What Efficient Market Hypothesis And Economic Bubbles Can Teach Us About The Current Economic State
The efficient market hypothesis or EMH is one of the most popular theories used to explain why the stock market behaves the way it does. By definition, most people would think an efficient market is one where prices are right, and consistent long-term growth paves the way for consistent gains.
While the markets provide healthy long-term gains, consistency is disrupted by economic bubbles and market crashes, suggesting some efficiencies in the market. However, efficient market theory somewhat accounts for all that, including the market bubbles. Understanding the theory helps investors paint a good picture of why the market behaves the way it does and why bubbles occur every decade.
What is the efficient market hypothesis?
EMH is an economic and investment theory developed by Eugene Fama back in the 1970s. The theory suggests that all the known market information influences the prices of investment securities. Thus, no investor will have an edge over others no matter how much they analyze the markets. The theory also suggests that investors might secure strong returns over the long-term, but those gains cannot surpass the market average.
The three types of EMH
EMH is categorized into three distinct types.
- Weak EMH which suggests that past information has a short-term impact on securities but it is useless over the long-term for both fundamental and technical analysis.
- The semi-strong EMH which suggests that new information is immediately factored into the pricing of securities. It also suggests that technical and fundamental analysis cannot offer any advantage to investors.
- The strong EMH suggests that private and public information is factored into the price of stocks and that no single investor has more advantage over the market compared to others. However, it does suggest that some investors can position themselves to tap into high returns while others may lose.
An economic bubble manifests when asset prices rise to unrealistic levels, usually due to too much speculative trading rather than a focus on company fundamentals. Just as the name suggests, an economic bubble can be visualized as inflation of asset prices to a point where they are unstainable, leading to the eventual downturn where prices crash.
The real estate bubble in the mid-2000s is one of the best examples where easily affordable mortgages and too much borrowing pushed up housing prices. People started buying houses for speculative purposes so that they could then sell them at significantly lower prices. The demand for homes continued to push up the speculation to a point where demand stagnated, and prices fell.
Another example is the dot.com bubble, fueled by the idea that emerging tech companies that promised to leverage the power of the internet would be the next big thing. Investors poured in their money expecting to reap big, and thus the dot.com bubble was born. Most of the companies whose share prices were exorbitantly inflated eventually died, leading to many investors’ huge losses. Some of the companies that were focused on growth and achieving organic growth managed to sail through the tough times and eventually shaped the direction of internet-based industries.
An economic bubble can influence many segments, including the real estate market, the equities market, and even the credit segment. For example, many Americans rely heavily on credit. In a market crash, banks would lose a lot of money, and they would likely suspend lending. People would not access credit, therefore limiting their ability to purchase goods and services, which would, in turn, worsen the economic downturn.
The relationship between economic bubbles and efficient market hypothesis
Inflated prices fueled by demand and the speculative desire to make quick profits seem to be a common theme associated with bubbles. A similar theme was apparent in the Bitcoin bubble, characterized by a strong rally in 2017. If the efficient market hypothesis exists, then why do bubbles happen?
The key point to note about the EMH is that no investors have an edge over others and the market responds quickly to new information. Although technical and fundamental analysis are important, the efficient market hypothesis suggests that their impact is not as pronounced on the stock market’s performance compared to the impact of supply and demand forces.
In an ideal scenario, investors would purchase a stock if its technical and fundamental blueprint highlights potential growth in the future. However, the markets are predominantly speculative, so stocks tend to rally beyond normal price levels. Unsurprisingly, many retail traders are participating in the market at any given point, trying to profit through price gains and short-selling.
The traders are hungry for profits, and thus the buying and selling activities maintain a balance in the market. For retail investors, the idea is to buy low and sell high, or short-sell when a price is too high or when there the news suggests some rocky times ahead. The economic downturn when an economic bubble bursts can be viewed as the market’s mechanism for correcting itself when prices are unsustainably high.
What would happen if the stock market goes belly up?
Stock prices in the U.S are at an all-time high, and analysts are concerned that the economy has been over-extended for some time. In the event of a major stock market crash, investors would likely rush to pull their money from the market to avoid further losses, thus putting the companies in trouble. They would have to rely on limited cash to maintain operations.
Chances are that some companies would let go of some of their employees to stay afloat while slashing most of their operations. Unemployment would increase, thus making the economic condition worse. More people would be unable to access credit or pay off their mortgages.
EMH explains why it is impossible to beat the market, while economic bubbles explain why long-term gains might be compromised. Some investors would argue that technical and fundamental analysis play a role, but those who subscribe to the efficient market hypothesis would argue that demand is key to the equities prices at any given point.