Testing Market Efficiency
by: Jay D. Franklin, CFA, FSA
IFA Director of Trading & Investment Risk
During this turbulent period, certain pundits have questioned the validity of the Efficient Market Hypothesis. There is nothing new about this, as these questions have arisen in every highly volatile market since the formulation of the Efficient Market Hypothesis approximately forty years ago. As a specific example, the author of this article cites the magnitude of the 2008 drop as evidence that market prices were previously incorrect, but now, of course, they have been corrected. Furthermore, if the market was so obviously inefficient then, why should anyone believe that it is efficient now? Like so many others, the author of that article has confused hindsight with foresight.
In an interview seen here, Professor Eugene Fama, the father of the Efficient Market Hypothesis, describes a simple test for determining whether or not the market does a good job of setting fair prices. In order to understand this test, it is necessary to visualize what an inefficient market looks like. Such a market would have lots of what we refer to as irrational and not-so-skillful “noise traders" creating prices that are incorrect and/or are not fair, leaving ample opportunity for skillful traders to "beat an appropriate benchmark." In an inefficient market, we would see smart, skillful, highly informed traders that are consistently exploiting and making money at the expense of the irrational and dumb traders, but we see no evidence of such skillful traders. In fact, successful traders have been more appropriately deemed "just lucky."
Eugene Fama indicated that another attribute of an inefficient market would be higher daily volatility than would be estimated based on annual volatility. In an inefficient market, daily price swings would be high, possibly creating mispriced stocks. But, as "skillful traders” scoop up the mispriced stocks from the poor ignorant traders, the volatility would smooth out over time.
Based on fifty years of annual returns data, IFA estimated the daily standard deviation of the S&P 500 to be 1.09%. This estimate was based on dividing the annual standard deviation by the square root of 250, the approximate number of trading days per year. In an inefficient market, the actual standard deviation of daily returns should be much higher than the estimated 1.09%. IFA obtained the daily S&P 500 data from Yahoo! Finance for the last fifty years, and the actual daily standard deviation is 0.98%. According to Eugene Fama's test, this result would not be indicative of inefficient markets.
Given that the fifty year data shows no indication of market inefficiency, one may argue that the market over time has become progressively more efficient due to increased availability of information about companies or that it has become less efficient due to wider accessibility to uninformed traders. Breaking up the fifty year period into five consecutive ten year periods gives no indication of either increasing or decreasing efficiency. In fact the only ten year period where the estimated volatility was substantially lower than the actual volatility was the middle period (1/1/1979 to 12/31/1988), as seen below:
Actual vs. Estimated Daily Standard Deviations of
S&P 500 Returns - (Inefficient markets would be the opposite result.)
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Even if the market is populated with unskilled traders, all that is needed for market efficiency is a sufficient number of intelligent participants with access to sufficient information. These informed and willing buyers and sellers compete to trade at a profit, and the price they strike is the consensus of their opinions of the stock’s value, otherwise known as the fair market value. As expressed by Marlena Lee of Dimensional, the market does its job of setting prices so that buyers can expect to receive a return that compensates them for the risks they bear.
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As recently noted by Gene Fama Jr., the very fact that the Efficient Market Hypothesis still comes under assault is stronger testimony to its deep relevance. Furthermore, it is important to remember that asserting market efficiency is not equivalent to asserting that the market is right, just that it is more likely to be right than any single market participant. Also, even if markets are not perfectly efficient, they are efficient enough that the time and resources spent in attempting to uncover inefficiencies exceeds the profits to be gained. Those who believe they can prosper by taking advantage of a market that they perceive as inefficient would do well to remember the thought expressed by John Maynard Keynes well before Professor Fama articulated Efficient Market Hypothesis: “Markets can remain irrational longer than you can remain solvent.”
 The conclusion of this analysis is that investors should invest, but never speculate. IFA keeps a crystal ball on its conference room table to remind us that nobody can predict tomorrow's news. When guests are asked to peer into the crystal ball, they see a fortune that Mark Hebner, IFA president and founder, received by chance in a fortune cookie from a Chinese restaurant. The message in that fortune says, "Invest, but never speculate."
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