http://cepa.newschool.edu/het/schools/finance.htm homepage of the "HISTORY OF ECONOMIC THOUGHT" http://cepa.newschool.edu/het/schools/aea.htm Finance theory A particularly disturbing finding was that it seemed that prices tended to follow a random walk. More specifically, as documented already by Louis Bachelier (1900) (for commodity prices) and later confirmed in further studies by Holbrook Working (1934) (for a variety of price series), Alfred Cowles (1933, 1937) (for American stock prices) and Maurice G. Kendall (1953) (for British stock and commodity prices), it seemed as there was no correlation between successive price changes on asset markets. The Working-Cowles-Kendall empirical findings were greeted with horror and disbelief by economists. If prices are determined by the "forces of supply and demand", then price changes should move in particular direction towards market clearing and not randomly. Not everyone was displeased with these results, however. Many viewed them as proof that the "fundamentalist" theory was incorrect, i.e. that financial markets really were wild casinos and that finance was thus not a legitimate object of economic concern. Yet others crowed that it proved the failure of traditional "statistical" methods to illuminate much of anything. High-powered time series methods were used by Clive Granger and Oskar Morgenstern (1963) and Eugene F. Fama (1965, 1970), but they came up with the same randomness result. The great breakthrough was due to Paul A. Samuelson (1965) and Benoit Mandelbrot (1966). Far from proving that financial markets did not work according to the laws of economics, Samuelson interpreted the Working-Cowles-Kendall findings as saying that they worked all too well! The basic notion was simple: if price changes were not random (and thus forecastable), then any profit-hungry arbitrageur can easily make appropriate purchases and sales of assets to exploit this. Samuelson and Mandelbrot thus posited the celebrated "Efficient Market Hypothesis" (EMH): namely, if markets are working properly, then all public (and, in some versions, private) information regarding an asset will be channelled immediately into its price. (note that the term "efficient", as it is used here, merely means that agents are making full use of the information available to them; it says nothing about other types of "economic efficiency", e.g. efficiency in the allocation of resources in production, etc.). If price changes seem random and thus unforecastable it is because investors are doing their jobs: all arbitrage opportunities have already been exploited to the extent to which they can be. The "Efficient Markets Hypothesis" was made famous by Eugene Fama (1970) and later connected to the rational expectations hypothesis of New Classical macroeconomics. It did not please many practioners. "Technical" traders or "chartists" who believed they could forecast asset prices by examining the patterns of price movements were confounded: the EMH told them that they could not "beat the market" because any available information would already be incorporated in the price. It also had the potential to annoy some fundamentalist practioners: the idea of efficient markets rests on "information" and "beliefs", and thus does not, at least in principle, rule out the possibility of speculative bubbles based on rumor, wrong information and the "madness of crowds". More disturbingly, the EMH has not pleased economists. EMH is probably one of the more resiliant empirical propositions around (albeit, see Robert Shiller's (1981) critique), yet it does not seem to have a clearly sound theoretical standing. It all seems to collapse on one particular objection: namely, that if all information is already contained in prices and investors are fully rational, then not only can one not profit from using one's information, indeed, there might not be any trade at all! These peculiar, contradictory implications of rational expectations were demonstrated by Sanford J. Grossman and Joseph E. Stiglitz (1980) and Paul Milgrom and Nancy Stokey (1982). Intuitively, the objection can be put this way (and here we are oversimplifying a bit). The efficient markets hypothesis effectively implies that there is "no free lunch", i.e. there are no $100 bills lying on the pavement because, if there were, someone would have picked them up already. Consequently, there is no point in looking down at the pavement (especially if there is a cost to looking down). But if everyone reasons this way, no one looks down at the pavement, then any $100 bills that might be lying there will not be picked up by anyone. But then there are $100 bills lying on the pavement and one should look down. But then if everyone realizes that, they will look down and pick up the $100 bills, and thus we return to the first stage and argue that there are not any $100 bills (and therefore no point in looking down, etc.) This circularity of reasoning is what makes the theoretical foundations of the efficient markets hypothesis somewhat shaky.