Now, I am no economist. Nor do I profess to understand financial markets. But I am interested in the stock market. As someone who studies how and where power is gained and exercised, watching the stock market today is like peering through the window of an exclusive gentleman’s club of old. Pushing your ear up to the glass you get to understand the goings on of the middling classes.

Such voyeurism brought me into contact with the efficient market hypothesis (EMH) or efficient market theory. The idea behind EMH is (briefly) that no one person can possess more knowledge than an entire market. The information a market possesses equals the sum total of all information on which market transactions are based. The more sources from which a market (or any entity) gathers its knowledge the more it will know and the more efficiently it will be able to set the price of commodities. As such, because the market is the sum total of all transaction it will have better knowledge of what prices should be than any government, financial analyst or group of analysts.

This theory comes from a number of sources, including Friedrich von Hayek, Milton Friedman and Eugene Fama. Although there are differences between the ideas of these three thinkers, for brevity and clarity their ideas of market efficiency can be distilled into two separate ideas: a theory of pricing and a theory of efficiency.

Pricing theory: If a farmer wants to sell milk then he’s going to know more accurately than anybody else how much his product is worth. If a farmer wants to sell milk he will know what it’s worth by gauging how many people want to buy milk. If lots of people want milk, it’s worth more. If nobody wants milk, it’s worth little. How is anyone else (including a government) going to improve on that price knowledge? They can’t.

Efficiency theory: Someone who is spending his or her own money will be more prudent than a person who is spending someone else’s money. For example, a government raising taxes and spending those taxes will waste more money than people spending their own money. Why? Because who in the government really cares if they waste the tax revenue? It’s not their money, so they’re going to care less. This also holds for charities. The basic idea, to draw on the previous milk example, is that the most efficient transaction occurs between the buyer and the seller. Both want to get the best price: the buyer the cheapest price, the seller the highest price. If a third party intervenes, it’s only going to bring an inefficiency. If the government raises a milk tax and then buys my milk for me with that tax revenue, they’re not going to try to get the best price for the milk because it’s not their money being spent — it’s my money.

From these two ideas comes the idea that markets are the most efficient means of setting prices. The transactions between buyers and sellers are the most efficient means to set a price. Both will use their best available knowledge of demand and supply to try to get the best price. ‘The market’ is simply the sum total of all such transactions.

But here is the problem. Take stock prices as an example. If markets are the most efficient means of setting prices, then all ups and down are presumably movements in response to new price information. The price of Apple stock skyrockets because people want to own it. If people want the stock, this counts as new information. The market processes this new information and the price goes up. The market has acted efficiently. But has it acted rationally?

The efficient market hypothesis doesn’t seem to be able to accommodate the idea of an irrational price. For example, in 2004 the Apple stock price rose to the point where Apple stock was selling for 93 times what the company was earning in revenue per stock (its Price/Earnings Ratio). The EMH doesn’t seem to have the capacity to deem such exorbitant stock prices irrational. The Apple stock price simply reflects the demand for the stock, so the market is acting efficiently. But is a stock price that is 93 times the companies earnings per stock a rational price? There seems to be two possibilities. The price is rational if the future earnings of the company may catch up, in which case buyers are speculating on Apple’s future growth. The price is irrational if the company has no prospect of future growth even near such levels. The price would then be an overreaction to the popularity of IPods and Macbooks.

If the latter is true, the efficient market hypothesis can only chalk such ‘irrational prices’ up to a lack of information in the market. Now nobody knew the future success Apple would enjoy until it occurred. Prior to its success, any ‘knowledge’ of Apple’s future growth was actually an hypothesis about Apple’s future growth. So the question of irrationality comes down to whether a P/E ratio of 93 is ever rational when based on an untested growth hypothesis. Unless we wish to deem Apple’s 2004 stock price as rational after the fact (an easy thing to do, but a fallacious piece of reasoning), it would seem that such speculation on growth is based on thin evidence. If so, the 2004 price was irrational. (Behavioural economics has a few things to say about irrational pricing.)

Irrational stock prices are more easily illustrated by looking at the 2008 global financial crisis (GFC). Figure 1 (below) shows growth in the All Ordinaries Index (a measure of stock prices over most Australian stocks) since 1988. I’ve superimposed a visual line of best fit to indicate average growth. As you can see, the All Ords follows the line pretty closely until 2005 when it shoots skyward. In late 2007, however, it plummets, continuing below the line of best fit until there’s a change of direction in early 2009 and an eventual return to average growth half way through the year.

Figure 1.
Visual line of best fit for All Ords since 1988

My question is: Does the 2005 to late-2007 bullishness and the late-2008 to early-2009 bearishness (where the All Ords plummets below the average) imply that markets can be irrational, or are these deviations from average growth attributable to an information deficit, or both? (see Figure 2 below)

Figure 2.
Is the deviation from average All Ords growth in the two shaded areas irrational, a product of an information deficit, or both?

The idea that the GFC was due to an information deficit seems untenable. It’s more likely that these deviations from the average are attributable to the dislocation of stock prices and realistic growth expectations. As such, you can have irrational markets. Any market theory that cannot account for such behaviour, or which attributes it to an information deficit only, is severely lacking. However, the fact that the All Ords has now returned to the line of average growth as if the GFC never happened seems to support the EMH, whereby markets will take on new information and price accordingly. The return to average growth in the All Ords would then indicate that the areas of strong deviation may have been irrational, but that in the end rationality — pricing stocks based on the best available evidence — prevails.