Eugene Fama vs. his student. Is the stock market efficient?

Sergey Gurov

Oct 1, 2024

On August 30, two materials were published simultaneously discussing the degree of stock market efficiency. There is still no consensus on this issue within the investment community.

The first publication is an interview with Nobel laureate in economics Eugene Fama by Financial Times journalist Robin Wigglesworth. Back in 1965, Fama formulated a then-revolutionary market efficiency hypothesis, which states that information is instantly and fully reflected in the market value of securities. It is worth noting that there are three forms of efficiency: weak (only past relevant information about the asset is reflected in the price), semi-strong (both past and all current public information are reflected in the quotes), and strong (all information — past, public, and insider — is reflected in the price).

Responding to frequently mentioned critical considerations against the market efficiency hypothesis, Fama implicitly refers to the criterion of falsifiability, suggesting that any scientific theory should not be fundamentally irrefutable. “Efficient markets are a hypothesis. They are not reality,” says Fama. The academic agrees that perfect efficiency does not exist and “individual stocks may trade at unreasonable prices, but on average, in the long term, the collective efforts of millions of people trying to outsmart the market mean that prices are more often fair than not.” Another frequently cited argument by Fama in defense of his position is: if pricing is so inefficient, why is it so difficult to earn high returns on a systematic basis in the stock market?

One of the main counterarguments from Fama's opponents regarding the latter point is the following: short selling carries more significant risks than opening long positions, which often leads to the squeezing out of bearish players from the market and, as a result, to less efficient pricing, and in extreme situations, to a sharp rise in quotes.

The second material is an article by Cliff Asness, a well-known investment manager, co-founder of the AQR hedge fund, and former student of Eugene Fama. He presents other arguments against the idea of informational efficiency of the stock market. The main one is purely theoretical: as shown by the model of Sanford Grossman and Joseph Stiglitz, another Nobel laureate in economics, it is precisely market inefficiency that gives investors the incentive to spend resources on finding information on which they will base their investment decisions. Without it, there would simply be a market collapse due to a lack of trading activity.

Moreover, according to Asness, there has been a decline in the level of efficiency in recent decades. In particular, he points to the rather modest results of the strategy of buying relatively cheap American stocks in the 21st century compared to more profitable strategies of buying expensive stocks of US public companies. The current quantitative indicators of the valuation of expensive stocks relative to cheap stocks (value spreads) are at their peak values and can only be compared to the dot-com bubble of 1999–2000. In the second half of the 20th century, the return from highs to levels close to historical averages occurred quite quickly. The current significant gap in stock prices with low and high multiples has been observed for several years and seems unlikely to disappear soon.

Asness considers various rational explanations that could confirm that this time everything will be different (“this time is really different”), but ultimately rejects them and concludes that “markets have become more detached from reality over time.” The article proposes three hypotheses as to why this might have happened:

• widespread index investing
• a long period of extremely low interest rates
• the development of modern technologies (such as trading apps).

Regarding the first assumption, Asness agrees with a number of other researchers that index investing has not significantly harmed the market. At the same time, he notes that the spread of passive investing practices may have made stock prices less elastic (in other words, trading volumes have started to move asset prices with greater amplitude than before). However, separate studies are required to accurately confirm the link between the spread of index investing and the increase in value spread.

The impact of low, even negative interest rates in the economy over a long period seems to Asness to be a more important factor — even though there have been bubbles in history when rates were by no means minimal (as during the aforementioned dot-com crisis). The author notes that persistently low rates per se are neither a necessary nor sufficient condition for the emergence of a bubble, but it can “make investors do crazy things.”

Asness considers the gamification of trading platforms to be the main “culprit” of the decline in informational efficiency (as we recently showed, this leads investors to take greater risks). Like Warren Buffett, who recently compared modern financial markets to a casino that “is now in many homes and tempts residents daily,” he expresses confidence that social media and trading apps have led to increased overconfidence among retail investors, who generally lack high financial literacy but have gained access to instant and round-the-clock trading without high commissions.

The arguments of supporters regarding the new hypothesis of “efficiently inefficient” stock markets, first formulated by economists Lasse Heje Pedersen and Nicolae Garleanu, seem to us the most balanced. According to this concept, a certain degree of informational inefficiency should be maintained in equilibrium. Asset management companies can offset their costs of searching for and processing information about financial instruments, but the scale of this reward — after deducting all costs and adjusting for risk — should not encourage the emergence of a large number of new investment companies in the market.

Why You Need to Know This

For rational investors, the ability to choose the right assets and adhere to the strategy considered correct over a certain period without significant portfolio drawdowns remains consistently important. Asness warns that the skills needed for successful investing have changed: the decline in market efficiency has simplified the first task but complicated the second.

In one of the following articles, we will examine the current methods for assessing the efficiency of pricing various assets.