A Random Walk to Nowhere

The following sections are included:

• Dedication
• Contents
• Preface
• About the Authors

As mentioned in the Preface, one of the authors (Edward E. Williams) and M. Chapman Findlay published a controversial article in 1980 titled “A Positivist Evaluation of the New Finance.” It was intended to be a spoof on Milton Friedman’s concept of positivism which will be a major concern in this book. They presented the paper in 1978 at an academic conference, and they knew at the time that they were venturing into treacherous waters. Nevertheless, the article was one of the most read in the journal that published it for many years. Basically, the article called into question what had been going on in academic finance for the previous two decades, i.e., the introduction of the “scientific method” to finance (or what was soon becoming “financial economics”)…

Over the past 50 years, the late Professor M. C. Findlay (1944–2008) joined one of the authors (Edward E. Williams) to provide a critique of the intellectual path taken by financial economists. The late Professor J. R. Thompson (1938–2017) joined in the task more recently. Some of the fruits of these collaborations are provided in this chapter…

The seeds for the EMH were germinated by a modest effort by Harry Roberts (Journal of Finance, 1959) who was a statistician at the University of Chicago at the time. Roberts’ paper posited the following: (1) Movements in stock prices conform to a normal (bell curve) distribution, (2) random selections may be made from such a distribution, and (3) the results may be added to an arbitrary starting price. From this Roberts noted that the results looked a lot like the DJIA over time (for the interested reader, the process is described in mathematical detail in Thompson, Williams and Findlay, Models for Investors in Real World Markets, 2003)…

As we observed in Chapter 3, under semi-strong efficiency all publicly available information is supposed to be impounded in stock prices. As a consequence, the economic and financial analysis of securities is useless. A stock (bond, etc.) is “worth” what its present market price is. This always seemed an odd notion to the many people who earn a living examining corporate financial statements, talking to management, and generally trying to understand and determine the fundamental value of securities. The essence of the securities analyst was (and is) to look at present market prices in order to determine whether a security is correctly valued, undervalued, or overvalued…

As we have acknowledged in earlier chapters, information is more widely available today than it was at the turn of the 20^th century or when Keynes made his observations in the 1930s. Whether this makes markets completely efficient is another matter. We would argue that perhaps there are degrees of efficiency, and that present (21^st century) markets may be more efficient than the rigged game that was played a hundred years ago. The advent of the computer has made it less difficult to engage in the task of interpreting large quantities of data. Although it is certainly not clear that we have entered the world of perfectly efficient capital markets, it is likely the very chaotic world that Keynes described has passed…

It will be recalled, that, even in a world of perfect certainty, prices of securities could be expected to change over time as long as the income (dividend) stream is not instantaneous and constant. Indeed, price change would be necessary in such a case to cause the expected return for each holding period to be obtained. In a world of less-than-perfect certainty, changes in expected income or the required rate of return (caused, in turn, by changes in the level of interest rates or the perceived risk of the issue) could also cause the prices of securities to change over time…

Precedent and inertia impede change in any significant field, such as the legal system or academic financial economics. In the Erika P. John vs. Halliburton fraud on the market case discussed earlier in the Preface and Chapter 1, the District and U.S. Supreme Courts acknowledged a growing field of anomalies research which calls into question the EMH. In spite of Halliburton’s presentation of numerous studies providing “overwhelming empirical evidence” which “now suggest[s] that capital markets are not fundamentally efficient” (Fed. Sec. Reporter, 2014), “scores” of “efficiency-denying anomalies” make market efficiency more contestable than ever (Langevoort, 2002). But in the end, the U.S. Supreme Court affirmed the EMH principles espoused in Basic Inc. v. Levinson (1988)…

While financial economists were testing the EMH (as in Chapter 6), the idea was proposed that the original Markowitz (1952a) work on portfolio analysis could be used as a foundation for an overall theory of how assets are priced in the capital markets. During the 1960s, Treynor (1961), Sharpe (1964), Lintner (1965), and Mossin (1966) proposed economic models that purported to demonstrate how financial markets operate. This early work became known as the Capital Asset Pricing Model, or CAPM…

By the 1990s, the “joint hypothesis” of efficiency (the semi-strong efficient market hypothesis, EMH) and equilibrium (CAPM) had gained traction as the “new” theory of finance. Even then, however, the growing anomalies literature discussed earlier in Chapter 7 created problems for the CAPM, and a consensus began to form that a new model, the arbitrage pricing model or APM, would replace it. More recently, the CAPM has been pretty much discarded by practitioners (even those with MBAs from the University of Chicago) and questioned in the academic literature…

We come to this point considering what effect this Efficient Market Hypothesis (EMH) has had in shaping the intellectual landscape of the finance world, indeed not just finance, but in jurisprudence as well…

The following section is included:

• Bibliography