Submitted by Eric L. Prentis,
The financial elite—using academe for intellectual cover—want you to believe that markets are efficient, as defined by the Efficient Market Theory (EMT). My research strikes down this hoary old EMT economic dogma, used by duplicitous bankers and hedge fund managers to con US politicians and 99% of Americans.
The Efficient Market Theory (EMT) is a significant foundation theory in economics. Prove the EMT wrong, and economics becomes largely an empty shell. Therefore, the EMT is the most important fundamental issue in economics and for America.
US politicians mistakenly use EMT based economic theories to pass laws favorable to Wall Street. First causing and now worsening the credit crisis. Examples of credit crisis enabling legislation include:
- Gramm–Leach–Bliley Financial Services Modernization Act of 1999
- Commodity Futures Modernization Act of 2000
- Bankruptcy Abuse Prevention and Consumer Protection Act of 2005
- Jumpstart Our Business Startups (JOBS) Act of 2012
Three tenets define the EMT.
- The first tenet—that markets are in equilibrium and if unexpected events cause disequilibrium, it is only temporary because markets are self-equilibrating—is disputed in the literature. A stock market always in equilibrium and efficient is impossible because traders have different endowments, beliefs and preferences. In addition, arbitrage costs throw markets out of equilibrium.
- The second tenet—that stock prices “fully reflect” all information—has long been challenged in the literature, with many inconsistencies reported. Tenet number two goes on to say asset prices properly represent each asset’s intrinsic value, and as a result, prices are always accurate signals for capital allocation. Researchers in behavioral economics find fault with this EMT assumption, because it does not account for human nature and inherent herding behavioral instincts of market participants. EMT theorists—Eugene F. Fama and Burton G. Malkiel—claim assuming market equilibrium is close enough to reality, and that research into EMT tenet two contests only the semi-strong form of efficiency. That is, where earning higher returns than the stock market, with lower risk, is not achievable by knowing all publicly available information. EMT theorists continue to support the EMT and say, “If you want to do better than stock market returns, you have to take on more risk than the stock market.”
- EMT tenet number three is most important—that is, stock prices move randomly or are uncorrelated with, if not independent of the prior period’s price change. Therefore, earning higher returns than the stock market, with lower risk, is impossible to achieve using only past prices (i.e., technical analysis stock trading rules or stock charts). Empirically prove EMT tenet number three wrong— because it tests the weak form of market efficiency—and the EMT is wrong, period!
EMT theorists specify two methods to test EMT tenet number three. The first method is statistical inference. Calculate serial correlation coefficients of stock price changes. If the serial correlation coefficients are zero or close to zero, this supports assuming serial independence in the price data. Therefore, one can infer that technical analysis stock trading rules cannot work. The second method requires using a technical analysis stock trading rule predictive model that forecasts the future, based solely on past prices—where expected profits are greater and risk lower than they would be under a naïve buy-and-hold policy.
Research that supports the EMT makes one-or-all of the following mistakes:
- Using the wrong data—Systemic market risk and random unsystemic risk make up individual company stock price movements. As much as 50% of a company’s stock price actions are random unsystemic risk variations associated with the internal circumstances within that particular company. The remaining 50% of a company’s stock price movements represent the systemic risk of the overall market. The random unsystemic risk is the chaotic portion of the stock price data—that if removed leaves only the systemic market risk of the overall market, which may then be analyzed. Most EMT research studies day-to-day stock price movements of individual companies, which is mistaken. Granted, this unsystemic and systemic, day-to-day individual company data look random, but it is the wrong data to analyze to determine overall, long-term market trends.
- Using the wrong method to analyze the data—Most researchers use statistical inference to test tenet number three. However, there is a serious problem with using statistical inference to test whether stock price data are independent. That is, it is difficult to distinguish between a rootless series and one where the systemic quality is faint. Research shows that five-thousand years of data are needed to identify independence in stock price data using statistical inference. However, these data do not exist. Consequently, statistical inference is not the correct method to use to test tenet number three.
- Jumping to mistaken conclusions based on half-truths—Statistical inference tests using day-to-day individual company data report serial correlation coefficients that are close to zero. This supports assuming serial independence in the price data. Therefore, one can infer that tenet number three is valid. Unfortunately, this proves nothing of the sort. Analyzing the wrong data over an inadequate number of years simply gives a false positive.
What day-to-day stock price movements are for individual companies is the wrong research question. Instead, we want to know what the overall stock market is doing over the long term. The correct way to look at market data follows.
Using correct data—Individual company stock price behavior, which includes the randomness of unsystemic risk, is not evaluated. Instead, only systemic market risk is analyzed in my published journal research—please see here and here—by comparing only systemic market risk of two well-diversified S&P 500 Index portfolios. S&P 500 Index portfolio B is for active trading and S&P 500 Index portfolio A is the benchmark portfolio. Focusing only on systemic market risk in the data studied, removes much of the random or chance stock market price behavior of individual companies.
When investing over 1, 2, 3, 4, 5 years or more—day-to-day stock price movements are immaterial to trading success and may be thought of as just daily market chatter. Concentrating on daily price movements of individual company stock or the stock market as a whole is not the correct question. Day-to-day stock price action is volatile. To dampen out this daily chatter and give perspective to what is occurring long-term in the stock market, S&P 500 Index “monthly price data” are used to smooth out stock price volatility.
Monthly price data are important in dampening out day-to-day price movements. However, using last month’s price to predict next month’s price is also not conducive to long-term trend development. To further smooth price variations and focus on systemic stock market risk. Nine and two-month simple moving average (SMA) trend lines are fit to the S&P 500 Index monthly price data for actively managed portfolio B. Smoothing out data volatility, which gives an overall view of the long-term stock market trend. This is the third step in removing much of the random stock market price behavior from the research data.
Focusing only on systemic stock market risk in the monthly data and smoothing stock price volatility using nine and two-month SMA trend lines for the well-diversified S&P 500 Index portfolio B—to lessen random variations—is a major difference between my research and other EMT research in the literature, and a major reason the results are so significant.
My research covers 1871-through-2008, 138 years. All available Standard & Poor’s (S&P) 500 Index data are included in this research study, making it the longest duration and complete in the literature.
Using the correct method to analyze the data—Fama’s approved second method for testing the EMT, requires using technical analysis. Fama says to develop and test, over both good and bad economic conditions, a technical analysis stock trading rule predictive model that forecasts the future, based solely on past prices—where expected profits are greater and risk lower than they would be under a naïve buy-and-hold policy.
My empirical research method directly tests stock market price independence of EMT tenet number three, using a new technical analysis stock trading rule predictive model. To test whether expected profits are greater and risk lower than a benchmark naïve buy and hold policy, which Fama calls, “an equally valid scientific method versus statistical inference.”
Empirical results—In my US stock market research, the relative maxima and minima stock trading rule S&P 500 Index portfolio B—by $495,360 dollars (i.e., $580,423 - $85,063)—makes +582% more money than buy-and-hold S&P 500 Index portfolio A—and is only 64% as risky over 138 years—from January 1871 through December 31, 2008.
The new technical analysis relative maxima and minima stock trading rule predictive model makes substantially more money at significantly less risk than the naïve buy-and-hold policy. EMT theorists say this thorough beating of the US stock market should be impossible to achieve using only technical analysis. Thus, tenet number three and the weak form of the EMT are invalid, making the Efficient Market Theory wrong, period!
Neoliberal economic philosophy, starting around 1980 and now mainstream in academe and American politics, promotes laissez-faire economic policies of reducing the size of government, deregulation and privatization of government services. Neoliberal economists base this philosophy on the belief that neoclassical economic theory is correct. That is, that “markets are efficient”—my research shows the EMT is dead wrong.
Gullible US politicians believe that markets are efficient and defer to them. Therefore, US politicians abdicate their responsibility to manage the overall economy, and happily for them, receive Wall Street money. Mistakenly, the primary focus during the 2008 credit crisis is on fixing the financial markets (Wall Street banks) and not the “real economy.”
Wall Street touts markets as trustworthy and infallible, but that faith is misplaced. Big market players easily manipulate markets. For example, by changing accounting laws so banks no longer have to mark-to-market, High Frequency Trading (HFT) front running, and multinational companies buying back their common stock shares, along with favorable huckstering of stock positions on CNBC—owned by Comcast and General Electric. In addition, Chairman Bernanke, because of his Quantitative Easing II, takes credit for the Russell 2000 Index of small company stocks reaching an all-time high of 860.37.
The Federal Reserve (Fed) talks of added quantitative easing (QE), but this would mainly help the richest 1% of Americans and hurt the “real economy,” with higher gasoline and food price inflation. Unfortunately, QE only helps overinflate the stock and commodity markets by manipulating prices. Despite Fed programs QE I&II and Operation Twist, America is experiencing the worst economic recovery from a recession, ever! President Obama, if he wants to lose the 2012 election, will let Bernanke electronically print more QE money and make the “real economy” worse than it otherwise would be.
The continuing credit crisis is serious—with the world economy poised for a double-dip recession. The current US government policy of increasing the national debt by $5 trillion dollars over the past four years, keeping insolvent banks from going bankrupt, a Federal Reserve zero interest rate policy (ZIRP), causing malinvestment, and monetizing the national debt (which is what tin-pot dictators do just before they are forced to flee the country) with quantitative easing by the Fed, and austerity for the 99% to repay bad bank loans has not worked—and doing more of the same will not work—and defines insanity.
The financial elite are using this “cover-up and pray” policy—hoping that rekindled “animal spirits” will bring the economy back in time to save the status quo. This is impossible because the trust is gone. The same sociopaths control the economy. Instead, the financial elite are just protecting themselves with outlandish pay bonuses, based on cooked books; while the “real economy” flounders with high unemployment, unsustainable budget deficits, a struggling real estate market, and low capital formation, crumbling infrastructure and high gasoline and food price inflation.
Conclusion—this is what to do:
- Reenact the Glass-Steagall Act. Allowing investment banks to speculate with savers’ money is criminal.
- The daisy-chained, unregulated $707 trillion dollar OTC Derivatives market will bring down the world economy, when it goes bust. JP Morgan’s recent huge OTC Derivative trading losses are a prelude to this eventuality, with many more instances to come. Start unwinding the OTC Derivatives market now, before it is too late.
- Insolvent banks are a drain on the “real economy.” Force insolvent banks to go bankrupt. TBTF is an irrational policy. Allow capitalism to work for the 1%.
- Public and private debt to GDP is about 360%, and 30% of Americans are being hounded by bill collectors for unpaid debts. Americans can no longer service their massive debt loads. Allow debt forgiveness for the 99% and institute austerity for the 1%—they can afford it.
- ZIRP is destroying capital formation and savers. Allow interest rates to rise, which will increase consumer demand. The Fed’s manipulation of capital markets causes malinvestment—resulting in crippling long-term penalties for the “real economy.”