EMH Efficient-market hypothesis

According to EMH, investor's reactions to new information should be normally distributed in a sense that they act in different ways (over react and some may under react) to particular information that is released/already available. That was not the case in housing bubble and dot com bubble with lack of "consensus of opinion, where investors just invested everything blindly to maximize their future returns. In case of dot com bubble, investors relied on efficient market hypothesis that prices of the stock markets and companies with dot com prefix will earn substantial profits in future, without considering the fact what kind of business they have. So clearly prices of shares at that time didn't reflect all the information that what will happen in the future and suddenly it crashed bringing the EMH in controversy.

Market is not efficient enough to see through because of numerous reasons. First of all due to corporate fraud that exists to deceive the investors, shareholders and potential investors/ shareholders. Most of the time corporate fraud exists because of insider information not being disclosed to investors/ potential investors which makes the market inefficient. This clearly creates an inefficient investment for investors mainly because of conflict of interests between investors and management (agency theory) and information asymmetry. Information disclosed might be inaccurate to mislead investors and investors based on that inaccurate information will invest to maximize his/her expected return in the future. Even if the accurate information is disclosed by management on which investors rely; still some investors might not be have all the information of what will happen in the future with certainty, so how can the market be efficient? The prices might go up or down not based on the current information available and historical data following a random walk theory. Even though certain rules and regulations like SOX exists to deter any kind of fraud and information asymmetry, but still there are certain loopholes that exists in these regulations with the most important one that SOX doesn't applies to only publically traded companies. It should be applicable to private companies and banks aswell, which can increase market efficiency.

Inaccurate predictions based on historical statistics/ data made by companies or others (including some financial analysts) to mislead the investors to purchase shares/securities or even houses results in an inefficient market. Sometimes even investors themselves make these inaccurate predictions without any research or information. There exists no brainless management who will release predictions of their downfall in future to investors/potential investors; now does this information asymmetry make market efficient?- No.

There is a direct relationship of new technological invention with the share price. Whenever company releases the news of such innovations, investors buy more shares. For instance, when Microsoft released the news of new Windows 7, people bought more share expecting that share prices will go up when windows 7 comes out, without considering the fact Windows 7 can be a failure. Expectations also result in increase of the value of shares/houses (both normal and abnormal), which eventually increases sales and profits according to CAPM model but this wasn't the case in housing and dot com bubble. From these two bubbles we can just conclude that beta is almost close to 0 because prices don't correlate with the market in these cases.

Investing in stock prices is always a risky investment because of uncertainty of the possible outcome, if investors know the probability of certain outcome for sure then there is still a risk that the outcome will be undesirable. There is no rational investor in reality, people invest based on their judgments and based on other's judgments. Greed, fear and emotions also make a rational investors act irrationally to any available information. Investors don't have any subjective probability of what will happen in the future if it will be a good state or a bad state, that's the reason why they can't calculate their expected utility to base their decision on; might result in an irrational behavior of investors. Adding to that market is not rational enough to earn profits in future.

Information is not always rational because interpretation is required to make a rational decision and most of the time information is not interpreted due to time constraint and also due to the assumption that market is efficient and information need not be interpreted. The truth is that it needs to be interpreted to act rationally, to reduce the risk (also because of "lack of trust on businesses). Investors just follow other irrational investors which creates a "noise factor. Hence to avoid that and to make better decision investors need to wait and analyze and check the reliability of the information which costs the investors. The time constraint factor plays a vital role because it changes the relevance of the information. So by the time investor's act upon the available information after analyzing; share prices or prices of an asset will change and hence making the market inefficient because some of those investors who already had all the relevant information (insider information) on or before it being released are the ones to benefit the most.

Sometimes information to be acquired is costly to make a more appropriate decision and it varies with investors how much information they need to acquire to make a decision to invest how much or just not to invest. Even the information acquired needs to be analyzed and this analysis also varies with cost. Also the information analyzed needs to be verified if it's reliable or not which also costs the investor. All these factors vary with the amount the investor spends and hence investors might have different perception of the investee to make a decision.

In 2005 builders built too many houses, supply was too high. In 2000 after dot com bubble, government decreased the interest rates to soften the effect of recession, which eventually reduced the mortgage rates and demand for houses increased. When demand increased prices of home increased to bring down the demand to match the supply. Then banks started lending money to home buyers for no down payment, with poor credit and even to those who had no jobs. Eventually prices rose even further because demand increased more because a rational investor would assume that prices will go up more and it's an investment to buy a real estate property. But now in late 2008, due to recession again supply increased because people lost their jobs and had their homes for sale and demand decreased because people couldn't afford to buy homes and when supply is more than demand, prices drops and it dropped significantly due to reduced interest rate (mortgage rates) resulting in a housing bubble just like a dot com bubble. And investors are not the only one to blame in this case. Realtors would never want to holdback buyer or seller to get into an agreement due to their own commission purposes. So there comes the trust problem, should a rational investor trust a realtor to make an investment in real estate property. Afterall, buyers don't have the information that realtors and mortgage brokers have in terms of what might happen in future if it can pose a problem or can result in a loss of that investment, due to agency conflict

In case of housing market, it was good news for investors which persisted from 2002- late 2008, so investors assumed it as an ideal state and made assumptions to have some utility in terms of their future returns. But the reality is that we are under a non-ideal conditions and the future is more likely to be independent of the current situation.

Then early in 2009, banks dropped the mortgage rates and government provided more incentives for home buyers to invest in real estate property by providing various tax advantages. The consequence for that was people started buying more again and demand increased as a rational investor assumes that the prices will go up in future when we are out of recession, which will result in an increase of mortgage rates. Also supply is reduced just because some sellers will predict the prices to increase in future to sell it at higher price (at least for what they paid for) But due to information asymmetry, they don't consider the other negative side of the mortgage interest rates which might go up when they renew their mortgage term after 5 years; hence these buyers don't realize due to lack of clear alternatives that interest rate might go up when they have to renew their mortgage after 5 years, will they be able to pay back their debt (including principal amount and interest payments) considering they have other household expenses too. These buyers might default on their mortgage payment and who will own their collateral capital asset/ rental property? Banks will. So it is a risky investment just like stock markets. But realtors and mortgage brokers argue that buyers are getting mortgages at low mortgage rates and hence they save almost 3% of the debt annually as their reduced interest payments, assuming that mortgage rate before (2 years ago) was 5% and now is nearly 2%. And they argue that what home buyers save for reduced payments due to lower mortgage rates can be used to pay the principal amount for 5 years which will increase their equity in homes and will eventually decrease the interest payments after 5 years due to less debt outstanding. But most of the buyers don't have information on these viable alternatives. Also, they predict that once the recession is over, mortgage rates will go up and prices of houses will increase from which the buyers who are investing in real estate property now will walk off with huge amount of profit. So, investors are lured away with these ideas to invest more and more in real estate properties, even though they don't have permanent jobs and some investors are buying multiple homes just to gamble. But who could predict that housing prices will drop that much due to recession? And who can predict now that it will increase and when it will increase? Hence market is not efficient enough to see through it.

Speculating the increase in value of stock markets during dot com is very similar to what is happening in housing market. Home buyers are just speculating that they can earn at least $50,000 or more on a $300,000 now in 2 years, even if they have to pay approximately $12,000 in interest payments for two years at a low mortgage rate as of now. Hence these low prices lead rational investors to speculate to maximize their future returns, but can they really? Even if they can, don't they have to buy a house to live eventually at the fair market value at that time? It might be true for those owners who own multiple houses, but they will lose money for interest plus principal payments for those 2 years (assuming it's not rented), also no tax advantage as it won't be principal residences and gain will be taxed as business income rather than capital income. So the return they get is not a real investment instead its just they are just getting what they paid for.

Media is also the one to blame to support recession and hence low mortgage rates. According to the research, people tend to absorb more of the bad news rather than good news, demand decreases and as a result prices drop and banks have to eventually lower the interest rates to give an incentive to investors to keep on investing to boost the economy. Hence some financial analyst suggests that investors should act optimistically by seeing the positive side/good news to recover from recession.

We conclude that market for is guaranteed not to be termed as strong form efficiency just because insiders do have information that is not released to outsiders (information asymmetry) at proper time which does have an impact on investor's decision as seen in the case of housing bubble and dotcom bubble but we can conclude that market is a weak form efficient or almost inefficient because clearly in the case of housing bubble and dotcom bubble historical prices and available information of these assets didn't reflect any future returns. So basically these two recent bubbles made the market inefficient and unreliable because the probability of the future events/returns due to which investors invested to maximize their returns was completely erroneous. And finally banks should be considered lemon because they do have all the information that can change the investor's decision. That is why we need accountants, auditors and financial analysts to atleast try to help investors not to act irrationally by and reduce their behavioral biases to some extent.

  • http://network.nationalpost.com/np/blogs/fpposted/archive/2009/04/13/why-we-love-bad-news-and-how-it-supports-the-recession.aspx

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