Eugene Fama was selected as one of the three Nobel Prize for Economics recipients this week.
His hypothesis regarding the efficiency of financial markets is indeed elegant (which sometimes is enough for an award to be made) but it is also utterly and completely wrong.
Not particularly impressed with his Fama-French Three-Factor Model either (but more on that later).
If there were no government interferences, no psychopathies, no behavioural irrationalities, no corruptions nor criminalities and if market sectors didn't always evolve towards maturity, he would be right.
But as these inputs drive all markets, the laureate is surely wrong.
Fama's Efficient Markets Hypothesis was put forward in 1970 and formed an intellectual basis for the shock doctrine disaster neo-capitalism that the world has experienced since.
By being a part of the "intellectual" framework gathered as an neo-con edifice at the University of Chicago, Fama bears some responsibility for this sociopathic system.
So, what is Gene's hypothesis and why is it incorrect?
The Efficient Markets Hypothesis is split into three levels - strong-form, semi-strong-form and weak-form efficiency.
Strong-form suggests that market prices reflect all information, public and private, and it is not possible for anyone to earn excess returns.
In semi-stong-form, prices adjust to new information rapidly and rationally.
While weak-form structures, prices simply follow a random walk.
Before we go any further we need to look at the architecture of markets.
The public markets are just the top of an iceberg of submerged Dark Pool markets - there are hundreds of unregulated Dark Pools where insiders trade against insiders in markets that the public only sees when an excess of over-enthusiasm occurs. It is in these markets that the big market plays are made not the public ones.
For all assessments of Fama's Hypothesis, therefore, it will need to be addressed on two levels - the public markets and the Dark Pools.
1) The most dominant input to the wrongness of Fama's Hypothesis is behaviouralism.
Work in the sixties by Daniel Kahnemann, Amos Tversky, Paul Slovic and Richard Thaler had already introduced psychology to the market and, in 1979, Kahnemann and Tversky developed Prospect Theory which represented the final psychological nail in the coffin of Efficient Markets. Investors do not behave in a rational manner in the marketplace for a whole continuum of different reasons that both exist within themselves and also interact in complex ways between themselves to produce the behaviours that we project. Market prices represent mass human psychology far more than they do unproved economic fundamentals.
So by 1979, Fama's Hypothesis should have been put to bed...
... unfortunately, it took the blinkered Chicago School until 2007 to acknowledge the impact of behaviouralism in markets, attempting to convince us in the meantime that an efficient pricing infrastructure underpinned the alleged validity of Friedmanian late capitalism..
Slavoj Žižek: "The problem is today when you have chaos or disorder, people lose their cognitive mapping."
2) All of the information is not in the market. Even if behaviouralism did not exist and we were all perfectly rational in all of our decision-making, efficient markets would be compromised on all three levels of Fama's efficiency hierarchy.
Public markets are largely inefficient being too far from the core Dark Pools to be benefiting instantaneously to the flow of real information. The public markets offer a distilled filtered form of this driving underground Dark Pool marketplace. Dark Pool trading strategies become converted into a holistic market strategy as Dark Pool liabilities are hedged in the public sphere.
What about the Dark Pools?
Are they a proof of Fama efficiencies?
No.
Behaviouralism is a "plug in" in any market, public or Dark Pool.
Additionally, the information flow in Dark Pools is, by its very nature, opaque.
Proxy trading, algorithmic distortions, hidden players away from the table, consortia strategies, disinformational trading, cornered markets etc etc.
At any given time, the market tends to inefficiency.
As mature markets might evolve into anything the primary operators desire, the price can be anything too.
Mature markets (and these are the ones most traded in the Dark Pools) are largely under the absolute control of a small grouping of operations, think OPEC. Individual members of OPEC have their own hidden agendas over and above the shared agenda with fellow members. Even when the structure is held in place with extra robustness due to government scaffolding around the market, the major player(s) is/are still able to make the market whatever they desire whenever they desire.
In effect monopolistic corruption distorts any semblance of efficiency in the market while duopolistic or cartel behaviour offers a slightly diluted version of the same.
3) Disaster capitalism undermines any efficiency in any financial market.
The Friedmanian disaster capitalism complex thrives on chaos. When a disaster strikes or, as in the case of Chile, is created, the Chicago school Hayekians move in with their shock tactics to further destabilise an already destabilised people. As US security entities move into the vacuum, the markets are utterly chaotic. Although some efficiency and robustness is added to the marketplace ironically by the strategies of these security operations (the same template being micro-adjusted from territory to territory) the holistic performance of the markets are driven by irrationalities and the efficiencies fall off the bottom of Fama's ratings chart. Andrew Haldane, who should have been made Governor of the Bank of England, refers to this inability to judge risk as "disaster myopia".
Disaster myopia in a disaster capitalism complex!
4) Private information is introduced to the market in a variety of strategies that, by their very nature, imply market inefficiencies being created for the advantage of Dark Pool operations.
Knowledge within a company, governmental or central bank policies, trading disinformation for future profits, competitive market poker play all are based around the possession of the ultimate power play for the marketplace. Just think of the variety of ways in which, say, Ben Bernanke could have utilised his absolute knowledge of the variables related to quantitative easing. An individual, with evolving strategies, could make money without the full reality hitting the market by placing trades laterally and peripherally.
Noam Chomsky would call this "cogntive regulatory capture" and it is a structure typical of late capitalism.
5) The most obvious way in which financial markets are inefficient is by their refusal to accept the cost of externalities in the price of an asset.
How on earth can a price be efficient in the holistic sense if externalities are not included in the calculation? The price can only be considered in any way efficient in short time frames as, when the true costs are included, the asset value is very different indeed. The timing of this market implosion can be an unknown variable.
Friedmanism underprices risk and ignores externalities.
The eventual impact of these externalities is infrastructurally significant.
Although Dark Pools are displaced up the efficiency hierarchy due to lack of time lag and the primary element in the insider trading, the markets increase in efficiency is only marginal and only due to corrupting inputs being introduced to the market price.
If all corrupt inputs in a mature market could be known and assessed both singly and in association with one another, only then might a corrupt market approach strong-form efficiency and in a non-regulated marketplace this is simply not going to occur.
Which brings us to the conclusion of yet another aspect of the fake of Friedmanism.
Fama's only other claim to fame is the already mentioned Fama-French Three-Factor Model.
This attempts to replace the old Capital Asset Pricing Model (which, by the way, is also inadequate).
Needless to say the Three-Factor model doesn't work as it ignores corruption and behaviouralism.
Entertainingly, Foye, Mramor and Pahor (2013) have shown an improvement in the performance of the Fama-French model if one of the terms is replaced by a term that acts as a proxy for accounting manipulation!
These papers are amongst the first tentative steps of economics crawling towards holistically analysing the hyperreality.
Benoît
Mandelbrot: "Financial economics, as a discipline, is where Chemistry
was in the 16th century: a messy compendium of proven know-how, misty
folk wisdom, and unexamined assumptions and grandiose speculation."
As a former pupil of Mandelbrot, Fama should know better...
... grandiose models, unexamined inputs, misty economic wisdom mixed with the status quo.
And, anyway, as economics in rather dubious fashion claims to be a science, let's address it as such...
Michel Foucault: "If one recognises in science only the linear accumulation of truths or the orthogenesis of reason, and fails to recognise in it the discursive practice that has its own levels, its own thresholds, its own various ruptures, one can describe only a single historical division, which one adopts as a model to be applied at all times for all forms of knowledge."
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