Thoughts on the Efficient Market Hypothesis: Answering a Friend's Question
Brilliant question: Your University of Chicago law training shines through it.
Not systematically, and I think some versions of the efficient market hypothesis are true, while others are false. But we must remember that there are several efficient market hypotheses---and they make subtle but importantly different claims.
As for predicting the market, there are times where one can determine that something is likely off base, but that is it. One cannot systematize it (turn it into some grand equation of the stock market). After all, if one were to create such an equation, it would then require another set of equations to deal with how market actors will act with that new knowledge, which in turn would require yet another set of equations---ad infinitum. So, no mathematical algorithm can ever predict market results.
However, as I said above, there really are several "efficient-market-hypotheses." To my mind, it merely requires that the markets will produce the efficient outcome eventually, most of the time---as the incentive to return to the "true" value of a financial instrument (the present value of its revenue stream) gets larger as its price deviates more and more from that value. This weakest form of the idea is actually what I was basing my prediction on: And in that sense I believe it.
For stronger versions of the idea like that the market always reflects all the information available to all current market participants and produces the "true" (i.e. present value of an investment's future revenue stream) value for a financial instrument or commodity, this is clearly false---as it, theoretically, should apply to a market run by retarded children (there is no stipulation in the theory that the market participants should all have IQ's above a certain number).
Furthermore, as a strong proponent of Austrian Business Cycle Theory, I cannot believe in the stronger versions of the efficient market hypothesis holding under all conditions. Why I didn't realize the incompatibility of the two theories earlier is beyond me. However, the main idea of Austrian Business Cycle Theory is that there are systematic errors that occur as a result of new money unevenly entering the economy, distorting the information embedded in prices. If the efficient market hypothesis is true in its strong forms, then the Austrian Business Cycle Theory is wrong: And, indeed, the only business cycle theory we are permitted is the neo-Keynesian supply shock theory, which denies that business cycles really exist.
For example, when the housing bubble burst, one could have examined the relationship between property values and rents and determined that rents were well below the normal rate of profit. This was a sign that the market price was inefficient, but it also was something that eventually was corrected for.
I hope that clarifies things. I have spent many an hour agonizing over the efficient market hypothesis and its relationship to business cycle theory. All I can say is that market incentives create strong and increasing pressures to return to the efficient price, unlike government action which normally follows perverse ones.