MBA essay/report/paper/assignment
The Australian Economic Review, vol. 43, no. 4, pp. 464
FortheStudent
Market Efficiency and the Global Financial Crisis
Steve Eastonand Paul Kerin
Newcastle Business School, The University of Newcastle Melbourne Business School, The University of Melbourne
1. Introduction
The Global Financial Crisis (GFC) has led many journalists, market participants and politicians to reject the efficient markets hy- pothesis (EMH). For example, in a much dis- cussed essay in The Monthly , former Australian Prime Minister Kevin Rudd blamed the GFC on belief in the superiority of unregulated finan- cial markets, a belief he claimed ultimately rest[ed] on the EMH (Rudd 2009). He asserted that this belief had failed and called for much greater financial market regulation. Our purpose in this student note is to present an analysis of the evidence with respect to mar- ket efficiency and to discuss what additional evidence, if any, the GFC provides. Such a presentation requires making a dis- tinction between micro-efficiency and macro- efficiency. At the micro level, market efficiency is the extent to which the prices of finan- cial securities reflect information relative to other securities within the same asset class; for example, whether BHP Billiton shares are fairly priced when compared with RIO shares or whether one firms collateralised debt obli- gations are fairly priced when compared with those of another firm. At the macro level, the issue is whether the market as a whole reflects all available informationwhether, for exam- ple, the share market is fairly priced compared with a less risky asset class such as government debt. Careful analysis of this evidence demon- strates the need to avoid overly simplistic
We are grateful to the editor of the Australian Economic Review (Michael Coelli) and two anonymous referees for helpful comments and suggestions.
assertions based upon it and to carefully assess
whether any efficiencies are such that avail-
able market correction instruments are likely
to achieve more good than harm.
2. What Is Market Efficiency?
Before addressing what, if anything, the GFC
can tell us about market efficiency it is neces-
sary to define what the EMH is and examine
what empirical evidence indicates regarding its
validity. While many definitions of market effi-
ciency exist, Famas (1970) is the most widely
accepted: an efficient market is one in which
prices fully reflect all available information.
Asking whether a market is efficient or
inefficient per se is not very useful: it will
always produce a negative answer unless the
market is at one polar extreme on the efficiency
scale ( perfectly efficient). The more meaning-
ful question is: to what extent is a market ef-
ficient? (Doukas et al. 2002). This is not mere
semantics, but an important matter of approach.
If we wish to know something about a rooms
temperature before deciding whether to enter it,
asking what the rooms temperature is will be
more useful than debating whether it is white
hot or not. Likewise, policy-makers need to
consider how efficient markets are and whether
any inefficiencies are significant enough to
warrant policy intervention.
In discussing market efficiency, it is also im-
portant to clarify which level of efficiency
micro or macro is being referred to.^1 Micro-
efficiency does not necessarily imply macro-
efficiency. For example, it is possible the
market as a whole can be overvalued due
to irrational exuberance^2 and that rational
C2010 The University of Melbourne, Melbourne Institute of Applied Economic and Social Research
Published by Blackwell Publishing Asia Pty Ltd
Easton and Kerin: Market Efficiency and the Global Financial Crisis 465
investors know itbut if those investors can- not predict when the bubble will burst, they may still buy/sell securities that they think are relatively cheap/expensive. While this ar- bitrage between securities may maintain high micro-efficiency, it may not eliminate macro- inefficiency.
3. Evidence
Researchers have examined comprehensively the extent to which markets are micro-efficient. While share markets have been tested most thoroughly, other markets such as debt mar- kets and derivative securities markets have also been extensively tested.^3 Fama (1991) provided a three-way categorisation of these tests based on the methodologies employed. First, tests of return predictability have been used to ascertain whether future returns may be predicted on the basis of past information such as past returns, the time of the year or the book-to-market ra- tio. The dominant finding of such studies is that there is little evidence of return predictability. Second, so-called event studies have been used to examine the behaviour of returns around the time of a significant event such as the public announcement of the companys profit, dividend details or intention to take over another company. These studies show that most information is incorporated into prices almost instantaneously when (and sometimes before) it becomes publicly available. Third, tests for private information have been designed to determine whether investors may trade profitably by making investment deci- sions on the basis of privately held information (known to insiders but not publicly disclosed). The evidence from these tests is less clear, with some evidence suggesting that company direc- tors and security analysts trade profitably on the basis on such information. Unfortunately, in contrast to room tempera- ture, there is no single objective summary mea- sure of the evidence on market micro-efficiency upon which everyone can agree. However, Ken French (in Doukas et al. 2002) provided an entertaining summary of his attempts to gener- ate micro-efficiency scores. French and four other leading researchers who had published
research evidence on market micro-efficiency
(and had been perceived to hold widely differ-
ent views on micro-efficiency) each provided
an overall market micro-efficiency score, on a
continuum from zero (completely inefficient)
to 100 (perfectly efficient),
The range of scores was surprisingly nar-
row, from a low of 79 (Jay Ritter, University of
Florida) to a high of 92 (Gene Fama, University
of Chicago); intermediate scores were 83 (by
both University of Chicagos Richard Thaler
and Emory Universitys Jay Shanken) and 87.
(Ken French, Dartmouth).
EMH critics often cite leading behavioural
economists like Thaler to support their views
against EMH supporters like French. Yet
these scores suggest a remarkable level of
agreementeven Thaler believes that relative
share prices reflect most available information
most of the time.
Much less research is available on market
macro-efficiency. But several studies have ex-
amined whether equity market prices at the
macro level may be explained by fundamental
measures of value.^4 Seminal studies here are
those by Campbell and Shiller (1988a, 1988b)
and Vuolteenaho (2002) who find that earn-
ings yield (earnings per share divided by price
per share) and future returns are positively re-
lated. However, the key difficulty here is in the
interpretation of the results. For a given earn-
ings per share, price per share will be lower in
periods when risk is higher because investors
discount prices as they are less willing to in-
vest. Therefore, lower prices per share and the
concomitant higher earnings yields may be pos-
itively related to future returns because of the
basic riskreturn relationship; that is, higher
risk needs to be compensated with higher re-
turns. Disentangling what component of the
earnings yieldfuture return relationship is due
to market inefficiency and what component is
due to variation in risk is ultimately rendered
impossible due to imperfections in modelling
risk.
Careful examination of expert commentary
is consistent with the evidence that suggests
that markets are largely micro-efficient but that
they may not always be macro-efficient. While
former US Federal Reserve Board Chairman
466 The Australian Economic Review December 2010
Alan Greenspan has long believed US markets to be exceptionally efficient at the micro-level (see Greenspan 2000), he coined the phrase irrational exuberance to explain why market bubbles can exist (see Greenspan 1996, 2008). Princeton Universitys Burton Malkiel has ar- gued extensively in many editions over 36 years of his classic book, A Random Walk Down Wall Street (Malkiel 2007b), that markets are micro- efficient but, six months before the 2007 eq- uity market peak, questioned in The Wall Street Journal (Malkiel 2007a) whether the market was exhibiting irrational complacency; that is, macro-inefficiency. In the midst of the dot- com boom and soon after the Asian financial crisis, Nobel Prize winner Paul Samuelson pro- pounded his now-famous dictum that markets are highly micro-efficient but can be macro- inefficient (Samuelson 1998, 1999). Shiller, the author of Irrational Exuberance (Shiller 2001) and often cited by EMH critics as if he agrees with them, actually agrees with Samuelsons dictum (see Jung and Shiller 2005). These aca- demics and practitioners agree that markets are highly micro-efficient, and that markets can be macro-inefficient. Clearly, they all recognise that micro-efficiency and macro-inefficiency are not mutually exclusive. In the Australian context, commentary is similar. Harper and Thomas (2009) and Quig- gin (2009) use the GFC to argue that markets are macro-inefficient with Quiggin also argu- ing that the GFC reinforces the position that privately held information is not fully incorpo- rated into prices quickly.
4. Is the GFC Relevant?
Did the GFC provide any additional useful ev- idence on market efficiency? Not really. At the micro level, the GFC may have, as Quiggin (2009) asserts, reinforced extant evidence that privately held information is not fully incorpo- rated into prices quickly. At the macro level, a market crash per se does not prove macro-inefficiency. It may simply reflect rational investor reactions to new infor- mation. A simple numerical example illustrates this point. The S&P/ASX200 Index fell by 54 per cent between its all-time high of 6828.7 on
1 November 2007 and its subsequent low to
date of 3145.5 on 6 March 2009. While a fall
of 54 per cent may at first view appear large,
such a fall is consistent with reasonable esti-
mates of changes over this period in the rate
of return needed to compensate equity holders
for supplying capital (the cost of equity capital)
and in expected dividend growth rates.
For example, using the simple dividend
growth model, the present value of $1 of divi-
dend income with an annual cost of equity capi-
tal of 10 per cent and an expected annual growth
rate in dividends of 5 per cent is $21.^5 By com-
parison, the present value of $1 of dividend
income with an annual cost of equity capital
of 13 per cent and an expected annual growth
rate in dividends of 2 per cent is $9.27a fall of
56 per cent. Given the level of bad news over the
16-month peak-to-trough period from Novem-
ber 2007 to March 2009 (multiple GFC-related
shocks like the subprime crisis and Lehmann
Brothers collapse) and the resultant raising of
investors risk perceptions and reduced growth
expectations, such changes in the cost of equity
capital and expected dividend growth rates are
very reasonable.
5. Implications
With respect to micro-efficiency, to the extent
that the GFC supports evidence that privately
held information is not fully incorporated into
prices quickly, basic regulatory rulessuch
as disclosure requirements and insider trad-
ing lawsimprove market micro-efficiency, by
raising the quantity, quality and timeliness of
information that investors receive.
With respect to macro-efficiency, possi-
ble inefficiencies can warrant macroeconomic
intervention if governments can pick macro-
inefficiencies (such as asset bubbles) and if
interventions will do more good than harm.
However, substantial evidence demonstrates
that excessive market regulationssuch as
those imposed and maintained when macro-
inefficiency is thought to exist, like bans
on short-selling (Bris, Goetzmann and Zhu
2007) and on securities exchange market en-
try (Barclay, Hendershott and McCormick
2003; Gresse 2006)harm micro-efficiency.^6
Easton and Kerin: Market Efficiency and the Global Financial Crisis 467
Further, current US Federal Reserve Board Chairman Ben Bernanke and New York Univer- sitys Mark Gertler concluded, based on their empirical work, that changes in asset prices should affect monetary prices only to the ex- tent that they affect the central banks fore- casts of inflation as there are good reasons to worry about attempts by central bank to influence asset prices, including the fact that (as history has shown) the effects of such at- tempts on market psychology are dangerously unpredictable (Bernanke and Gertler 2001, p. 253). They also pointed out (p. 256) that tar- geting stock prices per se only makes sense if the central bank (i) knows with certainty that the stock-market boom is driven by non- fundamentals and (ii) know exactly when the bubble will burst, both highly unlikely condi- tions.^7 Likewise, forecast aggregate demand and supply conditions in the real economy not asset prices per seshould drive fiscal pol- icy. Nevertheless, the potential impact of asset bubbles bursting on the real macroeconomy the so-called financial accelerator (Bernanke et al. 1996)may justify some degree of pru- dential regulation for systematically important financial service providers. It is also important to distinguish between macro-inefficiency in financial markets versus the real economy. Samuelson once said that the real economys business cycle like her- pes, has always been with us. A Keynesian, he supported activist macro-economic policies to keep that disease in checkbut not activism in financial markets. The Federal Reserves 1929 intervention to prick what it saw as a stock- market bubbleand the Great Depression that followeddemonstrates the danger.
6. Conclusion
While a dramatic event, the GFC simply rein- forces the position that privately held informa- tion is not fully incorporated into prices quickly and adds one more data point to the economic evidence that markets may, at times, be macro- inefficient. Of itself, it provides small evidence for significant policy change.
August 2010
Endnotes
- Market macro-efficiency should not be confused with macroeconomic efficiency; the former concerns finan- cial security prices, the latter concerns overall economic activity.
- A term coined by Greenspan (1996), reminiscent of Keynes (1936) animal spirits.
- Detailed discussions of this voluminous evidence may be found in standard introductory finance textbooks such as Bodie, Kane and Marcus (2009) and Brealey, Myers and Allen (2008).
- It may be noted that in the finance literature studies of micro- and macro-efficiency are largely independent whereas macroeconomics is based upon microeconomic foundations.
- In this model, a present value (P 0 )orindexvalueis equal to the current dividend (D 0 ) multiplied by one plus the expected dividend growth rate (g), all divided by the difference between the cost of equity capital (ke)andthe expected dividend growth rate (g). This basic present value relationship was first developed by Gordon (1959).
- The Australian Securities and Investment Commission cited the GFC in banning short-selling for two months (non-financial company securities) and six months (finan- cial company securities) from September 2008. The Rudd government cited the GFC in deferring decisions on li- cence applications from three potential competitors to the ASX securities exchange monopoly. Those applications were submitted in October 2006, April 2007 and February 2008; the government is still yet to announce a decision on any application (as of the date of writing).
- Indeed, Bernanke (1995, p. 6) believes that Federal Re- serve monetary contraction in an attempt to curb stock market speculation was the major cause of the Great De- pression.
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