“No matter how much you point out that it is dead, the believers simply state that it is just resting. In part this is testament to the high degree of inertia that academic theories enjoy… It is bad enough that the EMH exists as an academic theory (filling student’s heads with utter garbage) but the very real damage it does comes from the fact that as Keynes opined “practical men are usually the slaves of some defunct economist”. The EMH has left us with a long litany of bad ideas that have influenced the very structure of our industry.  -James Monier

With the recent spate of bubbles in various equity markets the venerable efficient market theory and it’s corollary CAPM have come under vicious attack by a variety of academics who bear witness to the problems the theory presents.  The least of the problems lies in the very fact that it doesn’t work very well, especially when working with “long tails”: those ticklish anomalies that are ably described by Benoit Mendelbrot in “The Misbehavior of Markets.”

But academics don’t let loose of accepted ideology without a fight, despite a litany of  failures in the Efficient Market Theory’s predictive ability.  It is, at best, a dying testament to an irrational explanation, from an economic standpoint, to the inner workings of our equity markets. If a theoretical approach is not firmly grounded, it is not surprising that the predicted consequences that flow from it should fail to show up consistently in the way that investors and markets actually behave.  Such is the plight of Efficient Market Theory, and economist are scrambling for some sort of working model on the machinations that take place in the equity markets, and markets as a whole.  The idea of “rational investors” seems to have taken a terrible beating of late, but the question of completely abandoning EMT is beyond the scope of many economists and academic thinking.  After all, this theory has been doled out piecemeal to college students for decades as the “Holy Grail” of investing theories.  I suspect it’s demise will be a slow one, as academics are not fond of saying, “Geez, we were completely wrong on this one.”

Enter now, from stage left, the Adaptive Market Hypothesis.  The attempt to bring order and an overarching theoretical framework into analysis of the seemingly unruly behaviour of financial markets was a temptation that has for years proved too great for academics (and many market participants) to resist, but it has turned out to be a long and largely fruitless journey.  And Montier is none-too impressed with AMH:

“However, we are less convinced that AMH is a terribly useful concept. As we understand it, the AMH provides a halfway house where sometimes markets are irrational and sometimes they are rational. We would argue that the amount of time that markets are rational is near negligible. Instead markets seem to be in a constant state of disequilibrium – moving from boom to bust and back again, rarely if ever stopping off at “normal”.

If, as one of us has recently argued (Insight, June 25), the efficient markets hypothesis is the financial equivalent of a dead parrot, then the AMH may be a dodo.”

And so the quest to find a neat explanation for the way the market functions continues, without any real progress.  It seems most of the current literature spends hours debunking current theory and offers little in the way of explanation.

Why?

Mendelbrot had the problem pegged long ago, chaos and randomness…there has been no real explanations because a degree of randomness exists in the market and it is difficult to account for irrational behavior, or market noise.  Yet within this randomness certain substructures exists, fractals, and they are like signposts on a twisting winding road to nowhere.  The problem is simple, human nature has a hell of a time accepting randomness, surely, many argue, there must be some order in a disordered market.

The argument ranges on, and always will.

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