One of the great theories that underly all of modern finance as taught in every business school across the world is coming under attack these days. Simply stated the theory, known as the “Efficient Market Theory” states that prices at any point in time capture all the publicly available information at that point in time. The theory goes back to the 1970’s and the arrival of computers on university campuses. Finance professors collected price data from stock markets, going back 50 years, and attempted to develop trading rules that in essence would enable one (themselves they hoped) to make a killing. Instead, they discovered that every rule that they could dream up lost as much money in the long run as it made in the short run. The conclusion was that markets responded swiftly and accurately to public information so that trading was little different from flipping coins.
This notion that at any given point in time, prices reflected all available information became the foundation for all that we teach in business schools. If the market was all wise, then market prices could and should be used in accounting, for instance; hence the call for marking assets to market that has now become so controversial. If the market was all wise, then the ordinary investor was foolish to try to play the market; hence the rise of the mutual fund industry and the advice to put one’s money into a well-diversified portfolio. If the market was all wise, then it behooved regulators to get out of the way.
There is no theory around at this point to replace the Efficient Market Theory so its proponents, all trained in the last 20-30 yearss will continue to teach it and to tout it. But, sooner or later, someone is going to ask why it is that the market is swinging 700 points or more in a day. What did we know on Monday that caused the market to drop 10% that we did not know on Friday? What did we know on Tuesday that caused the market to swing back up 10% that we did not know on Monday? Is the market really reacting wisely to new information – or are we simply seeing emotions, fear and greed, driving the market. Are these prices being set by knowledgeable investors or are these prices being set by investors who have to sell because of margin calls and by folks who are irrationally spooked by the present volatility?
The mark-to-market rule, of which more tomorrow, is coming under attack because many companies no longer believe that the markets are setting the proper prices. The SEC has promised to “interpret” the mark-to-market rule less conservatively and EU regulators have followed suit. Jennifer Hughes has soundly criticized this move on grounds that it is akin to blaming a torch (aka flashlight) for shining a light in a dark corner. The problem is that the torch might itself be faulty. If the market is not processing the information that it is receiving in a rational manner, then the price mechanism breaks down and with it the foundations of mark-to-market accounting. Of course, returning to a street that one lived in 30 years ago because the light in one’s own street is not working properly is not a sensible strategy either. We really need to rethink what we are doing from the ground up now that it is clear that markets are not always, and may never be, efficient.