The commenter 123 sent me a link to an article by Andrei Shleifer, which argues that markets aren’t efficient. Before quoting Shleifer, a bit of background on the EMH.
The efficient market hypothesis implies that it should be very difficult to beat the markets, as asset prices should already reflect all publicly available information. Many people found this hard to accept; surely really smart people are better investors than the average schmuck! Not surprisingly, the very smartest people of all, including not one but two Nobel Prize-winning finance professors, gave in to temptation and joined a hedge fund that was set up to find market anomalies and to make investments that took advantage of the market’s inefficiencies. That hedge fund was called “Long Term Capital Management.” Of course anyone who has read ancient Greek tragedies knows what happened next. Things didn’t work out quite as well as planned. LTCM went bankrupt, and had to be rescued by a cartel of banks assembled by the Fed.
You might think this would lead the anti-EMH forces to give up their fruitless quest for the finance equivalent of the Holy Grail, the fountain of youth, or Prester John’s Kingdom. The search for the hidden “intrinsic value,” that diverges from the vulgar market value. You would be wrong. The anti-EMH forces are stronger than ever. But here is something I never would have expected. The failure of LTCM, a firm founded and run on the premise that the EMH was wrong, actually shows that . . . the EMH is wrong!
A shrewd investor who noticed, for example, that in the summer of 1997, Royal Dutch traded at an 8% to 10% premium relative to Shell, would have sold short the expensive Royal Dutch shares and hedged his position with the cheaper Shell shares. Sadly for this investor, the deviation from the 60-40 parity only widened in 1998, reaching nearly 20% in the autumn crisis. This bet against market inefficiency lost money, and a lot of money if leveraged.
In this case, it is said that when Long Term Capital Management collapsed during the Russian crisis, it unwound a large position in the Royal Dutch and Shell trade. Smart investors can lose a lot of money at the times when an inefficient market becomes even less efficient. In fact, as the
LTCM experience illustrates, their businesses might not survive long enough to see markets return to efficiency.
The inefficiency in the pricing of Royal Dutch and Shell is a fantastic embarrassment for the efficient markets hypothesis because the setting is the best case for that theory. The same cash flows should sell for the same price in different markets. It shows that deviations from efficiency can be large and persistent, especially with no catalysts to bring markets back to efficiency. It also shows that market forces need not be strong enough to get prices in line even when many risks can be hedged, and that rational and sophisticated investors can lose money along the way, as mispricing deepens.
You have to be impressed by the resourcefulness of the anti-EMH, crowd. If LTCM and its merry band of Nobel-Prize winning economists had actually beat the market, if they had used market anomalies to get rich, well then it would have been the death knell of the EMH. Every time Fama said “if you’re so smart how come you’re not rich,” people would have responded that Scholes and Merton did get rich by spotting market inefficiencies. Instead they failed miserably, and this shows . . . it show that markets are inefficient because the market can stay irrational longer than you can stay solvent.
The more I study the psychology of the anti-EMH crowd, the more surprised I am that anyone still believes in the EMH. It seems like anything that happens undercuts the EMH. It reminds me of people who see monopoly everywhere. High prices? Clearly monopolistic exploitation. Low prices? Ah, that’s predatory pricing. The same price as your competitor? Obviously price fixing.
OK everyone, tell me where I’m wrong. What outcome of LTCM’s bet on Shell Oil would have supported the EMH?
PS. I don’t know enough about Dutch corporate law to comment on the specifics. Is there any possible state of the universe that might cause the agreement between Royal Dutch and Shell to break down at a future date? If so, it would seem to me that Shleifer’s example is invalid.
PPS. After I wrote this I came across this excellent book review by Eric Falkenstein. I should just stop discussing the EMH and reference him from now on.