Market Pricing Beyond the Efficient Market Hypothesis
24 Pages Posted: 6 Jun 2006 Last revised: 2 Aug 2009
Date Written: November 1, 2006
The first part of this paper derives the Market Pricing Maxim (MPM): market transaction prices fully reflect available information. This is not the same as the efficient market hypothesis (EMH). The MPM holds whether prices are unbiased estimates of fundamental value, as the EMH hypothesizes, or whether prices depart from fundamental values, as behavioral and noise models suggest.
The MPM is put forward as a correct description of market pricing that can't be rejected, that is not an hypothesis, and that needs no testing to be known to be true. The EMH and behavioral models do not conflict over whether or not prices fully reflect available information. Prices have to and they do. They conflict over how prices reflect the information. The argument is over how close prices are to something called “fundamental value.”
The paper goes on to discuss how various concepts are interpreted in an MPM world. There is discussion of value, propagation and meaning of information, prices, fundamental value, speculative profits, buying and issuing securities, risk, and a framework for empirical research.
Next comes an extensive critique of the EMH (and to some extent behavioral models) in light of the MPM. A great deal of finance thinking that derives from EMH has to be substantially revised. For example, market prices are correct prices in the sense of reflecting all information, but this does not mean that prices are unbiased estimates of the true future prices. It is therefore dangerous to accept current prices at all times as the EMH suggests. Speculation is critical to markets, but the difficulty in making speculative profits arises not because prices are unbiased estimates of the true future prices or because properly discounted present values of assets vibrate randomly. It is because critical elements of the future that influence prices are mostly unknowable in changing ways that are unpredictable. The EMH notion that it is less than ideal (bad) if prices do not fully reflect all available information (that is, allow profits in the EMH view) is faulty. These judgments hinge on the notion that buyers and sellers can or should be able to allocate capital accurately in an efficient market without concern over whether prices are too high or too low. The sufficient conditions thought to produce market efficiency are all untenable, false, and highly misleading.
The paper closes with a brief contrast between a more helpful ideal for capital markets than efficient markets, namely, free capital markets.
Keywords: Market pricing maxim, efficient market hypothesis, speculation, noise trading
JEL Classification: G12, G14
Suggested Citation: Suggested Citation