Professional Documents
Culture Documents
Min Deng*
Shenzhen Divine Vision Investment Planning Co., Ltd
* Email: dengmin@public.szptt.net.cn
To my friend
Mr. Chen Yuping
Without his generous one million RMB funding support, this
research could never have been completed.
Acknowledgements
Copyright by the author. All rights reserved. No part of this publication may be reproduced, stored in a
retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or
otherwise, without the prior written permission of the author.
Death Of The Efficient Market Hypothesis
Min Deng
Shenzhen Divine Vision Investment Planning Co., Ltd
Abstract
This report summarizes the breakthroughs achieved by the present writer in
respect of the research on the investor behavior and stock price behavior as well as the
interrelationship between them.
On the basis of these achievements, the paper briefly analyzes the theory of
random walk, and point outs its main errors. The paper then dwells on details
identified with the errors and mistakes associated with the Efficient Market Theory.
The paper also provides an in-depth analysis into the basic elements constituting the
Efficient Market Theory (such as Rational Expectations and equilibrium) and
pinpoints the underlying non-scientific aspects in this regard, and provides a brief
judgment on the viewpoints advanced by Samuelson (1989), Fama (1998) and
Malkiel (2003), (2005).
Lastly, the paper concludes with the fact that Efficient Market Theory is far from
a reasonably close approximation to the stock market realities, and its scientific
content is close to zero.
Moreover, the paper provides brand-new interpretations on whether those
extraordinary investors who have succeeded in beating the market actually depended
on luck or not along with a number of other financial theoretical problems related to
the Efficient Market Theory.
Keywordss Investor behavior; stock price behavior; theory of the random walk;
Efficient Market Theory
JEL Classification: G14.
Table of Contents
1 Introduction............................................................................... 1
2 The Investor Behavior and Stock Price Behavior................... 5
2.1 The investor behavior.......................................................................................................5
2.2 The stock price behavior................................................................................................10
2.3 Inter-relationship between the investor behavior and stock price behavior...................14
3 A Historical Perspective on EMT........................................... 16
3.1 Pre-history Stage Of EMT (1900 1965)...................................................................16
3.2 Formation And Refinement Stage Of EMT (1965 1991).........................................18
3.3 EMT At the Stage Of Decline ( 1991 Present).........................................................21
4 Analysis of Errors with The Theory of Random Walk......... 23
4.1 Mistakes with perception...............................................................................................23
4.2 Erroneous research methodology...................................................................................25
4.3 Root cause analysis........................................................................................................27
5 Analysis on Errors with EMT................................................ 28
5.1 Absurdities with the efficient market definition.............................................................28
5.2 Unscientific theoretical models......................................................................................30
5.3 Assumptions and Theoretical Basis for EMT ................................................................34
5.4 Other mistakes................................................................................................................36
6 Analysis of Basic Elements Constituting EMT..................... 37
6.1 Rational Expectations theory.........................................................................................38
6.2 Rational Investor............................................................................................................46
6.3 Arbitrage........................................................................................................................49
6.4 Equilibrium....................................................................................................................51
6.5 Is EMT the reasonable approximation of the reality?....................................................54
7 Commentaries on EMT Theorists Viewpoints ..................... 64
7.1 Viewpoints advanced in Samuelson (1989) paper .........................................................65
7.2 Fama (1998)...................................................................................................................69
7.3 Malkiel (2003) and (2005).............................................................................................71
7.4 Malkiel (2003)................................................................................................................74
8 Concluding Remarks............................................................... 82
8.1 Summary........................................................................................................................82
8.2 Commentary...................................................................................................................83
Bibliography .................................................................................. 86
1 Introduction
1
They (market inefficiency) exist because we do not root out their basic causes.
These causes are easy enough to identify, if one looks with enough dispassion and
rigor.
2
------------Dean LeBaron
Efficient market theory
3
(EMT) is generally regarded as the cornerstone of the
mainstream financial theories. Fama (1970, p. 383) provides a classical definition
on the efficient market:
A market in which prices always fully reflect available information is called
efficient.
Underlying this definition is the economists assumption that the stock market
investors are rational agents and that the stock price is determined by their
interaction.
4
According to Frederic S. Mishkin, a more straightforward efficient
market definition can be provided as follows: in an efficient market, there is no
earning opportunity that has not been fully utilized.
5
EMT advocates proclaim that
the real-life stock markets (such as the US stock markets) are consistent with the
above definition of efficient market.
In the 1970s, EMT had, for a certain period of time, been looked upon as a
scientific truth turning countless young economists and financial students into its
faithful disciples. With the emergence of the anomalies
6
in the stock markets in
the 1980s and the 1987 stock market crash, EMT had aroused widespread suspicions
1
In this paper, the present author has made extensive references to the contents of the works by such distinguished
economists and finance professors as Paul A. Samuelson, Eguene F. Fama, Burton Malkiel, Stephen LeRoy and
Frederic Mishkin. The present author acknowledges his sincere appreciation and regards to the foregoing
scholars.
2
LeBaron (1983). Quotation.
3
Efficient market theory (EMT), in a broad sense, refers to efficient market hypothesis (EMH). In the context of
this paper, both terms share the identical meaning.
4
LeRoy (1989). See Page 1613.
5
Mishkin, Frederic S., The Economics of Money, Baking, and Financial Markets, Chinese edition, China Renmin
University Press. See Page 660. Quotation.
6
Anomaly refers to unexpected event, which could bring opportunities for investors to earn abnormal return, such
as seasonal anomalies, etc.
1
of the academic and investment management circles with regards to its scientific
nature. With the coming into fashion of Behavioral Finance in the academic circle
and the irrational exuberance in the US stock markets in the late 1990s, the
academic circle witnessed a major changeover in its attitude towards the EMT.
Some scholars believed that EMT should be abandoned, as in the case of Haugen
(1995) and Shiller (2000). Some other scholars took the view that EMT should still
play the role of a useful benchmark. A minority of scholars insisted that EMT
accurately recapture the realities as in the case of Malkiel (2003), (2005).
For the following three reasons, the academic circle has been unable to ascertain
whether EMT should be viewed as a scientific school of thought.
(i) Problems with EMT itself. First and foremost, the definition of efficient
market given by Fama (1970) was far too vague. According to Beaver (1981, p. 23):
The problem is not simply that concepts are difficult to test empirically, a
pervasive phenomenon not unique to the efficient Market literature, rather, the
problem is that, at a conceptual level, prior to empirical testing, it is unclear what is
meant by the term market efficiency.
Moreover, fully reflect in this particular context is not specified in any way, and it is
not possible to ascertain it.
Second, it had taken EMT more than 20 years from birth to final refinement.
During this period, Fama (1976) had strengthened the definition of efficient market.
And Fama (1991) carried out major revisions on the definition and description of
EMT.
(ii) Human factors. EMT may be described as the crystallization of years of
incisive research work conducted by scholars and pundits fully devoted to the study of
the behavior of stock price. As such scholar grouping enjoys high prestige in the
academic circle plus their religious faith in the accuracy of EMT, conclusions drawn
by those scholars opposed to the views of EMT have not received the same level of
attention. And research conclusions deviating from EMT viewpoints are invariably
questioned.
2
(iii) Technical difficulty. With the Capital Asset Pricing Model becoming the
mainstream financial theory and the birth of the Rational Expectations Hypothesis,
theorists managed to integrate EMT with CAPM along with Rational Expectations
Hypothesis. And such integration made it extremely difficult to ascertain whether
EMT was a scientific theory. To confirm whether EMT is a scientific theory or not,
we must have in place a scientific stock pricing model to explain the stock price
behavior and investor behavior. As scholars entertaining a questioning attitude at
EMT have not been able to achieve any major breakthrough regarding the stock price
behavior and investor behavior, it was not very difficult for us to comprehend why the
research work conducted by a number of established economists and finance
professors, such as Shiller (1981), DeBondt and Thaler (1985), Lo and Mackinlay
(1988), J egadeesh and Titman (1993), Shleifer and Vishny (1997), Haugen (1997) had
been unable to challenge the status of EMT as the cornerstone of the modern financial
investment theories.
In the early 1990s, the special environment at the time of the birth of Chinas
stock market has provided a precious opportunity for people involved in studies on
the actual investor behavior and stock price behavior. The present writer has had the
luck to experience the entire process. Through unrelenting efforts over 14 years, the
present writer has finally achieved a breakthrough in respect of the research
associated with the investor behavior and stock price behavior. By relying on the
breakthroughs achieved on the investor behavior and stock price behavior, we are
already in a position to formulate a correct judgment on the puzzle of whether EMT is
scientific or not.
The specific method is as follows. First of all, the present writer set up a simple
analysis framework to analyze the actual investor behavior and stock price behavior.
Secondly, the present writer regard the foregoing research conclusions in the above
framework as the reference standards to perform comparative analysis on the
scientific connotations of the basic elements related to EMT as employed by the
economists (such as equilibrium, Rational Expectations Theory and rationality and so
forth). Lastly, the present writer perform a comparative analysis on the possible
outcomes arising from the integration between these essential elements constructing
the EMT by the economists versus the basic elements of our analysis frameworks in
terms of integration.
As EMT is but a simplified replica of the stock market realities, we are not in a
3
position to demand that it should be consistent with the actual stock market realities in
all aspects. As a scientific theory, EMT is only required to be the reasonable
approximation of the stock market realities. The crux of the matter lies in what
constitutes the criteria for the reasonable approximation? The present writer has
divided the stock market reasonable approximation criteria into the following 3
aspects: Whether EMT scientifically recaptures the investor behavior; whether EMT
scientifically describes the stock price behavior; whether EMT scientifically reflects
the interrelationship between the investor behavior and stock price behavior.
Based on the above criteria, this paper has carried out a full comparative analysis
on the EMT. The concluding part of the present report demonstrates that: EMT is by
no means the reasonable approximation of the stock market realities, and its scientific
content is close to zero. The reason is pure and simple: EMT absurdly describes the
investor behavior and mistakenly represents and explains the stock price behavior.
Furthermore, EMT wrongly captures the inter-relationship between the investor
behavior and stock price behavior.
This paper is primarily intended for the academic and investment management
circles. The present writer very much hope that his research achievements will be
conducive to the academic and investment management circles in correctly judging
whether EMT is scientific or not. And it is conducive to assisting others to obtain a
scientific understanding of the nature of the stock market as well as the actual stock
price behavior.
To better clarify the mistakes associated with EMT, the present writer has
divided EMT into three stages, viz. pre-history of EMT (1900--1965), EMT formation
and refinement (1965--1991) and EMT decline (1991--to date). This paper is
arranged in the following sequence: Section 2 briefly outlines the analysis framework
formulated on the basis of the present writers research results associated with the
investor behavior and stock price behavior. Section 3 takes a brief look at the
evolutionary history of EMT. Section 4 analyzes errors and inadequacies identified
with the theory of random walk which precedes EMT. Section 5 describes and
analyzes the errors with the EMT. Section 6 provides a comparative analysis on the
basic elements used by the economists to formulate EMT. Section 7 brings together
Samuelson (1989), Fama (1998), Malkiel (2003) and (2005) research conclusions for
judgment. Section 8 provides concluding remarks on the underlying causes relative
to the errors with EMT.
4
2 The Investor Behavior and Stock Price Behavior
In order to provide a scientific description and forecast of the stock price
behavior in real life, we must obtain a scientific understanding of the
inter-relationship between the investor behavior and stock price behavior. To do
this, the prerequisite is that we must have in place a scientific description of the
investor behavior and stock price behavior.
2.1 The investor behavior
To have a scientific description of the stock price behavior, the most
fundamental condition is that we must provide a scientific description of the investor
behavior in the stock market. To scientifically describe the investor behavior, the
precondition is that we must have a scientific understanding of the investor behavior.
In respect of investor behavior, we are required to understand the human nature, the
limits of human brains, the investor ideal, investor expectations and investor
decision-making.
Human nature
The Wealth of Nations by Adam Smith is generally regarded as the Bible of
economics. In the foregoing book, Adam Smith laid emphasis on the self-seeking
nature of human beings. Another great book by Adam Smith entitled The Theory
of Moral Sentiments has not merited the same level of attention. In the book, Adam
Smith placed premium on the selflessness of human beings. Perception by Adam
Smith of human nature is comprehensive and profound: only by integrating
economical selfishness with moral selflessness can we hope to understand the
comprehensive true human nature.
7
Unfortunately, human selflessness has not
become one basic assumption for economics in the same way as human selfishness.
Understanding the true and full human nature is of crucial importance to our
understanding of the stock price nature and actual stock price behavior. This is
because: if we only know that human beings are selfish without knowing their
7
Smith, A., 1904, An Inquiry into the Nature and Causes of the Wealth of Nations, Chinese edition. See
Introduction, p. 4--5. Quotation.
5
altruism, it would be very difficult for us to comprehend why people tend to unite
closely together to defend their common interests when individual selfish acts harm
others interests without bringing good benefits to themselves. Over 100 years ago,
the phoenix tree outside of the No. 68 of Wall Street showed such a spectacle. To
defend their common interests, over 20 stockbrokers joined hands to sign up the
famous Buttonwood Agreement to lead to the eventual birth of the New York
Stock Exchange.
8
If the investor is like the rational investor under EMT
assumptions, the stock market could not have come into being in the first place.
Limits of human brains
In 1956, the psychologist George Miller issued a famous paper the magic
number seven plus or minus two highlighting some limits on our capacity for
processing information. In the report, George Miller pointed out that the channel
capacity for processing information on the part of human brains appears to be limited.
The typical range is epitomized by the magic number seven plus or minus two.
Inspired by the research conclusions of George Miller, the present writer has carried
out substantial research on the channel capacity of the framework in terms of human
brains forming expectations of the future stock price.
The present writers research conclusions indicate that the channel capacity of
the framework for forming expectations of the future stock price on the part of the
human brains is very close to the conclusions drawn by George Millers research
work. Under specified time frame (yearly, monthly and daily), the human brains
channel capacity for containing stock price quantities stands at number seven plus or
minus two. That is to say, the human brains channel capacity for formation of stock
price expectations are limited to number seven plus or minus two. If the human
brains are compared to a forecasting machine, the human brains oriented stock price
quantity to the input and the expected conclusion to the output, the output will be far
less than the input quantity. That is to say, although the framework space within the
human brains for anticipation and forecasting is 72, When forecasting the stock price,
the human brains are only capable of having expectations of the stock price of any
statistical significance less than 7 unit time, In real-life environment, as the stock
market is full of mutually contradictory information, the investor can only have
8
Gordon (1999), The Great Game: The emergence of Wall Street as a world power: 1653-2000, Chinese edition,
Citic Publishing House. See Chapter 2. Quotation.
6
forecast of stock price within 1 to 3 unit time that is of any practical statistical value.
The investor ideal
All human creations are reflections of mankinds pursuit of determinism. Such
is the case with the civilized society, literature, music and fine arts. As one of the
greatest inventions of mankind, stock market clearly reflects investor aspirations.
In addition to the material home for the human being, there is a spiritual home.
And human ideal is to hold sway at the spiritual home. Apart from a visible world,
the investor also possesses an ideal world. Human ideal realm is one of determinism,
it is totally incompatible with the random realm of throwing dices as is the order of
the day in the gambling process.
It is of paramount importance to understand the investor ideal vis--vis the
investor behavior and stock price behavior. The investor ideal constitutes the core
foundation for the birth and development of the stock market. The investor
aspiration constitutes the major driving force for the investor in terms of the purchase
of stocks. The stock price embodies the aspirations of the investor. As the stock
market embodies the aspirations of all the investors, all stock markets evolve towards
the orientation of the investors ideal stock market.
In the investors idealized stock market, due to all the investors holding fully
identical viewpoints on the history, present and near-term future of the market and
fully understand their own respective strengths and weaknesses, the market price will
only rise and never fall. The market price track is so clear-cut that prediction
becomes superfluous. Any new information, however good or bad, will not exert
any influence on the formation of the stock price. The reason is that, in an idealized
stock market, the investor is fully rational to such an extent that the market is strong
enough, this is very much like a healthy person (his own health being a source of
disease resistance or prevention) would not contract cough or catch cold in the wake
of sudden change in climate. In the idealized market, the stock price is equivalent to
its value, and the investor is completely rational. The investor does not need to
consider any specific investment strategy at all.
The idealized stock market is not a virtual market. Rather, it is the target that
all the current stock markets are striving for at this point in time. We can easily find
the shadow of the idealized stock market amongst the sways of the real-life stock
market tendencies, and feel the pulse of the real-life stock price in moving towards the
7
ideal stock market. For example, in the short term, any stock price index sequence
exhibits tendencies of more increase than decrease. In the long term, the stock price
indexes of the countries all over the world have been steadily on the increase, and
have not dropped below their respective initial starting points in the form of random
walk. The most obvious example is that, over the 100-odd years, the DJ IA has shot
up from its initial 50 points to over 14000 points.
Investor expectations
The investor relies on his own innate patterns to form expectations on the future
movement of the stock price. In forming his expectations of the future stock price,
the investor invariably has three kinds of expected values. These are the intuitive
prospect value, the momentum prospect value and historical experience-based
prospect value. It is rather easy for us to observe the intuitive prospect value and the
momentum prospect value. But it is rather difficult to judge the historical
experience-based prospect value, as it is a kind of statistical expected value.
The intuitive prospect value epitomizes the expectation formed by the investor
on the past stock prices. It is consistent with human nature, and, as a result, each
and every investor can engage in the intuitive expected value.
The momentum prospect value takes shape on the basis of the intuitive expected
value. It is an expectation arising from the price differential between the investor
forecast price and the realized stock price.
The historical cvncpgc ac+`_qcb prospect value refers to the expectation
arising from statistical conclusions drawn from the stock price patterns in recent
periods of time on the part of the investor in relation to the entire stock price historical
sequences showing similar patterns. Generally speaking, an investor needs a
minimum of 5 years of study of the market statistics to form the historical
experience-based prospect value. The historical experience-based prospect value
plays a pivotal role in the decision taken by the investor of a scientific nature.
Purely from the future expectancy standpoint, a veteran Wall Street pundit who has
spent over 3 decades in the area of financial analysis cannot said to be more accurate
than a newcomer to the Wall Street in terms of the forecast of tomorrows stock price
movement. However, from an investment decision point of view, a veteran Wall
Street pundit who has spent over 3 decades in the area of financial analysis will
certainly be able to arrive at a more reasonable investment decision than a green hand
8
at the Wall Street. This is because a newcomer can only rely on his intuitive
expected value and the momentum prospect value to reach an investment decision,
and he is simply unable to form precise historical experience-based prospect value.
The way that the investor anticipates the future stock price determines that the
investor can only predict the future stock price on the basis of the past and present
stock prices. The concept of discounting raised by the economist is not a basic
approach used by the investor to predict the future stock price in any way. It is only
an empirical methodology derived from the foregoing three approaches.
Discounting approach should not be used separately from the three basic modes of
investor expectation in the stock market.
It should be mentioned that, as the channel capacity of the framework for
forming the expectations of the future stock price on the part of human brains appears
to be limited, in forming expectation of the future stock price,
non-stock-price-information (such as interest rate increase by the US Federal Reserve
Bank and new products being unveiled by the listed companies etc.) cannot make its
way into the stock price expectation system on the part of the investor. Such
non-stock-price-information enters the expectation system that is independent of the
investors stock price expectation system. After going through the processing of the
investors expectation and cognition systems, what the investor eventually gets is no
longer the expected values of the non-stock-price-information, rather, it is qualitative
rather than quantitative assessment on the future stock price on the basis of the
expected values of the foregoing information. These assessments along with the
three expected values of the future stock price jointly make their way into the
decision-making system of the investor.
Investor decision-making
The investor decision-making system mainly comprises four parts, namely, the
investors 3 expected values, the investors assessments of the
non-stock-price--information, current earning/loss-making situation of the investor
and requirements imposed on his own behavior on the part of the investor. How the
investor takes his decision is dependent upon the outcome of the integration of the
foregoing four parts within the investors decision-making system. There are
thousands of investors in the stock market and the outcomes of the integration of the
foregoing four parts within the investors decision-making systems are miles apart, so
9
there will be investors buy and sell stocks at any price point in any time interval in the
stock market. Success on any one of the stock transactions in the stock market is not
because of the same sort of expectations of the involved stock price on the part of the
investors in the market at the time, mainly because the outcomes of the integration of
the foregoing four parts within the investors decision-making systems of the buying
and selling investors are different.
2.2 The stock price behavior
Only on the basis of having obtained a scientific understanding of the above
investor behavior is it possible for us to really comprehend the stock price behavior.
To analyze stock price behavior, we must, first and foremost, understand the nature of
the stock price movement and the prospect values of the stock price sequence.
Secondly, we are required to understand the patterns of the movement of the stock
price and the rules governing the stock price movement. Finally, we must
understand the stock price behavior in the absence of external information
interference.
Nature of the stock price movement
From a macro point of view, the stock market is not a gambling outlet. Rather,
it is a place where the investor harbors their aspirations and ideals. The trend of
stock price movement reflects a delicate balance between aspirations and expectations
of the realities on the part of the investors. And the rising trend of the stock price
represents the direction of the investor aspirations. From a micro standpoint, as any
one stock price sequence embodies investor aspirations and prospect values, any one
stock price sequence should be considered as a source of generic information. Such
generic information differs, in substance, from the outside information (such as the
news released by the Federal Reserve Board and the Iraqi war etc). It constitutes the
core driving force associated with the stock price movement. Because of the reason
that any random time sequences or emulation stock price sequences cannot embody
the two elements of the investor prospect values and investor community collective
aspirations. Consequently, any random time sequences or emulation stock price
sequences arising from gambling table, throwing dices and random cards lottery are
incompatible with the real-life stock price sequences in terms of substance. The
allegation that stock price movement is the result of noise is a totally mistaken
10
representation of the root cause leading to the stock price movement. J ohn Maynard
Keynes is also wrong in asserting that the stock price movement is motivated by
animal spirit.
The prospect values of the stock price sequence
The stock price at a unit time interval represents the basic unit of a stock price
sequence, it is composed of three elements, viz. direction of stock price movement,
magnitude of the stock price movement and stock price movement unit intervals.
The history sequence of the stock price is in fact, a sequence composed of these three
elements. As the stock price behavior is merely the result of the investor behavior,
any stock price sequence contains the aspirations and prospect values of the investor
community. In fact, stock price sequence constitutes the only basis for our
calculation of the stock price prospect values. Insofar as this is concerned, the use of
mathematical expectancy methodology by the standard financial theories to calculate
stock price expected values is totally unscientific.
Patterns of the stock price movement
Movement in stock price can be divided into three patterns. The first is the
pattern of continuity, which can be divided into upward continuous pattern and
downward continuous pattern. These two patterns can be sub-divided into certain
types. Any combination of two types of upward continuous pattern will result in a
brief stock price increase trend, Any combination of any type of upward continuous
pattern and downward continuous pattern will result in a brief stock price sequence
with variations in increase and decrease.
The second type is non-continuous pattern. Such pattern takes the form of
continuous pattern being disrupted, and its quantity is simply too numerous to be
counted. The third type is the independent pattern, and can be divided into upward
independent pattern and downward independent pattern. Each independent pattern
can be further broken down into certain types of categories. The same type of the
same or different independent pattern occurs with great frequency. In stock price
sequence, we often see continuous skyrocketing or nose-diving, and these are
manifestations of the continuous occurrence of the same or different types
independent patterns.
Studies performed by the present author indicates that any stock price sequence
11
is comprised of the above three patterns of combinations of their constituents. The
three patterns and their types in identical or different combinations can yield
constantly changing combinations, and this is the root cause of why the movement in
stock price is so capricious. Although changes in stock price are evolving all the
time, the rules constituting the constraints of their movement are rather simple, and
the patterns and types of their movement are also limited. In the Dow J ones
Industrial Average daily closure figures spread over a period of 102 years (involving a
total of 28500 turnover figures), around 12000 days of turnover figures belong to the
continuous pattern, representing 42% of the total. Approximately 15000 days of
turnover figures belong to the non-continuous pattern representing 53% of the total.
About 1500 days of turnover figures belong to the independent pattern making up 5%
of the total.
Rules governing stock price movement
The stock price movement follows certain rules. Normally, a 5-year-long stock
price historical sequence with the transaction day as the time interval contains all the
patterns of the stock price movement. All the historical sequences of the stocks all
over the world are composed of the same kind of the patterns of the stock price
movement.
Movement in stock price boils down to the result of investor decisions. As
investor decision matches individual aspirations and logic, the patterns of stock price
movement certainly matches human aspirations and logic. As a result, patterns of
stock price movement must necessarily fit in with human aspirations and logic. As
human aspirations are knowable and human logic itself means the following of
prescribed rules, the stock price changes according to certain rules of the game.
However, only when we truly understand how investors make decisions is it possible
for us to understand the rules governing the stock price movement.
The rules governing stock price movement are different from the nature rules
such as the accurate automatic rotation of the earth within 24 hours for one round.
They are logical rules with multiple ways of expression. Through analysis of stock
price sequences, we are fully capable of analyzing logical rules governing stock price
movement, in the same way as the understanding of the meaning (logic) of a sentence
through its analysis.
To properly analyze the logic associated with the analysis of stock price
12
movement is by no means an easy task. And to beat the market by utilizing the logic
linked with the analysis of stock price movement is even more difficult. The stock
price movement logic is expressed in multiple forms in the same way as we use
different sentences to express the same meaning (logic). For this reason, unless you
really understand the ways of expression of the logic associated with all stock price
movement, it is impossible for you to be sure to be able to beat the market.
The above discussion has, in fact, not taken into account the impact of
fundamental factors, which, if taken into consideration, would enable us to see that
the logic of stock price movement is invariably interrupted by the said fundamental
factors. Let us make a comparison, when someone is in the middle of talking, he is
abruptly interrupted, and so the logic of his flow of thoughts is put to a halt.
Consequently, to prevent the logic of your stock price movement from being affected
by fundamental factors, you must, beforehand, perform analysis on all possible
fundamental factors. This would mean that, unless you are both an expert at logical
analysis of the stock price movement plus an expert at the analysis of fundamental
factors, it is just impossible for you to be sure to be able to accurately understand the
stock price movement logic and ultimately beat the market.
Stock price behavior in the absence of external information interference
Due to the presence of thousands of investors in the stock market, the investor
behavior of pursuing profits has made the stock price fully covered with layers of
investor decision systems on any one timing point. Such a market does not entail
any lasting profitable opportunities at all. As the stock price is the most important
criterion determining the predilection of the investor and it consists of three elements,
viz. direction of stock price movement, magnitude of the stock price movement and
stock price movement unit intervals, change of any one of the foregoing three
elements could result in numerous investors experiencing change in their expectation
values. Change in the investor expectation values will give rise to change in the
investors decision. And change in the investors decision will in turn lead to new
change in the stock price. In this cycle of price change change in investor
expectation values change in investor decision new change in the stock price, in
the absence of influence exerted by the external information, the stock price will keep
on changing with the sole investors ideal is taken on board.
13
2.3 Inter-relationship between the investor behavior and stock price
behavior
Only on the basis of having obtained a scientific understanding of the investor
behavior and stock price behavior is it possible for us to understand the
interrelationship between the investor behavior and stock price behavior. With
respect to the interrelationship between the investor behavior and stock price behavior,
the focus of our concern should be laid squarely on the way the investor interprets the
stock price sequences.
First of all, it is incumbent upon us to comprehend the way of the intrinsic
prospect values on the part of the investment communities conveyed and expressed by
the stock price sequences. Such prospect values are not expressed through one unit
time stock price from the stock price sequence, but through a group of the stock prices.
Although our vision system enables us to observe the stock price sequence over a
rather extended period of time on the surface, we cannot deduce the prospect values
embodied in the stock price historical sequences.
Second of all, to calculate the expected values of the stock price sequence, one of
the prerequisites is that we must obtain a scientific understanding of the relationship
between the stock price sequence, unit time stock price and the expected price (or
return).
The relationship between the real-life historical stock price sequence, unit time
stock price and the expected price (or return) is just like the relationship between a
sentence, word and the meaning of the sentence. The word is the basic element of a
sentence, and a sentence is normally composed of several or a dozen words. The
sequence of each word in a sentence is of crucial importance to a sentence. To
understand the complete meaning of a sentence, we must observe the meaning of each
and every single word. At the same time, we must observe the sequencing of the
words making up the sentence along with the involved internal logic. We cannot
decipher the meaning or the associated logic of the entire sentence from the meaning
of a single constituent word. If you change the sequencing of the words in the
sentence, the meaning of the sentence would be changed, because you have changed
the logic of the involved sentence.
When we embark on the analysis of the prospect values of a stock price sequence,
we must, concurrently, take the sequence order of the stock prices comprising the
14
stock price sequence and the basic elements of One unit time stock price, viz.
direction of stock price movement, magnitude of the stock price movement and stock
price movement unit intervals into consideration. This is because, if the sequencing
of the stock price experiences changes, the prospect values of this sequence change
accordingly; if we change any one element out of the foregoing three elements, the
prospect values associated with the stock price sequence experience change
accordingly. That is to say, change in the stock price sequencing or change in any
one of the three elements at a given time interval could lead to alteration in the stock
price sequence prospect values.
The stock price at a given unit time represents but one single reference point of
the prospect values of the stock price sequence, and, as such, does not possess any
independent logical connotations. In recognition of this, it is impossible for us to use
the stock price of a given time interval to fully reflect the prospect values contained
in a stock price sequence. In fact, it is merely impossible for us to derive the
prospect values of the stock price sequence involved from one unit time stock price.
Lastly, at the time of the formation of the future stock price expected value, the
investor has three kinds of different expectation values. As a result, we need a
sufficiently long stock price sequence instead of a single group of stock prices to form
accurate expectancy of the future of the stock price. On average, to scientifically
observe the movement of a certain stock over a certain transaction day, we must, at
least, examine the daily data for the involved stock over the past 5 years.
To integrate the above research conclusions regarding the investor behavior, the
stock price behavior, the interrelationship between the investor behavior and stock
price behavior along with a combination with the stock pricing formula drawn up by
the present author, we are in a position to pass brief judgment on whether Efficient
Market Theory is scientific or not. In the sections that follow, the present writer will
use the basic elements of this particular analysis framework as terms of reference to
carry out a detailed comparative analysis on the theoretical models of EMT and the
basic elements making up EMT.
15
3 A Historical Perspective on EMT
3.1 Pre-history Stage Of EMT (1900 1965)
EMT can be traced back to the French mathematician Louis Bacheliers thesis
(1900) entitled Theory of Speculation. In the paper, Louis Bachelier, for the first
time ever, assumes that changes of the stock price from transaction to transaction are
independent, identically distributed random variables. He asserts that speculation
should be a fair game and the expected profits to the speculator should be zero.
Louis Bacheliers research means that the current stock price presented an unbiased
estimation of the future stock price. Unfortunately, Bacheliers research did not
arouse much attention at the time. Over 50 years later, his above-mentioned paper
caught the attention of the economists.
In the 1930s, research on stock and futures prices mainly include Cowles (1933),
Working (1934) and Cowles (1944). Through the study of the main financial
services companies and investment media of the time, Cowles finds that the best
financial institutions investment records and the best individual forecasting records
failed to demonstrate that they exhibited skill, and indicated that those records more
probably were results of chance. Cowles therefore conjectures that these financial
institutions relied on luck instead of competence or anticipating techniques to acquire
investment and anticipate results. At the same time, Security Analysis by Graham
and Dodd (1934) and Theory of Investment Value by Williamsg 1938 have
influenced countless financial analysts and economists. The concepts of intrinsic
value, fundamental value, discounting outlined in these two books have played a
crucial role in shaping EMT.
The British statistician Kendall (1953) after examined the behavior of the weekly
changes in time sequences associated with the cotton, wheat futures price and stock
price indexes, declares in his paper that changes in the price sequences placed under
scrutiny are independent, the observed price changes in those time series seem to be
approximately normally distributed, there is no hope of being able to predict the
behavior of these price changes for a week ahead without extraneous information.
Roberts (1959) appeals that use should be made of Kendalls statistical approach in
studying the behavior of the stock price.
On the basis of Louis Bachelier, Osborne (1959) had carried out a major revision
16
on the research target: the percent change in the stock price is no longer the target of
research. In its place is the change in log price. For the first time ever, Osborne
specified that common stock prices can be regards as an ensemble of decisions in
statistical equilibrium, with properties quite analogous to ensemble of particles in
statistical mechanics. He declares that the investor evaluates the stock on the basis
of the expected return, and the expected return is the weighted average of the sum of
all possible rates of return. Research work carried out by Osborne represents a
major milestone in the development of EMT. Close on the heels of Osborne
research, Larson (1960), Working (1960), Houthakker (1961), Alexander (1961),
Cootner (1962), Moore (1962), Granger and Morgenstern (1963) in succession,
published their respective papers supporting the assumption that the stock price
follows a random walk.
The Random Character of Stock Market Price by Cootner (1964) is a
collection of a full batch of papers constituting the foundation of EMT. At the same
time, the theory of Portfolio Selection by Markowitz (1952) specifies why the
diversification of investments could reduce risk. The Capital Assets Pricing Model
by Sharpe (1964) proceeds on the basis of Markowitz to specify how investors would
go about their investment activities if they were rational.
The research paper by Fama (1965) concerning stock price behavior wrapped up
the research results of all of his predecessors concerning the random walk model, and
provides new theoretical evidence for the theory of random walk. That paper
highlights inconsistencies between the actually observed statistics of the behavior of
the stock price and the predictions of the theory of random walk. For instance, the
distribution of daily price changes in a speculative series is not approximately normal,
and changes in the stock price sequences are not fully independent etc. For the first
time ever, Fama (1965, p. 35) brings up the concept of efficient market and defines
that the independence assumption of the random walk model could be accepted as
long as the independence in the series of successive price changes is not above some
minimum acceptable level. More specifically,
The independence assumption is an adequate description of reality as long as
the actual degree of dependence in the series of price changes is not sufficient to allow
the past history of the series to be used to predict the future in a way which makes
expected profits greater than they would be under a nave buy-and-hold model.
Some findings of the same period also identify that the stock price movement is
17
inconsistent with the random walk model as in the cases of Houthakker (1957),(1961),
Osborne (1962), Larson (1960), Cootner (1962), Steiger (1964). But these findings
did not receive adequate attention from the academic circle. Alexande (1961) was
subjected to query. Cowles (1960, p. 914) discoveries that:
A positive first-order serial correlation in the first difference has been disclosed
for every stock price series analyzed in which the intervals between successive
observations are less than four years.
However, such important statistical analysis conclusions did not receive the level
of attention from the academic circle that they deserved due to suspicion that there
could be statistical anomaly and that there would be no economic return after
deduction of the involved transaction cost. Another noteworthy figure is Kendall
(1953, p. 20-21) who writes that:
We get greater serial correlation in the averages than in the constituent series,
which at first sight seems absurd and in any case is very misleadingWhatever the
reason, the existence of these serial correlation in average series is rather disturbing.
Fama (1965) also mentions the foregoing paragraph. However, such important
finding again did not merit adequate attention.
3.2 Formation And Refinement Stage Of EMT (1965 1991)
Mandelbrot (1966) gives Efficient Market Hypothesis, a rigorous probability
foundation and provides explanations on the stock price behavior from an economics
standpoint. To give a defined economic justification on the capricious stock price
behavior, Samuelson (1965) paper entitled proof that properly anticipated prices
fluctuate randomly provides the same sort of demonstration in his thesis in relation
to the Martingale models: in an information-efficient market, if the stock prices are
properly anticipated, their changes will certainly not be forecast. This particular
thesis by P. A. Samuelson concerning commodity futures price behavior is generally
regarded as a milestone for the formation of Efficient Market Hypothesis. From then
on, Martingale models have taken the place of the random walk model for economists
to describe the stock price behavior.
Robertsg 1967divides EMH into three categories, viz. weak form, semi-strong
form and strong form.
Fama (1970) has brought together all the research results of his predecessors to
form the eventual Efficient Market Hypothesis. Fama (1970, p. 383-416) asserts:
18
We shall contend that there is no important evidence against the hypothesis in
the weak and semi-strong form testsand only limited evidence against the
hypothesis in the strong form testsin short, the evidence in support of the efficient
markets model is extensive, and (somewhat uniquely in economics) contradictory
evidence is sparse.
In the mean time, Markowitzs Portfolio Selection theory, Sharpes Capital Asset
Pricing Model, Rosssg 1976APT and Black-Scholesg 1973Option Pricing Model
have jointly formed the theoretical framework of studying the capital markets. The
emergence of EMT has provided staunch theoretical support to the foregoing models.
As such expressions as fully reflect and all available information by Fama
(1970) are too vague, it is imperative to provide specification when actually applying
them to the practical stock market to ensure that they are operable. In addition,
Fama (1970) theoretical deduction process is somehow linked to intentional setting of
the logical framework. To accurately test the efficient market validity, especially the
feature of fully reflecting all available information, financial scholars have
conducted a large amount of research work in this regard.
A decade after Samuelsons (1965) landmark paper, many others extended his
framework to allow for risk-averse investors, yielding a neoclassical version of the
EMT (for example, LeRoy (1973), Rubinstein (1976) and Lucas (1978). Malkiel
g 1973best-seller A Random Walk Down Wall Street has made it possible for
more people to accept the EMT.
Fama (1976a) serves to strengthen and reinforced the definition of EMT in Fama
(1970). J ensen (1978, p. 1) provides a succinct and practical definition of EMT and
asserts that:
I believe there is no other proposition in economics which has more solid
empirical evidence supporting it than the Efficient Market Hypothesis.
Grossman and Stiglitz (1980) advance a paradox. Grossman and Stiglitz (1980,
p. 404-405) argue that perfect informational efficient market is impossible. In view
of the paradox presented by Grossman and Stiglitz (1980), especially some research
conclusions showing enormous amounts of transactions in the stock market and the
observation of the irrational behavior of investors, it is hard to see proper coordination
with the EMT. Black provides an answer: Noise causes markets to be somewhat
inefficient. Black (1986, p. 533) also supplies a definition of EMT as follows:
We might define an efficient market as one in which price is within a factor of 2
19
of values, i.e., the price is more than half of value and less than twice value.
From the development history of EMT over this period of time, we can see that
the research work carried out by some scholars has possibly changed the fate of EMT.
For example, Niederhoffer and Osborne (1966, p. 897) identifies that:
The accurate record of stock market ticker prices displays striking properties of
dependenceafter two prices changes in the same directions, the odds in favor of a
continuation in that direction are almost twice as great as after two changes in
opposite directions.
Although their findings aroused some attention, they did not exert any impact on
the formation of EMT. As far as Fama is concerned, the type of dependence
uncovered does not imply market inefficiency.
Shiller (1981) research conclusion dealing with stock price volatility poses a
challenge of historic significance on EMT. DeBondt and Thaler (1985) took issue
with the correctness of EMT. The real heavy blow to EMT is the stock market crash
of 1987. From October 13 through October 19 of 1987, DJ IA falls from 2508 to
1739 with the stock price index witnessing a drop of nearly 31% within 4 full trading
days, which represent about 1 thousand billion US$ loss of all the US stocks.
Economists commented that there did not exist any tangible factor leading to 30%
fluctuations on the stock price.
9
Confronted with the above crude reality, EMT
theorists have had no alternative but maintain silence.
For some investors such as Warren Buffet, J ohn Templeton, J ohn Neff, Paul
Tudor J onesL , beating the market over the long-term is clearly contradictory with the
EMT. Samuelson (1989, p. 4-5) argues:
Those lucky money managers who happen in any period to beat the
comprehensive averages in total return seem primarily to have been merely
luckybroadly speaking, the case for efficient markets is a bit stronger in 1989 than
it was in 1974
However, for the first timeo he admits that:
On the whole, I side with Shiller and Modigliani and am prepared to doubt
Macro Market Efficiency.
Confronted with a large amount of evidence contradictory to EMT stemming
from theoretical study and empirical research, Fama (1991) makes major revisions on
9
Samuelson, Paul A. and Nordhaus, W., 1998, Economics, Chinese edition, Hua Xia Publishing House. See p.
395, comment by the Nobel laureate economist J ames Tobin of Yale University: to the effect that there does not
exist any tangible factors could cause stock value to change by 30%.
20
the definition of EMT and the descriptions of the three forms of the EMT. In view
of the paradox of Grossman and Stiglitz (1980), Fama (1991) lists a number of
prerequisites in support of the establishment of EMT.
He further incorporates J ensen (1978) definition into EMT. At the same time,
Fama (1991) revamps the weak-form test under Fama (1970) to tests for return
predictabilityo and changes semi-strong test into event studies, and strong-form test
into test for private information. Fama (1991, p. 1577) writes:
The empirical literature on efficiency and assert-pricing models passes the acid
test of scientific usefulness. It has changed our views about the behavior of returns,
across securities and time...the empirical work on market efficiency and assert-pricing
models has also changed the views and practices of market professionals.
To this point, revisions and refinement of EMT drew to a conclusion.
3.3 EMT At the Stage Of Decline ( 1991 Present)
With the emergence of a large number of Anomalies in the 1980s stock
market, CAPM could no longer provide rational explanations on them. Fama (1992),
(1993), (1996) abandoned his support for CAPM which he had adhered to for over
two decades. By that point, when mentioning market efficiency, economists no
longer referred to fundamental value efficiency and informational efficiency together.
They were, in fact, making references to informational efficiency.
In the 1990s, Behavioral Finance began to emerge in the financial academic
circle. Important research papers of this period include the following: J egadeesh and
Titman (1993), Lakonishok, Shleifer, and Vishny (1994), Shleifer and Vishny (1997)o
Barberis, Shleifer, and Wishny (1998), Hirshleifer, and Subramanyam (1998).
Lo and Mackinlay (1999) argue that the random walk hypothesis can be rejected.
Shiller (2000) gives a detailed analysis the behavior factors that lead to investment
bubbles. He argues that stock prices are to some extent predictable and that efficient
market hypothesis should be rejected.
In the face of the wave-like challenges to the EMT, Fama (1998, p. 284) writes:
It is time, however, to ask whether this literature, viewed as a whole, suggests
that efficiency should be discarded, my answer is a solid no.
He reiterates yet again:
Like all models, market efficiency (the hypothesis that prices fully reflect
available information) is a faulty description of price formation. But following the
21
standard scientific rule, market efficiency can only be replaced by a better specific
model of price formation, itself potentially rejected by empirical tests.
He further warns his opponents:
Any alternative model has a daunting task. It must specify biases in formation
processing that causes the same investors to under-react to some types of events and
over-react to others. The alternative must also explain the range of observed results
better than the simple market efficiency story.
The real lethal blow to EMT came when the irrational exuberance and the
Internet Stock Price Bubble emerged in the United States stock markets in the late
1990s. To make matters worse, one of the main proponents of EMT, Paul A.
Samuelson issued a statement through his personal correspondence to the effect that
the stock market is Micro Efficient but Macro Inefficiency. According to J ung
and Shiller (2002, p. 3), Samuelson argues:
Modern markets show considerable micro efficiency (for the reason that the
minority who spot aberrations from micro efficiency can make money form those
occurrences and, in doing so, they tend to wipe out any persistent inefficiency). In
no contradiction to the previous sentence, I had hypothesized considerable macro
inefficiency, in the sense of long waves in the time series of aggregation indexes of
security prices below and above various definitions of fundamental values.
Over the past 5 years, reports which continue to defend the EMT include
Rubinstein (2001), Schwert (2003), Malkiel (2003) and (2005). Although CAPM is
no longer held in high esteem, EMT has also somehow reached a dead end.
However, it should be noted that the hot Behavioral Finance also contains its own
inherent drawbacks, and cannot replace EMT as the new core of financial theories.
Currently, some scholars have already embarked on the coordination of EMT with
Behavioral Finance, such as Lo (2004) and (2005). Some scholars have proposed
New Finance as in the case of Haugen (1995) and (2003), Stout (2005). In addition,
some scholars are relatively pessimistic, such as Barberis and Thaler (2003, p. 61)
concludes:
We have two predictions about the outcome of direct tests of the assumptions of
economic models. First, we will find that most of our current theories, both rational
and behavioral, are wrong. Second, substantially better theories will emerge.
22
4 Analysis of Errors with The Theory of Random Walk
It can be clearly seen from the history of development of EMT that the theory of
random walk essentially represents the pioneering empirical study of EMT. From
this perspective, EMT is the theory of random walk duly tempered and rationalized by
the principles of economics. Although EMT does not necessarily mean that stock
price changes follow a random walk, if the stock price movement follows a random
walk, it follows that the market is efficient. According to Fama (1965, p. 34-35), the
random walk theory can be recaptured as follows:
The theory of random walk says the future path of the price level of a security is
no more predictable than the path of a series of cumulated random numbers. In
statistical terms the theory says that successive price changes are independent,
identically distributed random variables. Most simply this implies that the series of
price changes has no memory, that is, the past cannot be used to predict the future in
any meaningful wayThe theory of random walks in stock prices actually involves
two separate hypothesis: (1) successive price changes are independent, and (2) the
price changes confirm to some probability distribution
Fama (1965, p. 90-98) conclusion concerning the random walk theory:
The independence assumption of the random-walk model seems to be an
adequate description of realityit seems safe to say that this paper has presented
strong and voluminous evidence in favor of the random-walk hypothesis
Research performed by the present author indicates that Fama (1965) research
conclusions are entirely wrong. Errors with the random walk theory also include
cognitive errors and mistaken research methodology.
4.1 Mistakes with perception
First of all, the theorists of random walk wrongly judge the nature of the stock
price behavior.
The only similarity between a real-life stock price sequence and a random time
sequence is that they change with the passage of time.
In the random time sequences of turning gear, throwing dice and random card
dealing along with particle movement in the micro world, past, present and future do
not have any particular meaning. As any one of the historical sequences of the stock
price embodies human aspirations, it enables the historical sequences of the stock
23
price to contain the time arrow aimed at the future.
In addition, the stock price movement sequences also contain the prospect values
of the investment community. Such intrinsic prospect values are not expressed
through one unit time stock price from the stock price sequence, but through a group
of the stock prices. Consequently, the random walk model assumes that successive
changes of the stock price are mutually independent is simply not fit for describing
the stock price sequences.
Because of the reason that any random time sequences or emulation stock price
sequences cannot embody the two elements of the investor prospect values and
investor community collective aspirations. Consequently, any random time
sequences or emulation stock price sequences is not fit for describing or
approximating the stock price historical sequences. This means that any models
describing the random time sequences or emulation stock price sequences are not fit
for describing the real-life stock price sequences. But in the eyes of the scholars of
the time, the historical price sequence behavior on the part of a particular stock is no
different from that of the random time sequence of throwing dices and dealing cards
or molecular particles movement in the micro world.
Second of all, the theorists of random walk wrongly judge the very nature of the
stock market.
On the surface, the stock price behavior appears to be determined by the
capricious psyche of the market. To the mind of the random walk theorists, stock
price movement is very much like the footprints left behind by a drunkard with no
logic to speak of. In other words, stock price movement is comparable to the digits
of the gambling table with no memory capacity at all. In recognition of this, stock
price movement follows no defined rules. Stock market is akin to a gambling house.
But, in actual fact, stock market is not a gambling house. Rather, it is the venue
where investors harbor their dreams and aspirations. The rising trend in the stock
market price points to the same ideal direction of the investors. It goes without
saying that the stock market is not a balanced static market. Rather, it is a dynamic
market that is constantly evolving towards the direction of hope and aspirations for
the investors. The ideal market is not an assumed or virtual one. It is the ultimate
objective of present stock market.
24
4.2 Erroneous research methodology
The theorists of random walk have chosen the wrong research direction and
inappropriate research target analysis of the stock price behavior from probability
distribution angle boils down to statistical behavior of the stock price. Percent
changes of the stock price or changes in log price of the stocks become the research
object.
Irrespective of Bachiler, Osborne or Fama, they are all engaged only in studying
the statistical behavior of the stock price to the total neglect of the three principal
elements, viz. direction of the stock price movement (rise and fall), the magnitude of
the stock price movement and the unit time of the stock price movement. This has
not come about abruptly, and should be attributed to the fact that, irrespective of
Bachiler or the contemporary scholars, they all hope to be able to formulate a full set
of mathematical statistical models to accurately capture the speculative price
behavior.
And standard statistical techniques are the tools with which to make the
foregoing dreams come true. However, in order to apply the standard statistical
techniques to the analysis of the behavior of the time sequence of the stock price,
people must assume that the behavior of the time sequence of the stock price has the
same statistical nature as the behavior of a random time sequence. That is because
the target of such standard statistical techniques must be independent and identically
distributed variables. If the successive price changes are independent, and
identically distributed variables, then when the amount of the stock price sequence is
big enough, the Central-Limit theory will leads us to expect that price changes will
have normal distributions.
Substantial studies carried out in the 1960s demonstrate that stock price
statistical behavior is inconsistent with the scholars assumptions. Such studies
demonstrate that price changes do not conform to normal distributions. If the stock
rate of return is not normally distributed or approximation to normal distribution,
standard statistical analysis tools, such as serial correlation analysis, will give
misleading answers. Scholars assume that the stock price follows a random walk,
25
and such assertion is very much in doubt.
Since two reasons have created the situation whereby the statistical behavior of
the stock price and the stock rate of return are not fit for the research direction and
target.
First, The overwhelming majority of the people (with the notable exception of a
very small minority who have received very good professional training) are not used
to conduct their thinking on the basis of probabilistic distribution. The human brains
are not used to calculation on the basis of percentile figures. The overwhelming
majority of the people will have the mistaken impressions, viz. stock price movement
sequences are of the same statistical nature as the gambler games in terms of random
time sequence.
Second, Each and every investor only focuses his attention on the stock price
point. And the stock market is concerned about the price zone of the entire stock
market. From an analysis technique point of view, we can use stock price point and
stock price zone as a combination for calculating the expected stock price. But it is
very hard, if not impossible, for us to set a sort of reasonable zone for the rate of
return of the stock price, and then integrate it into the calculation of the expected
return. Even if we preset a reasonable zone for the stock rate of return, that would
result in misguided conclusions of the standard statistical tests of the data.
Based on the above conclusions, we can say with certainty that, in analyzing the
stock price statistical behavior, by using the standard statistical analysis tools, we will
be able to arrive at the misguided conclusions. For instance, when we use run
tests
10
to test dependence of the stock rate of return, the results would be major
deviations or totally misguided conclusions. In actual reality, Fama (1965), (1966)
mentions such run tests maybe resulting in mistaken conclusions on two occasions.
Specifically, Fama (1965, p. 80) writes:
There are situations in which they do not provide an adequate test of either
practical or statistical dependencethe run tests are much too rigid in their approach
to determining the duration of an upward and downward movements in prices. In
particular, a run is terminated whenever there is a change in sign in the sequence of
prices changes, regardless of the size of the price changes that causes the change of
the signit is possible, however, that price changes are dependent only in special
conditions.
10
According to Fama (1965): A run is defined as a sequence of price changes of the same sign.
26
4.3 Root cause analysis
The main reason contributing to errors with the random walk theory is that the
theorists simply lacked systematic study of the actual investor behavior.
For instance, According to Campbell, Lo and Mackinlay (1997), the simplest
random walk model can be written as the following equation:
t
t t P P + + = 1 , , (1) ) , 0 ( ~
2
IID
t
(Where is the expected price changes or drift, and denotes that ) , 0 ( ~
2
IID
t
t
is independently and identically distributed with mean 0 and variance .)
2
) (
1 , + t j
P E
t
From the above cause analysis, we can clearly see that the left side of the
formula
)
~
( 1 , t t j p E +
is obviously absurd. The right side of the formula
[ )]
~
( 1 , t t j r E +
is also absurd for the same reason. Consequently, the Fair Game
model
[ ] jt t t j t t j p r E p E )
~
( 1 )
~
( 1 , 1 , + = + +
is not fit for describing the stock price behavior. Nor is it fit for describing the
interrelationship between the investor behavior and stock price behavior.
31
The Martingale models
jt t t j
p p E =
+
)
~
(
1 ,
and
jt t t j
p p E >
+
)
~
(
1 ,
(3)
Due to the same reasons as illustrated above, the Martingale and Sub-Martingale
Models are also not suited to be used to describe the stock price behavior.
In light of the brief history of EMT, we can see that, because of Samuelson
(1965), Martingale models have replaced the random walk model as the theoretical
models of EMT. Additionally, because of Samuelson (1973), Martingale models are
regarded as equivalent to the expected present-value model. Regrettably, due to the
following three reasons, irrespective of Samuelson (1965) or Samuelson (1973), the
conclusions are, without exception, unscientific.
(i) To construct a stock price behavior model, we have to describe the investor
behavior. The reason is that the stock price behavior is but the outcome of the
investor behavior. Should we fail to scientifically describe the investor behavior, it
would be impossible for us to construct a scientific stock price behavior model. In
section 2, the present paper has already listed out the basic elements required of the
investor to scientifically describe the investor behavior. If these elements are
compared against the investor behavior assumed by Samuelson (1965) and Samuelson
(1973), we can easily find out that, irrespective of the investor behavior assumed by
Samuelson (1965) or Samuelson (1973), they are totally absurd descriptions of the
actual investors behavior.
(ii) The expected-present-value model itself is not a scientific one. It is
unscientific because it wrongly regards discounting
13
as the basic approach which
investor uses in predicting the future stock price. In Section 2, the present paper has
already stated that the investor relies on three basic approaches in anticipating the
future stock price behavior. In reality, discounting is not a basic approach used by
the investor to predict the future stock price in any way. It is only an empirical
methodology derived from the foregoing three approaches. Special attention should
be made of the fact that discounting approach should not be used separately from
13
In the Malkiels famous book A Random Walk down the Wall Street, Malkiel, one of the outstanding advocates
of EMT has provided an objective and accurate description of the concept of discounting drawn up by Williams.
32
the three basic modes of investor expectations in the stock market. Although
discounting as an approach is widely used in the pricing of bonds, it would be
entirely wrong to use it as a basic approach for pricing the price of stocks. The
reason is pure and simple: fundamentally speaking, stocks and bonds are of entirely
different nature.
14
In addition, the process of stock price formation is totally
different from that of the bonds.
(iii) The definition of investor being risk-neutral is far from scientific. It is
well known to all that such definition exerts direct bearing on the modes of
expectation of the future on the part of the investor. As the standard financial
theories assume that the investor relies upon mathematical expectation to calculate
future returns, such critical assumption is totally inconsistent with the patterns of
anticipation of the future on the part of the actual investor. Consequently, definition
of the attitude towards risks on the part of the investor, such as risk neutral or
risk-averse etc. do not really possesses any scientific content. In other words, the
definition of being risk neutral or risk-averse on the part of the investor is actually an
unscientific description of the actual risk neutral or risk-averse attitudes on the part of
the investor.
If economists proceed from the Samuelson (1965) and (1973) research to rewrite
the EMT model as a model relates the current stock price to its expected present value,
and use it to validate EMT, economists will inevitably reach unscientific conclusions,
as in the case of Shiller (1981b).
15
The reason is as follows:
Firstly, martingale models are not at all fit for use in describing the stock price
behavior. Secondly, Samuelson (1965) and (1973) research conclusions are
unscientific. Lastly, The expected-present-value model is itself unscientific. We
cannot expect to have the model based on the integration of the above three
unscientific elements to bring about really scientific conclusions for us.
In addition, as there is no inherent linkage between EMT and the Martingale
models, it is impossible for us to pass any correct judgment on whether EMT is
scientific or not by merely relying on Martingale models or on empirical validation
conclusions on the foregoing model.
To sum up the analysis conclusions of the above fair game model and Martingale
models, we can see that, irrespective of Martingale models or fair game model, they
14
Due to limitation of the subject matter and space, it is impossible to dwell on the vastly different subjects of
stocks and bonds in this context.
15
Shiller (1981b) had used this particular model to validate the EMT, his research conclusions had not been
accepted by EMT theorists.
33
simply cannot scientifically describe and explain the interrelationship between the
actual investor behavior and stock price behavior. Consequently, irrespective of
Samuelson (1965), Mandelbrot (1966) or Fama (1970) theoretical models, they are all
not appropriate for use in describing the stock price behavior.
5.3 Assumptions and Theoretical Basis for EMT
Hypothetical conditions for EMT
Martingale Models and Fair Game model could be feasible in the ideal world of
EMT theorists for the reason that these models are predicated on a series of
assumptions that simply could not stand in real-life situations. The importance of
such series of assumptions is akin to the role of the wand to the magician during a
typical performance.
Samuelson (1965) conclusion is dependent upon the following major
assumptions: the rate of return associated with the stock is a random variant, the
investor thinks on the basis of probability distribution, and the investor anticipates the
expected price on the basis of mathematical expectations. The investors are
risk-neutral, etc.
Mandelbrot (1966) conclusion is depend upon the following core assumption:
stock price or rate of return is a random variant, stock market price movement evolves
around the intrinsic value, viz. the stock has its own unique intrinsic value. The
investor uses mathematic expectations to predict future stock price.
Fama (1970, p. 384-387) assumes that:
The conditions of market equilibrium can (somehow) be stated in terms of
expected returns(i) the conditions of market equilibrium can be stated in terms of
expected returns, and (ii) the information
t
= RET RET
of
(6)
Through replacement, we can obtain the following pricing formula in the
efficient market:
= RET RET
of
(7)
Such equation effectively tells us that, current prices in a financial market will be set
so that the optimal forecast of a securitys return using all available information
equals the securitys equilibrium price.
In the above formulao represents the expected price. stands for the
optimal expected price with all the market information taken into full account.
e
t
P
1 +
of
t
P
1 +
e
RET
is the expected rate of return.
of
RET is the best possible rate of return with all the
available market information taken into full account.
Malkiels three papers are as follows: Malkiel (2003), Passive investment strategies and Efficient Markets,
European Financial Management, Vol. 9, NO. 1, 1-10, Malkiel (2005), Reflections on the Efficient Market
Hypothesis: 30 Years later, The Financial Review 40, 1-9, and Malkiel (2003), The Efficient Market Hypothesis
and its critics, CEPS working paper, NO. 91. Princeton University.
65
with a majority of other economists, performance on the part of investors who have
consistently obtained abnormal returns does not mean that they have relied on sheer
luck. Rather, they have depended upon their knowledge of the stock market and
investment techniques.
Research conducted by the present writer indicates that, if an investor can
provide scientific description of the actual investor behavior, he will then stand a 20%
chance of being able to obtain abnormal returns on a continuing basis. If an investor
can provide a scientific description of the actual investor behavior and stock price
behavior, he will then have a 40% chance of being able to obtain abnormal returns on
a consistent basis. If an investor can not only provide a scientific description of the
actual investor and stock price behavior, but also define the interrelationship between
the actual investor behavior and stock price behavior, he will then stand a 60% chance
of being able to attain abnormal returns on an on-going basis. If an investor can not
only provide a scientific description of the actual investor and stock price behavior,
but also define the interrelationship between the actual investor behavior and stock
price behavior, and, at the same time, he has a scientific understanding of the stock
pricing process, he will then stand a 80% chance of being able to attain abnormal
returns on an on-going basis.
Lastly, the present writer has paid special attention to deciphering the works by
the great investment guru W. D. Gann.
42
W. D. Ganns work demonstrates beyond
any shred of doubt that W. D. Gann has not relied on luck to emerge successful during
his illustrious 50-yeaer career in the Wall Street. Rather, he has depended upon his
professional expertise and transaction techniques accumulated and matured over 50
years of practice in the Wall Street. W.D. Gann has not only been able to provide
scientific description of the investor behavior and stock price behavior, but also
provided scientific representations of the mutual relationship between the actual
investor behavior and stock price behavior. At the same time, this great investor has
had highly scientific insights into the process of stock price formation.
The present writer has also gone through and studied almost all the famous
writings and speeches delivered by George Soros since 1987. George Soros writings
and speeches tell us in a crystal-clear way that, like the great investment guru W. D.
Gann, George Soros not only can provide a scientific description of the actual investor
behavior and stock price behavior, but also can describe the mutual relationship
42
Concerning introduction to W. D. Gann works, please visit www.wdgann.com for details.
66
between the actual investor behavior and stock price behavior in a scientific fashion.
At the same time, this great investor has obtained a thoroughly scientific
understanding of the process of the stock pricing. It goes without saying, therefore,
that George Soros has not relied upon luck and instincts in achieving successes to date.
It should be noted that, these successful investors place emphases on different time
interval of the stock price behavior. In the case of W. D. Gann, his focus has been
laid on the short-term stock price behavior. In the case of George Soros, the main
point of attention has been the middle-term stock price behavior. In the case of
Warren Buffet, the main concern has been the long-term stock price behavior.
Knowledge and techniques on the part of the successful investor can be
duplicated and transferred
Research work conducted by the present writer has shown that the knowledge
and techniques possessed by these successful investors, like other forms of human
knowledge and technology, can be duplicated and transferred. Regrettably,
irrespective of W. D. Gann or George Soros or any other successful investors, they are
simply not willing to systematically and succinctly make their investment knowledge
known to all. As the investors investment techniques are formed on the basis of the
investment knowledge, insofar as the transfer of their investment knowledge is
concerned, it would be a lot harder for the investors to transfer investment techniques
to posterity.
Investors knowledge may be regarded as a group of schemas
43
or models.
These schemas represent the summary and distillation of the rules governing the
stock market behavior (including the investor behavior and stock price behavior) as
well as interactions between the investor and the market. The investors schemas
mainly cover three aspects: schemas description of the stock market behavior,
schemas forecast of the future stock market behavior and schemas rules of the
investors themselves. Investors investment techniques are actually based on these
schemas whereby specific circumstances of the real-life stock market are integrated
to form the proper investment strategies.
Obviously, if the investor is willing, their schemas may be very easily transferred
to other investors for the simple reason that these schemas are summaries of general
43
For detailed explanations on schema, please refer to Murrey Gell-Manns famous book Quake and J aguar
Rendezvous of Simplicity and Complexity. See Chapters 2 and 3.
67
rules of investor knowledge. This is very much like a world chess champion
transferring knowledge to a young chess player. However, if an investor is to
transfer investment techniques to a green hand, the task becomes much harder. The
reason is that, in the event of an investor wishing to transfer his/her investment
insights to a green hand, he/she must help the green hand to establish an investment
technique system that suits his/her own individual characteristics. That is to say, the
investor shall use his own investment knowledge, viz. schema-based knowledge, to
present and demonstrate to the green hand how to apply the schemas to the actual
stock market with the actual stock market information taken into full account.
Through such practical demonstrations and transactions in relation to the green hand,
the green hand will be able to form his unique investment technique system.
This is very much like a world chess champion coaching the young chess player
through actual chess games played. A new chess player needs to skillfully master at
least tens of thousands of actual chess games before he is able to reach the level of a
world champion. In the case of investor coaching, an investors investment
techniques must be practiced hands-on thousands upon thousands of times before
turning into a full-fledged investor in his own right. During the process, good
investment strategies are upgraded and retained, whereas shoddy ones are discarded
or refined. Undoubtedly, if an investor wishes to transfer his investment techniques
to a green hand, he will exert major efforts in terms of time and money.
For reasons known to all, it is extremely difficult for us to find a successful
investor who is ready and willing to expend large amounts of time and energy to
transfer his own investment techniques to a green hand. We can, however, envision
the following scene: almost every successful investor is ready to spend vast amounts
of time and energy transferring his know-how to the investors all over the world
through publishing their writings, although writings by many a successful investor
are notoriously obscure and hard to follow, such as the writings of W. D. Gann and
George Soros.
By summing up the above conclusions, we can see that the investment
performance on the part of successful investors has not come from sheer luck.
Rather, they owe their success to their knowledge and technology. The knowledge
and techniques on the part of the successful investors can be duplicated and
transplanted. However, for reasons known to all, not a single successful investor
has been willing to transfer his own unique investment techniques.
68
7.2 Fama (1998)
Fama (1998, p. 25) concludes:
The recent finance literature seems to produce many long-term return anomalies.
Subjected to scrutiny, however, the evidence does not suggest that market efficiency
should not be abandoned. Consistent with the market efficiency hypothesis that the
anomalies are chance results, apparent overreaction of stock prices to information is
about as common as under-reactionmost important, the long-term return anomalies
are fragile. They tend to disappear with reasonable changes in the way they are
measured.
In this section, the present writer will use his research achievements as basis to
perform a comparative analysis between two groups of Behavioral Finance Scholars
research findings which listed in Famag 1998and Famas research conclusions.
Research findings by the behavioral finance scholars
DeBondt and Thaler (1985) find that when stocks are ranked on 3- to 5-year past
returns, past winners tend to be future losers, and vice versa. They attribute these
long-term return reversals to investor over-reaction. J egadeesh and Titman (1993)
find that stocks with high returns over the past year tend to have high returns over the
following three to six months. They attribute this to the momentum effect.
Fama (1998) research conclusions
Confronted with the challenge of the above behaviorist financiers, Fama (1998, p.
5) asserts that:
The market efficiency hypothesis offers a simple answer to this
question---Chance. Specifically, the expected value of abnormal return is zero.
But chance generates apparent anomalies that split randomly between over-reaction
and under-reaction.
Viewpoints of the present writer
Research performed by the present author has demonstrated that:
First of all, the stock price patterns identified by DeBondt and Thaler (1985) and
69
J egadeesh and Titman (1993) exist in large quantities in any stock market.
Irrespective of DeBondt and Thaler (1985) findings or J egadeesh and Titman (1993)
findings, we can easily observe them in actual stock markets, so they are not chance
results as asserted by Fama (1998). However, their findings must undergo the
process of scientific systemization before application to the stock market by the
investor.
Second of all, it is not really difficult to provide reasonable explanations on the
DeBondt and Thaler (1985) and J egadeesh and Titman (1993) findings if we have a
scientific stock pricing model which could describe accurately the actual stock price
behavior.
Lastly, J egadeesh and Titman (1993) findings and DeBondt and Thaler (1985)
findings are not the same thing.
J egadeesh and Titman (1993) findings are that, insofar as the fundamental factors
are not taken into account, the stock expected value can be put into the picture. In
other words, the stock provides possible tips on the future stock price movement.
Therefore, their findings are not a stock price movement pattern. J egadeesh and
Titman (1993) findings also exist in masse in the annual, quarterly, monthly, weekly
and daily historical figures associated with the stock price.
The finding by DeBondt and Thaler (1985) represents a kind of stock price
patterns that have not gone through the scientific and systematic process. Such stock
price pattern not only exists in the annualized stock price figures, but also exist in the
quarterly, monthly, weekly and daily price figures. Such stock price pattern along
with the follow-on stock price change exhibits a very important feature, which, to put
it in simple terms, if a real-life stock price sequence contains such a pattern, then the
possibility of the follow-on stock price movement in the reverse direction stands at
80%.
Regrettably, their explanations of such significant findings are wrong.
44
As the
behavioral finance essentially continues to use the standard financial theories
analysis frameworks, and the standard financial theories along with their analysis
frameworks are unfortunately unscientific, the above-mentioned scholars just cannot
provide any scientific explanations on the stock behavior that they have observed.
Because of the same reason, it is not difficult for us to comprehend why Michaely,
Thaler and Womack (1995, p. 606) writes:
44
For a better understanding of the unscientific nature of Behavioral Finance, please refer to the present writers
paper On the Investor Behavior and Stock Price Behavior.
70
We hope future research will help us understand why the market appears to
overreact in some circumstances and under-react in others.
Commentary
In Fama (1991, p. 1577), Fama proclaims that:
The market efficiency literature should be judge on how it improves our ability
to describe the time-series and cross-section behavior of security
returnsNevertheless, judge on how it has improved our understanding of the
behavior of security returns, the past research on market efficiency is among the most
successful in empirical economics, with good prospects to remain so in the future.
If the above criterion regarding evaluation of EMT is used to assess Fama (1998)
conclusions, then the conclusion can only be that EMT not only fails to strengthen our
understanding of the actual stock price behavior, but also misleads us. Explanations
from Fama (1998) are entirely wrong.
7.3 Malkiel (2003) and (2005)
Malkiel (2003, p. 2) writes the following:
Indexing is a sensible strategy because our security markets appear to be
remarkably efficient in digesting and adjusting to new information.
Malkiel (2005, p. 2) writes that
The strongest evidence suggesting that markets are generally quite efficient is
that professional investors do not beat the marketIf prices were often irrational and
if market returns were as predictable as some critics of the efficient market hypothesis
believe, than surely actively managed investment funds should easily be able to
outdistance a passive index that simply buys and holds the market portfolio.
In this sub-section, the present writer will make a brief commentary on Malkiel
(2003) and (2005) viewpoints.
Commentary on Malkiel (2003) research conclusions
The fact that Malkiel (2003) conclusions are rational is predicated on a crucial
assumption: the stock market is efficient.
From the past to the present time, performance on the part of an overwhelming
71
majority of institutional and individual investors have indeed never been able to beat
the stock price index. The indexing strategy derived from the conclusions of EMT
and CAPM. Research by the financial academic circle within the past 30 years has
proven that indexing strategy is a useful investment strategy. However, as the
present writer has elaborated earlier, the random walk model and EMT are all
mistaken theories. Consequently, the assumptions associated with Malkiel
conclusions are simply not feasible. As a result, conclusions drawn by Malkiel are
unacceptable. Obviously, the indexing strategy is a useful investment strategy not
because that the market is efficient, but for other reasons.
As EMT analysis framework is unscientific, EMT theorists inevitably had errors
with their cognition of the situation. They have regarded indexing as the only
rational investment strategy available to the investor. As a result, the indexing
strategy has been over-used to the extreme. A simple fact is that, irrespective of the
past or the present, as long as the market is one of real-life stock market including the
burgeoning stock market in China, indexing is certainly a useful strategy.
Indexing is a useful investment strategy for the investor is because of the
following reason. Currently, any one of the stock markets is slowly evolving
towards the human idealized stock market. Irrespective of the burgeoning stock
market in China or the matured US stock markets with a history of over 100 years or
the European stock markets, we can clearly identify plenty of evidence pointing to the
stock index rising rather than falling. As all stock markets embody human
aspirations to dash towards the ideal stock market of the investors, in the distant
future, the stock price rising more than falling would become a model of only rising
and never falling. The investor aspirations inherent in the stock markets all over the
world make the stock price rising more than falling and this would lead to the
situation where indexing strategy would be a useful investment strategy.
However, indexing strategy is not the optimal investment strategy, and far from
the only scientific investment strategy, the reason is that, although all stock markets
evolve towards human aspirations, the velocity of such evolution is really too slow,
with wild ups and downs in the process. To illustrate with the J apanese stock market
as a case in point, since its peak in 1990, the market has stayed at a trend of decline.
In 2003, the J apanese stock market began to rebound and rise. If the investor had
applied the indexing strategy to invest in the J apanese market in 1990, his loss could
have been enormous.
72
Commentary on Malkiel (2005) research conclusions
Malkiel (2005) correctly pointed out that professional investment managers
could outperformed their index benchmarks in a period of 4 years when return is
measured over a time-interval of 10 years, over 80% of active managers are
outperformed by the index. When returns are measured over a period of 30 years,
few active managers could outperform the index.
First and foremost, plausibility of Malkiel (2005) conclusion is predicated on one
critical assumption to the effect that stock price movements approximate those of a
random walk. Earlier, the present writer has already discussed that the random walk
theory and EMT are both mistaken theories. As Malkiels assumption cannot stand,
his conclusions are unacceptable as well.
Under the following two scenarios, the stock market (index) is unbeatable: firstly,
stock price movement is real random sequencing. As a famous scholar once put it,
the randomness could be defined as invincible. This accounted for the root cause of
the earnings of the insurance company and the gambling houses. Secondly, the
stock price only increased and never decreased. Under such two scenarios, the best
strategy on the part of the investor is buy and hold low-cost broad-based index fund
that holds all the stocks comprising the market portfolio, or resorting to the passive
management. That is to say, only when the stock market approaches the nearly
idealized state (the stock price only increased and never decreased) or the stock price
sequence is of the real random time sequence, the market is invincible. So the best
policy for the investor is to buy and hold. But the actual stock price behavior is just
inconsistent with the definitions of random walk model and EMT. Currently, the
stock price experiences both rises and falls. In recognition of this, irrespective of
theory or practice, we can beat the real-life stock markets. Warren Buffet and
George Soros are best test cases.
Secondly, Malkiel (2005) interprets the statistical results of fund investment
returns as evidence supporting EMT. Such practice is clearly unacceptable. The
reason is that he has ignored a critical question, viz. the physiological limit of human
foresight of the future. Theoretically speaking, a person can only form the
expectations of the future stock price of any statistical significance less than 7 unit
time. In real-life situations, as the market is filled with mutually contradictory
information, a person can normally form the expectations of the future stock price of
73
any real statistical significance covering 1-3 unit time. The performance of the fund
manager is predicated on his expectations of the future trend of the stock price
movement. Unfortunately, the fund manager is not God, and he normally could only
provide expectations of the future stock price of any real statistical significance valid
for 1-3 unit time. Specifically, Mutual and pension funds own about half of all
equities and account for an even larger percentage of all trading. It would hardly be
surprising that institutions on average fail to beat the market when they very nearly
are the market. (Lynn A. Stout, 2005). Consequently, we can easily understand why
the fund manager can beat the market (index) within 1-3 years, but invariably finds it
difficult to beat the market (index) within 10-30 years.
The time gaps for Malkiel (2005) statistical results are 10 and 30 years.
Obviously, such gaps have far exceeded the physiological limits of human brains.
On the crucial question of which time gap should be adopted to measure up the fund
managers investment performance, EMT theorists have simply not given any slight
consideration of the very existence of limits for human brains.
7.4 Malkiel (2003)
Malkiel (2003, p. 34) makes the following summarys
The market cannot be perfectly efficient or there would be no incentive for professionals to
uncover the information that gets so quickly reflected in the market prices, a point stressed by
Grossman and Stiglitz (1980)Periods such as 1999 where bubbles seem to have existed at
least in certain sectors of the market, are fortunately the exception rather than the rule. Moreover,
whatever patterns or irrationalities in the pricing of individual stocks that have been discovered in
a search of historical experience are unlikely to persist and will not provide investors with a
method to obtain extraordinary return.
Concerning Grossman and Stiglitz (1980)
45
This paper is by far the most influential among the series of papers by Grossman
and Stiglitz dealing with the stock market. Grossman and Stiglitz (1980, p. 404-405)
correctly points out the inherent inconsistencies in terms of logical deduction with the
45
According to Grossman and Stiglitz (1980), the authors intentions are as follows: We are attempting to redefine
the Efficient Market notion, not destroy it. In Grossman and Stiglitz (1982), the two authors stated the purpose
of the paper as follows: The goal of our paper was to show that when information is costly, a perfectly
competitive equilibrium will not exist which completely transmits the informed traders information to uniformed
traders.
74
EMH:
We show that when the efficient markets hypothesis is true and information is
costly, competitive markets break downBecause information is costly, prices cannot
perfect reflect the information which is available, since if it did, those who spent
resources to obtain it would receive no compensation. There is a fundamental
conflict between the efficiency with which market spread information and the
incentives to acquire information
EMH advocates almost unthinkingly transplants the conclusions of the above
paper to EMH. For example, Fama (1991, p. 1575) writes the following:
A precondition for this strong version of the hypothesis is that information and
costs, the costs of getting prices to reflect information, are always 0 (Grossman and
Stiglitz (1980))Since there are surely positive information and trading costs, the
extreme version of the market efficiency hypothesis is surely false.
Now the issue is: although Grossman and Stiglitz (1980) theoretically pointed
out that it is impossible for perfect efficient markets to exist, Grossman and Stiglitz
(1980, p. 393) outlines the stock market status and the relationship between investor
behavior and stock price behavior under this particular stock market status in the
following manner:
There is an equilibrium degree of disequilibrium: prices reflect the information
of informed individuals (arbitrageurs) but only partially, so that those who expend
resources to obtain information do receive compensationprices perform a
well-articulated role in conveying information from the informed to the
uniformedthus the price system makes publicly available the information obtained
by the informed individuals to the uniformed. In general, however, it does this
imperfectly; this is perhaps lucky, for were it to do it perfectly, an equilibrium could
not exist.
Is the above description a close approximation of the actual stock market realities?
And the more crucial issue is that: is it possible for the stock market status described
in Grossman and Stiglitz (1980) to provide substantive support to the efficient
market theorists new assertion that the stock market is just remarkably efficient?
Research work performed by the present author demonstrates that, unfortunately,
the answers to the above two issues are negative.
As the paper lacks scientific understanding of the actual investor behavior and
stock price behavior along with the interrelationship between both, plus the lack of
75
scientific content in the basic elements of the other analysis frameworks (such as
equilibrium and Rational Expectations etc.), the stock market status described by
Grossman and Stiglitz (1980) in terms of competitive equilibrium and the
interrelationship between the investor behavior and stock price behavior under this
particular status is far from a rational approximation of the stock market realities. In
fact, the stock market status and the interrelationship between the investor behavior
and stock price behavior under this particular status is a totally absurd description of
the actual stock market realities.
To provide a scientific description of the actual stock market status, we must
meet the following three conditions. The first condition is that we must be able to
perform a scientific description of the actual investor behavior and stock price
behavior along with their mutual interrelationship. The second condition is that we
must be able to have a scientific understanding of the stock pricing process in the
stock market. The third condition is that we must have a scientific understanding of
the nature of the stock market. As a matter of fact, only by meeting all of the
foregoing three conditions is it possible for us to provide a scientific description and
explanation of the actual stock market status and the interrelationship between the
investor behavior and stock price behavior under actual stock market status.
First of all, we need to examine whether Grossman and Stiglitz (1980) can
scientifically describe the investor behavior.
In Grossman and Stiglitz (1980), investors are divided into two categories, viz.
one the informed trader and another the uninformed trader. According to Sanford
Grossman (1976, p. 573):
Informed traders learn the true underlying probability distribution which
generates a future price, and they take a position on the market based on this
information, and chances are that uninformed traders invest no resources in collecting
information, although they know that current prices reflect the information of
informed traders. Uniformed traders form their beliefs about a future price from the
information of informed traders which they gather from observing current prices.
If we compare the above description with the description in Section 2 concerning
the actual investor behaviour, we can easily identify that, irrespective of the informed
trader or uninformed trader, their actions are not scientific descriptions of the actual
investor behaviour. In the said paper, the investor is assumed to have Rational
Expectations. In Section 6 of this paper, the present writer has already stated that the
76
theory of Rational Expectations is not a scientific theory. Besides, in the paper, the
investor is assumed to be the price taker. In reality, the investor is not only a price
taker, but also a price shaper.
46
The authors of the paper has used the traditional
economic analysis practice to assume that the investor is only the price taker is not
only unscientific, but also has made it impossible for us to understand the relationship
between the investor behavior and stock price behavior in the stock market.
Obviously, the investor behavior portrayed by the paper is totally inconsistent with
that of the actual investor.
Second of all, let us examine whether the paper can be used to scientifically
capture the relationship between the investor behavior and stock price behavior.
In the eyes of the earlier economists and economists of later generations (such as
the authors of the foregoing paper), stock price itself does not constitute information.
Stock price is but the carrier of information. As a result, according to Grossman and
Stiglitz (1980), we can see a significant amount of statements regarding prices
transmitting information as well as prices revealing information and so on and so
forth. The issue in this respect is: are these statements scientifically based? Are
they scientific descriptions of the stock price behavior? To our regret, because of the
following three reasons, the answer is negative.
(i) In Section 2 of the present paper, the present author has already mentioned
that, only on the basis of having obtained a scientific understanding of the investor
behavior is it possible for us to proceed with scientific descriptions of the actual stock
price behavior along with the interrelationship between the investor behavior and
stock price behavior. The above analysis leads inevitably to the conclusion that
Grossman and Stiglitz (1980) lack scientific understanding of the investor behavior.
Consequently, the paper lacks a scientific basis for describing the stock price
behavior.
(ii) Fundamentally speaking, as the investor aspirations, expectations and logic
are embodied in the stock price movement sequences, the stock price itself is a kind of
inherent general information. Such inherent general information provides a
yardstick for measuring up the stock price behavior. Both the economists of earlier
and later generations (such as the authors of the foregoing paper) simply lack
scientific understanding of the foregoing inherent information associated with the
stock price.
46
In The alchemy of Finance and Open Society, George Soros provides very scientific description of the investor
behavior.
77
(iii) From the standpoint of the process of the formulation of future stock price
expectations on the part of the investor, at the early stage of the human brains forming
the expectations of the future stock price, the external information being input is
rather limited. Moreover, the demand on the quality of the external information is
rather stringent. As a result, only the external information conforms to the
physiological characteristics of the human brains can manage to make its way into the
stock price expectancy system of the human brains. As the overwhelming majority
of the external information simply does not match the physiological characteristics of
the human brains, during the course of the formulation of the future stock price, such
overwhelming majority of the external information just cannot enter the stock price
expectancy system of the investor. The overwhelming majority of the external
information actually makes it way into the expectation system that is independent of
the stock price expectation system on the part of the investor. After going through
the processing of the investors expectation and cognition systems, what the investor
eventually gets is no longer the expected values of the external information. Rather,
it is qualitative rather than quantitative assessment on the future stock price on the
basis of the expected values of the foregoing information. Such assessments along
with the three expected values of the future stock price jointly make their way into the
investors decision-making system.
Summing up the above three points, we can easily draw up the following
judgment: irrespective of the statements such as prices transmitting information and
prices revealing information by Grossman and Stiglitz (1980) or Famas classical
allegation (stock prices reflect all the available information), they all lack scientific
connotations, and the statement in the paper that prices reflect the information only
partially is not supported by any scientific evidence.
Lastly, as the paper cannot meet even the first and second terms of the above, it
certainly cannot meet the third condition. That is to say, we cannot realistically
expect the stock market status along with the interrelationship between the investor
behavior and stock price behavior under the foregoing status as described by
Grossman and Stiglitz (1980) to be a close approximation of the actual stock market
realities. As a result, research conclusions by Grossman and Stiglitz (1980) are not
adequate for the purpose of providing any substantive support for EMH in its revised
and improved-upon form.
It should be noted that, although Grossman and Stiglitz (1980) points out the
78
logical absurdities with EMT, the conclusions of their paper have fallen far short of
shaking the foundations of EMT, and have provided EMT proponents with a good
excuse to resort to in case of need. For example, when the connotations or forecast
of EMT are found to be inconsistent with the stock market realities, the EMT theorists
would use pretexts such as claiming that the market is not fully efficient or that the
market is only remarkably efficient to ward off the major impacts exerted on EMT by
the stock market.
Stock price patterns
To provide scientific responses to a full array of questions including whether the
stock price patterns exist due to data mining, whether the stock market patterns exist
on a long-term basis, whether the stock price patterns would involve self-destruction,
and whether the stock price pattern can be used to earn dependable abnormal returns
etc., we must obtain scientific understanding of the investor behavior and stock price
behavior.
In Sections 2 and 6 of this paper, the present writer has already dealt with the
conclusions associated with the market closure data spanning over 102 years for the
DJ IA and the stock price patterns in general. The present writers research has
demonstrated that the stock price patterns discovered by financial economists, such as
long-term reversal pattern and short-term momentum pattern, not only exist on a
long-term basis, but also exist in all the historical data sequences of any one single
stock market all over the world. For this reason, the allegation by EMT theorists that
such stock price patterns are attributed to data mining is totally unscientific.
To scientifically classify the stock price patterns requires special techniques, it is
necessary to recall that any one actualized stock price pattern represents the
combination of the investor ideals, pattern of the investor anticipation of the future
and fundamental factors. At the same time, every kind of actualized stock price
pattern has minor shades of difference in terms of magnitude. As a result, even
though the same kind of stock price pattern appears repeatedly in front of the investor,
it is impossible for the investor to rely on his vision and experience to discern the
involved stock price patterns provided that he does not possess the specialist skills
required for scientific classification of the stock price patterns. To make matters
worse, as the total amount of the kinds of stock price patterns far exceed the very
limits of human memory and processing in the brains at a given unit time, when
79
different kinds of stock price patterns mix up and appear before the investor, it is just
impossible for the investor to recognize the involved stock price patterns provided he
does possess the scientific cognition of all the stock price patterns.
The present writers research has also demonstrated that, normally, a 5-year-long
stock price historical sequence with the transaction day as the time interval contains
all the patterns of the stock price movement. On average, every 30 units time (such
as daily, weekly, monthly and annual) data of the stock price contain around 4 stock
price patterns; the consecutive price data (not rate of return) at every 60 units time
contains the pattern of movement of stock price repeating itself once. An obvious
fact of the matter is that, since 1998, the DJ IA annual data has maintained operations
at the same price pattern on two separate occasions.
By integrating the above conclusions with our discussion on whether EMT is a
close approximation of reality in Section 6, we are in a position to identify that
Malkiels allegation that many of these patterns, even if they did exist, could
self-destruct in the future is simply lacking in scientific evidence.
Is it possible for the investors to make use of these stock price patterns to form
investment strategies to earn abnormal returns in a reliable manner? The answer is
both affirmative and negative at the same time. As the present writer has already
dealt with this subject matter in Section 6 and this particular sub-section, the present
writer is not prepared to repeat in this particular context right now.
It should be noted that, irrespective of Lo, Mamaysky and Wang (2000) or the
behavioral finance proponents, such as DeBondt and Thaler (1985), the involved
stock price patterns have not undergone any scientific systemization process. If we
cannot perform any scientific classification on these stock price patterns, it is then
impossible for investors to rely on these patterns to obtain abnormal returns in a
reliable manner. By integrating the present authors discussion in Section 6 with this
sub-section, we can easily understand why Richard Roll complains in the following
way:
I have personally tried to invest money, my clients money and my own, in
every single anomaly and predictive device that academics have dreamed up. I have
attempted to exploit the so-called year-end anomalies and a whole variety of strategies
supposedly documented by academic research. And I have yet to make a nickel on
any of these supposed market inefficiencies.
47
47
See Malkeiel (2003), p. 23-24. Quotation.
80
Stock price bubble and stock market crash
The present writers analysis of the stock price patterns associated with the DJ IA
at the time of the crash of the stock market in 1987 reveals that, irrespective of the
annual data, quarterly data, monthly data, weekly data and daily data, they all gave
clear signals in the run-up to the crash of the stock market. The present writers
analysis on the price patterns associated with the three major stock price indexes
between 1990-2000 in the US stock markets indicates that, irrespective of NDXI,
S&P500 or DJ IA, they all displayed clear signals of falling of the stock price by the
end of 1999. Irrespective of the US stock market crash in 1987 or the falling of the
stock price in the US stock market at the beginning of 2000, they all boil down to one
single cause: the stock prices have been overly valued. And the major reason in this
respect is that: people lack scientific understanding of the actual investor behavior and
the mutual relationship between the investor behavior and the stock price behavior.
48
What deserves special mention is that, the movement patterns of the historical
figures of the DJ IA in 1987 not only look rather simple, but also very frequent in the
stock markets. In particular, the annual data, quarterly data and monthly data all
display regular patterns to such an extent that it is possible to draw the crash
conclusions by relying on simple technical analysis methodologies. Therefore, it is
not difficult for us to comprehend why Paul Tudor J onesL has been able to earn
good money through technical analysis methodology in the midst of the stock market
crash. Prior to the falling of the stock price in 2000, the patterns of movement of the
three principal stock markets in the US looks very rare in light of the annual figures.
Consequently, even the world-famous investment guru commits errors in judging the
market movement (as in the case of George Soros who began to sell short US shares
at the beginning of 1999).
In fact, irrespective of the movement patterns of the historical sequences of the
DJ IA at the time of US stock market crash in 1987 or the movement patterns of the
stock price index prior to the falling of the stock price in 2000, these patterns emerge
with great frequency in the daily historical price data of US stock markets and are also
widely seen in the daily historical price data of other major stock price index such as
48
To provide detailed explanations on these special stock price phenomena goes beyond the scope of the present
paper. For this reason, the present author has chosen to make but a brief mention.
81
HSI and FTSE and so forth. Consequently, we can say with assurance that
explanations offered by Malkiel (2003, p. 27-29) are unscientific.
It would be a mistake to dismiss the significant change in the external
environment, which can provide an entirely rational explanation for a significant
decline in the appropriate values form common stocksBut even here, when we
know after the fact that major errors were made, there were certainly no arbitrage
opportunities available to rational investors before the bubble poppedFortunately,
bubble periods are the exception rather than the rule and acceptance of such
occasional mistakes is the necessary price of a flexible market system that usually
does a very effective job of the allocation capital to its most productive uses.
8 Concluding Remarks
8.1 Summary
Errors with EMT can be summarized as follows:
Mistaken basis for ascertainment. EMT founding fathers have chosen the
observations and statistical conclusions drawn up by theorists of the random walk as
basis for ascertaining EMT. As a result, EMT is founded upon the wrong
ascertainment basis.
Mistaken research methodology and inappropriate analysis framework. EMT
theorists have carried forward the incorrect methodology associated with stock price
behavior analysis favored by the theorists of the random walk. Inappropriate
economic analysis framework is adopted to try to rationalize the seemingly
random-walk-like stock price behavior. However, theorists have never attempted to
perform any in-depth analysis on the series of unrealistic assumptions arising from the
economic framework, which would exert critical impact on the correctness of their
research conclusions. At the same time, theorists have totally ignored study of the
scientific connotations of the basic elements inherent in the economic analysis
framework. As a result, it is easy for us to see why the random walk model,
Martingale and Fair Game models are all not suitable for use in explaining the stock
82
price behavior.
Mistaken conclusions. All the statements on the stock price behavior by EMT
are highly unscientific. EMT proclamation that technical analysis is useless is
mistaken.
49
The conclusion drawn by EMT advocates that the investor cannot beat
the market is entirely wrong. Explanations provided by EMT theorists on the
findings of the behavioral finance scholars are totally erroneous.
EMT errors can be summed up as follows. EMT is by no means the reasonable
approximation of the stock market realities, and its scientific content is close to zero.
The reason is pure and simple: EMT absurdly describes the investor behavior, and
mistakenly describes and explains the stock price behavior. Furthermore, EMT
wrongly represents the inter-relationship between the investor behavior and stock
price behavior.
8.2 Commentary
Efficient market hypothesis is founded upon a series of unrealistic assumptions.
As these assumptions are simply unscientific in quintessence, from Fama (1970)
onwards, it has been rather difficult to ascertain EMT. Because of the
supplementation and revisions by Fama and other EMT theorists over a 20-odd-year
period, up to Fama (1991), EMT has become a financial theory that defies overturning
by facts.
50
A famous economist once put it well: in the entire scientific methodology
framework, the most important point is that it is possible for the theoretical
conjectures to be overturned by facts. A theory that defies overturning by fact is
simply never fit for clarification and explanation. In other words, science is not
tantamount to the pursuit of correctness or wrongfulness. What science aspires to
achieve is the possibility of being overturned by facts.
51
Although EMT theorists
have exerted tremendous efforts and energy in refining EMT theories, they are far
from enthusiastic about ascertainment of EMT, especially when the connotations of
EMT are jeopardized by empirical validations, EMT theorists invariably look for
49
Research carried out by the present author has proven that the core principles of Technical Analysis are correct.
Research has also proven the judgment of perceiving market and investor psyche through analysis of stock price
movement.
50
Fama (1991) proclaimed: Thus, market efficiency per se is not testable. (p. 1575)
51
WuChang, Zhang, Economics Explanations, Section Four: On Possibility of Being Overturned by Facts.
Quotation.
83
countless pretexts and excuses
52
or revise their theories in order to render the
validations ineffective. They are only interested in pursuing purely theoretical
studies, and are never enthusiastic about facing the validations of facts, which is
clearly contrary to the spirit of science.
53
Partly because of the foregoing unscientific practices, over the past 40 years,
EMT theorists have made scant contributions to the clarification and explanation of
the investor behavior and stock price behavior. Up to this point in time, EMT theory
cannot even provide correct answers to some basic questions. For instance, why are
there transactions between investors themselves? Why is the turnover of the stock
market so huge at this point in time and so on and so forth?
In the following sub-section, the present writer will quote the comments made by
three famous scholars, and, in the present writers opinion, they have grasped the core
of the issue under scrutiny.
(i) Edgar Peters mentioned in his Chaos and order in the capital markets that
EMT came into being under special circumstances when the actual stock price data
conflicted with their theoretical models. Through a critical assumption on the
mutual independence of the observations or rates of return within a single economic
frameworko the concept of rational investor and the efficient market hypothesis are
constructed to justify the application of the probability calculus. At last, EMT
conversely becomes the theoretical proof of the hypothesis that stock price follows a
random walk, although there are lots of empirical evidence showing that stock price
does not follow a random walk. Such practice has been referred to by Edgar E.
Peters as: Any scientist would complain that development of a theory to justify a
methodology is akin to putting the cart before the horse, which is terrible science.
54
(ii) Robert A. Haugen wrote in Chapter 10 of his The New Finance:
Overreaction, Complexity and Uniqueness that:
Financial economists, both Modern and Behavioral, dazzle themselves with
sophisticated mathematics. They gain much comfort in the intellectual rigor of the
methodologies.
It makes no difference if their assumptions are completely unrealistic, so long as
52
Such as data snooping and chance etc.
53
In Stigler, G.J (1950), (he pointed out that scholars lacking the enthusiasm about testing theories) G. J . Stigler
wrote: The criterion of congruence with reality should have been sharpened sharpened into the insistence that
theories be examined for their implications for observable behavior. Not only were such implications not sought
and tested, but there was a tendency, when there appeared to be a threat of an empirical test, to reformulate the
theory to make the test effective. Economists did not anxiously seek the challenge of the facts.
54
Peters, E., (1999). See p. 10 and 29. Quotation.
84
they parallel those made by their peers.
To them, elegance is all that matters. They look with disdain on the studies of
psychologists, sociologists, and anthropologists because their work seems so mushy in
comparison to their own. They dismiss, as unimportant, forces that may actually be
crucial but impossible to treat with mathematical rigor.
(iii) In an article entitled There is no Invisible Hand in The Guardian, J oseph
Stiglitz states that:
Last years laureates implied that markets were not, in general, efficient; that
there was an important role for government to play. Adam Smiths invisible
handthe idea that free markets lead to efficiency as if guided by unseen forces is
invisible, at least in part, because it is not thereThe Nobel Prize signifies how
important it is to study people and economies as they are, not as we want them to be.
Only by understanding better actual human behavior can we hope to design policies
that will make our economics work better as well.
55
55
The Guardian, Dec 20, 2002. Quotation.
85
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