Question #1: The author gives several reasons why the blame cast on the EMH for the global financial crisis is unfounded. Which one makes the most sense to you? Why? Which argument do you disagree with, or are not convinced by? Why?
Question #2: The author proposes several lessons about market efficiency that we can learn from the financial crisis. One is that there are limitations to the EMH as a theory of financial markets. He specifically argues that the EMH is silent on the “supply side” of the information market. What does he mean by this? Do you agree with his view? Why or why not?
Question #3: What are the implications for corporate financial managers of the EMH as articulated and defended by the author? Frame you answer around implications for issues such as capital raising, dividend payouts, capital expenditures, managerial incentives, and firm performance.
VOLUME 21 | NUMBER 4 | FALL 2009 APPLIED CORPORATE FINANCE Journal of A M O R G A N S T A N L E Y P U B L I C A T I O N In This Issue: Market Efficiency and Risk Management The Global Financial Crisis and the Efficient Market Hypothesis: What Have We Learned? 8 Ray Ball, University of Chicago Contingent Capital vs. Contingent Reverse Convertibles for Banks and Insurance Companies 17 Christopher L. Culp, Compass Lexecon and University of Chicago International Insurance Society Roundtable on Risk Management After the Crisis 28 Panelists: Geoffrey Bell, Geoffrey Bell & Company; Nikolaus von Bomhard, Munich Re; Prem Watsa and Bijan Khosrowshahi, Fairfax Financial Holdings. Moderated by Brian Duperreault, MMC Lessons from the Financial Crisis on Risk and Capital Management: The Case of Insurance Companies 52 Neil A. Doherty, University of Pennsylvania’s Wharton School of Business, and Joan Lamm-Tennant, Guy Carpenter & Co. and the Wharton School The Theory and Practice of Corporate Risk Management 60 Henri Servaes and Ane Tamayo, London Business School, and Peter Tufano, Harvard Business School Measuring the Contributions of Brand to Shareholder Value (and How to Maintain or Increase Them) 79 John Gerzema, Ed Lebar, and Anne Rivers, Young & Rubicam Brands Creating Value Through Best-In-Class Capital Allocation 89 Marc Zenner, Tomer Berkovitz, and John H.S. Clark, J.P. Morgan Using Corporate Inflation Protected Securities to Hedge Interest Rate Risk 97 L. Dwayne Barney and Keith D. Harvey, Boise State University The Gain-Loss Spread: A New and Intuitive Measure of Risk 104 Javier Estrada, IESE Business School Assessing the Value of Growth Option Synergies from Business Combinations and Testing for Goodwill Impairment: A Real Options Perspective 115 Francesco Baldi, LUISS Guido Carli University, and Lenos Trigeorgis, University of Cyprus 8 Journal of Applied Corporate Finance • Volume 21 Number 4 A Morgan Stanley Publication • Fall 2009 The Global Financial Crisis and the Efficient Market Hypothesis: What Have We Learned? * Ball is a trustee of Harbor Funds and serves on the Shadow Financial Regulatory Committee and FASB’s Financial Standards Advisory Council, but the views expressed here are his own. 1. Cited (with apparent approval) in a widely read New York Times business column, Joe Nocera, “Poking Holes in a Theory on Markets,” New York Times, June 5, 2009. www.nytimes.com/2009/06/06/business/06nocera.html?scp=1&sq=efficient%20 market&st=cse. See also Grantham’s foreword in Andrew Smithers, Wall Street Revalued: Imperfect Markets and Inept Central Bankers (Chichester, UK: Wiley, 2009). 2. Justin Fox, The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street (New York: HarperCollins, 2009), page 320. See also: George Cooper, The Origin of Financial Crises: Central Banks, Credit Bubbles, and the Efficient Market Fallacy (New York: Vintage Books, 2008); Richard A. Posner, A Failure of Capitalism: The Crisis of ‘08 and the Descent into Depression (Boston: Harvard University Press, 2009); George Soros, The Crash of 2008 and What it Means: The New Paradigm for Financial Markets (New York: Perseus, 2009); and Andrew Smithers, op. cit. 3. Cover story, University of Chicago Magazine, Vol. 102 No. 1, September-October 2009. 4. Ray Ball, “The Theory of Stock Market Efficiency: Accomplishments and Limitations,” Journal of Applied Corporate Finance 8, Spring 1995, pp. 4-17, and “On the Development, Accomplishments and Limitations of the Theory of Stock Market Efficiency,” Managerial Finance 20 (issue no.2/3), 1994, pp. 3-48. 5. Fama referred to “an ‘efficient’ market for securities, that is, a market where, given the available information, actual prices at every point in time represent very good estimates of intrinsic values.” Eugene F. Fama, “The Behavior of Stock-Market Prices” The Journal of Business, Vol. 38, No. 1 (January 1965), p. 90. The idea did not become known outside of narrow academic circles until the 1970s. It was not an easy sell to practitioners at the time. 6. The first of the many studies reaching this finding is Michael C. Jensen, “The Performance of Mutual Funds in the Period 1945–1964,” Journal of Finance 23 (May 1968), pp. 389–416. A recent Morningstar report concludes that only 37% of managed funds outperformed their respective Morningstar style indexes over the past three years, adjusting for risk, size and style. Similar numbers were observed for five and 10-year returns. See: http://news.morningstar.com/newsnet/viewnews.aspx?article=/dj/2009100713 14dowjonesdjonline000480_univ.xml. B by Ray Ball, University of Chicago* T he sharp economic downturn and turmoil in the financial markets, commonly referred to as the “global financial crisis,” has spawned an impressive outpouring of blame. Free market economics—the idea that coordinated political forces do not improve on the “atomistic” actions of individuals—has come under concerted attack. The Efficient Market Hypothesis (EMH)—the idea that competitive financial markets ruthlessly exploit all available information when setting security prices— has been singled out for particular attention. As one prominent example, market strategist Jeremy Grantham has called the EMH “responsible for the current financial crisis” because of its role in the “chronic underestimation of the dangers of asset bubbles” by financial executives and regulators.1 And in the prologue and epilogue to his meticulously researched, well-written, and best-selling history of modern financial economics, The Myth of the Rational Market, Justin Fox appears to say much the same thing.2 The reasoning boils down to this: swayed by the notion that market prices reflect all available information, investors and regulators felt too little need to look into and verify the true values of publicly traded securities, and so failed to detect an asset price “bubble.” The Turner Report by the UK’s market regulator (discussed more fully below) reaches a similar conclusion. And in a fit of soul-searching, the University of Chicago Magazine asks: “Is Chicago School Thinking to Blame?”3 These are but a handful of the many accusations that have been heaped on the EMH. I have argued in the past and will argue below that the EMH—like all good theories—has major limitations, even though it continues to be the source of important and enduring insights.4 Despite the theory’s undoubted limitations, the claim that it is responsible for the current worldwide crisis seems wildly exaggerated. If the EMH is responsible for asset bubbles, one wonders how bubbles could have happened before the words “efficient market” were first set in print—and that was not until 1965, in an article by Eugene Fama.5 Economic historians typically point to the 1637 Dutch tulip “mania” as the first such event on record, followed by episodes like the 1720 South Sea Company Bubble, the Railway Mania of the 1840s, the 1926 Florida Land Bubble, and the events surrounding the market collapse of 1929. But all of these episodes occurred well before the advent of the EMH and modern financial economic theory. As the above list suggests, unusually large price run-ups followed by unusually large drops have occurred throughout the recorded history of organized markets. It’s only the idea of market efficiency that is relatively new to the scene. Further, the argument that a bubble occurred because the financial industry was dominated by EMH-besotted “price- takers”—that is, by people who viewed current prices as correct and so failed to verify true asset values—seems wildly at odds with what we see in practice. Almost all investment money is actively managed, despite all the evidence of academic and industry studies showing that active managers fail to beat the market in an average year.6 Money flows into mutual funds strongly follow past performance, as if individual managers consistently beat the market over time, and despite the evidence that the past performance of most 9Journal of Applied Corporate Finance • Volume 21 Number 4 A Morgan Stanley Publication • Fall 2009 7. E. Sirri and P. Tufano, “Costly Search and Mutual Fund Flows,” Journal of Finance, 53 (1998), pp. 1589-1622. 8. The complete reference is: “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy?” The Challenge of Central Banking in a Democratic Society: Remarks by Chairman Alan Greenspan at the Annual Dinner and Francis Boyer Lecture of The American Enterprise Institute for Public Policy Research, Washington, D.C., December 5, 1996 (Washington, DC: The Federal Reserve Board). 9. Visited October 18, 2009. 10. It also seems worth pointing out that such people, having chosen these occupations and careers, have incentives, monetary and otherwise, to view themselves as more rational than their audiences. 11. Eugene F. Fama, “Mandelbrot and the Stable Paretian Hypothesis,” Journal of Business, Volume 36, Issue 4 (October 1963), pp. 420-429. money managers is a poor predictor of future performance.7 Much of the enormous losses by banks and investment banks in 2007-2008 originated in their trading desks and proprietary portfolios, whose strategies and very existence were premised on making money from market mispricing. Investors who poured money into the property market, stock market, and other asset markets in the years while the “bubbles” were forming seemed to do so in the belief that prices would continue to rise, with the implication that they believed current prices were incorrect. It seems inconsistent to argue simultaneously that asset price “bubbles” occur and that investors passively believe current asset prices are correct. Yet this is precisely what many EMH critics have claimed. But if more homeowners, speculators, investors, and banks had indeed viewed current asset prices as correct, they might not have bid them up to the same extent they did, and the current crisis might have been averted. The related argument that when asset prices are rising rapidly their level is not subject to scrutiny by investors also seems wildly at variance with the facts. Take the case of then Fed Chairman Alan Greenspan’s 1996 use of the words “irrational exuberance.” Despite its seemingly innocuous nature and positioning in a long and