Financial Accounting Blog

Wednesday, November 05, 2003

These two articles tie in with the Efficient Market Hypothesis. Bubble theory appears to be an ongoing argument against EMH.

An older article in the Economist (5/18/2002) entitled "Bubble Trouble" focuses on how the Fed chairman, Alan Greenspan was responsible for the late 90's / early 2000 financial bubble. Andrew Smithers and Stephen Wright argue that Greenspan could of avoided the bubble by raising interest rates by enough to bring down the 'Irrational Exuberance' and also lower share prices with the change. They blame Greenspans lack of action on two ideas. One is his belief in "Efficient Market Hypothesis". The article proceeds to explain that,
In efficient markets, prices are assumed to reflect fundamental values and to incorporate all relevant information. When ill-informed investors move prices away from their true value, informed investors will arbitrage them back to the right level, so there is no chance of a financial bubble, as defined by Peter Garber in his book "Famous First Bubbles" as a high price "at odds with any reasonable economic explanation"..... If a price goes to a level for which there is no obvious economic explanation, the believer will simply conclude that there is a non-obvious economic explanation- such as the coming of a more productive "new economy". What he will not conclude is that there is a bubble.

The article proceeds to argue that one weakness in EMH theory is the assumption that arbitrage (the simultaneous purchase and sale of the same securities, commodities, or foreign exchange in different markets to profit from unequal prices) by the informed against the uninformed is riskless and costless. The article explains that "Shorting shares involves borrowing a share and selling it now in the hope of buying it back later at a lower price to return to the lender. But borrowing a share can be costly, especially if the price continues to rise for a while before it falls. The further it goes above the price at which it was sold, the more nervous the lender will get and the more collateral he will want the borrower to post as Security." - higher risk.

In a more recent article "Professor Bubble" in Forbes , Vernon Smith, a nobel prize winning economist and expert in experimental economics conducted trading simulations using grad students for different time periods (in controlled academic environments). What he found was that once students ran the price of the security past the fair value, many kept buying. As soon as enough traders decided to stop paying a premium for the security the market crashed. When Smith ran the experiment a second time with the same group, another bubble formed, although smaller. The third time around, the investors were wiser and trading hovered around the security's value.

Smith repeated his experiments numerous times sometimes using students and sometimes using finance professionals. The financial types, he noted, made bigger bubbles. He claimed that people are "myopic. If the price is going up, they think it will keep going up."

His conclusion was that "New bubble danger comes down the road when a new generation of investors joins the market".

Thus, in an attempt to understand these concepts - I conclude that the markets greatest threat to efficient operation and potential argument to EMH is the routine influx of ignorant new investors entering the arena. The more new investors enter the market, the more likely the formation of a "Bubble" that disrupts Efficient Market Theory. However, one can take comfort that the investor learns with time. 2005? (?)