm

    David, I may have botched one point in my post. When I said you thought it wouldn’t be rational for people to become more bearish after stocks crashed, I meant something more like “You thought the rational expectations hypothesis implied that people would not become more bearish about the economy after stocks crashed.” Would that be correct?

    I do agree that expectations are a factor that affects the outcome. But I would argue that the markets efficiently estimate the impact of changes in expectations on asset prices (and aggregate demand), and that expectations don’t just change for no reason, but rather reflect fundamental changes in the economy.

    So I don’t see a problem for ratex or the EMH if the future course of the economy depends on people’s expectations, as long as those expectations are rational.

  11. 11 David Glasner September 11, 2015 at 9:35 am

    Jason, See Scott’s comment below and my response.

    M., There is a recursive loop introduced into the efficient market hypothesis and ratex once you allow that the system is not tending towards a stable equilibrium determined by tastes, technology and factor endowments. If the real equilibrium can be affected by what is expected, then the Keynesian beauty contest is not necessarily irrational because the most beautiful contestant is the contestant that people perceive as most beautiful. Beauty is in the eye of the beholder; it is not based on fundamentals. In the Keynesian beauty contest, you can’t do better than the market because the most beautiful contestant is the one the market thinks is most beautiful.

    Benjamin, I think it’s strong, too, but not conclusive. To make it conclusive you would need evidence that the kinds of funds that Scott describes consistently do not outperform the market. He (and you) are only offering a conjecture that they would not outperform the market.

    Scott, Yes, I think that would be better. Am I just imagining that in the concluding paragraph of your comment you are arguing in a circle (“there is no problem for ratex or EMH as long as those expectations are rational”)?

  12. 13 David Glasner September 21, 2015 at 12:46 pm

    JKH, Thanks for the link. There’s also a bandwagon effect, which we see in political campaigns. Voters often gravitate to the candidate who is becoming more popular. And it can work in both directions. Hence, you can peak too soon.


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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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