REVISITING MARKET EFFICIENCY: THE STOCK MARKET AS A COMPLEX ADAPTIVE SYSTEM

Well‐functioning financial markets are key to efficient resource allocation in a capitalist economy. While many managers express reservations about the accuracy of stock prices, most academics and practitioners agree that markets are efficient by some reasonable operational criterion. But if standard capital markets theory provides reasonably good predictions under “normal” circumstances, researchers have also discovered a number of “anomalies”—cases where the empirical data appear sharply at odds with the theory. Most notable are the occasional bursts of extreme stock price volatility (including the recent boom‐and‐bust cycle in the NASDAQ) and the limited success of the Capital Asset Pricing Model in accounting for the actual risk‐return behavior of stocks. This article addresses the question of how the market's efficiency arises. The central message is that managers can better understand markets as a complex adaptive system. Such systems start with a “heterogeneous” group of investors, whose interaction leads to “self‐organization” into groups with different investment styles. In contrast to market efficiency, where “marginal” investors are all assumed to be rational and well‐informed, the interaction of investors with different “decision rules” in a complex adaptive system creates a market that has properties and characteristics distinct from the individuals it comprises. For example, simulations of the behavior of complex adaptive systems suggest that, in most cases, the collective market will prove to be smarter than the average investor. But, on occasion, herding behavior by investors leads to “imbalances”—and, hence, to events like the crash of '87 and the recent plunge in the NASDAQ. In addition to its grounding in more realistic assumptions about the behavior of individual investors, the new model of complex adaptive systems offers predictions that are in some respects more consistent with empirical findings. Most important, the new model accommodates larger‐than‐normal stock price volatility (in statistician's terms, “fat‐tailed” distributions of prices) far more readily than standard efficient market theory. And to the extent that it does a better job of explaining volatility, this new model of investor behavior is likely to have implications for two key areas of corporate financial practice: risk management and investor relations. But even so, the new model leaves one of the main premises of modern finance theory largely intact–that the most reliable basis for valuing a company's stock is its discounted cash flow.     

The Global Financial Crisis and the Efficient Market Hypothesis: What Have We Learned?

The sharp economic downturn and turmoil in the financial markets, commonly referred to as the “global financial crisis,” has spawned an impressive outpouring of blame. The efficient market hypothesis (EMH)—the idea that competitive financial markets exploit all available information when setting security prices—has been singled out for particular attention. Like all successful theories, the EMH has major limitations, even as it continues to provide the foundation for not only past accomplishment, but future advances in the field of finance. Despite the theory's undoubted limitations, the claim that it is responsible for the current worldwide crisis seems wildly exaggerated. This essay shows the misreading of the theory and logical inconsistencies involved in popular arguments that EMH played a significant role in (1) the formation of the real estate and stock market bubbles, (2) investment practitioners' miscalculation of risks, and (3) the failure of regulators to recognize the bubbles and avert the crisis. At the same time, the author argues that the collapse of Lehman Brothers and other large financial institutions, far from resulting from excessive faith in efficient markets, reflects a failure to heed the lessons of efficient markets. In the author's words, “To me, Lehman's demise conclusively demonstrates that, in a competitive capital market, if you take massive risky positions financed with extraordinary leverage, you are bound to lose big one day—no matter how large and venerable you are.” Finally, behavioral finance, widely considered as challenging and even supplanting efficient markets theory, is viewed in this article as complementing if not reinforcing efficient markets theory. As the author says, “it takes a theory to beat a theory.” Behavioralism, for all its important contributions to finance literature, is described as not a theory but rather “a collection of ideas and results”— one that depends for its existence on the theory of efficient markets.     

The Theory of Bank Risk Taking and Competition Revisited

There is a large body of literature that concludes that—when confronted with increased competition—banks rationally choose more risky portfolios. We argue that this literature has had a significant influence on regulators and central bankers. We review the empirical literature and conclude that the evidence is best described as “mixed.” We then show that existing theoretical analyses of this topic are fragile, since there exist fundamental risk‐incentive mechanisms that operate in exactly the opposite direction, causing banks to become more risky as their markets become more concentrated. These mechanisms should be essential ingredients of models of bank competition.     

MERTON MILLER'S CONTRIBUTIONS TO MODERN FINANCE

Winner of the 1990 Nobel Prize in Economics, and widely regarded as the “father of modern finance,” the University of Chicago's Merton Miller died last June at age 77. This article attempts to sum up Miller's career in terms of a single governing principle: the role of arbitrage in ensuring the “efficiency” of financial markets and, more generally, the effectiveness of such markets in promoting economic growth and creating social wealth. Starting with the formulation of Proposition I (also known as the capital structure irrelevance proposition) with Franco Modigliani in 1958, Miller's research over the next 40 years is seen as applying—with remarkable clarity and consistency—the principle of arbitrage to the study of many aspects of financial markets. Miller's main accomplishment, according to the author, is to have made arbitrage arguments the cornerstone of modern finance. The arbitrage proof of Proposition I introduced a new standard in finance—namely, that any finding in financial research deserving serious consideration must have the critical property that it cannot represent opportunities for riskless profit by investors. And the article goes on to show that arbitrage is a constant theme in Miller's writings, from his work in corporate finance to his later studies of financial innovation, derivatives markets, and financial crashes and crises. Having started and presided over the transformation of financial studies from a “glorified apprenticeship system” into a scientific discipline, Miller devoted much of the last 15 years of his life to a different, though clearly related undertaking: the defense of financial markets against the attacks of politicians and regulators, as well as businessmen intent on stifling competition (including hostile takeovers). Whether it was the alleged role of the stock index futures markets in the 1987 market crash, the claims of “overleveraging” in the LBOs of the '80s, or the derivatives fiascos in the mid‐'90s, Miller was there to provide careful economic analysis of the problems. In the early '90s, he explained why the “myopia” of the U.S. stock market was likely to cause far fewer problems than the “hyperopia” induced by regulatory distortions of the Japanese market. And in one of his last speeches, Miller showed that the primary cause of the recent Asian crisis was not “too much reliance on financial markets,” as claimed by politicians and the popular press, but “too little”—in particular, the heavy dependence on bank financing (particularly state‐owned banks) and the failure to develop alternative sources of capital that continue to depress the Japanese economy.     

Footprints in the market: Hedge funds and the carry trade

This paper uses a new database provided by the Commodity and Futures Trading Commissions to examine the price impact of hedge fund carry trades in “hot” and “cold” markets. We find that hedge funds significantly increase their carry trade positions during hot markets (periods with very high currency returns). Consistent with currency overpricing, positions in hot markets are followed by exchange rate reversals. Optimism in the stock market seems to have a spillover effect on hedge fund speculation in the currency market: controlling for the variance risk premium fully accounts for the reversal effect. Overall, our results add to a growing body of empirical evidence that institutional demand can move asset prices.     

Difference Systems in Financial Futures Markets

Many financial futures markets allow substitutions for the par grade of security at delivery. Substitutes are deliverable at premiums or discounts—“differences” in commodities parlance—to the futures price. The rule that establishes these differences is called a difference system. This paper characterizes financial futures market equilibrium with yield-based difference systems and investigates particular systems in use. The major finding is that currently used difference systems effectively limit deliverable supply in the futures markets and lead to futures prices which understate the cash market price of the par security.     

The Federal Reserve,the Emerging Markets,and Capital Controls: A High‐Frequency Empirical Investigation

In this paper, I use weekly data from seven emerging nations—four in Latin America and three in Asia—to investigate the extent to which changes in Fed policy interest rates have been transmitted into domestic short‐term interest rates during the 2000s. The results suggest that there is indeed an interest rates “pass‐through” from the Fed to emerging markets. However, the extent of transmission of interest rate shocks is different—in terms of impact, steady state effect, and dynamics—in Latin America and Asia. The results also indicate that capital controls are not an effective tool for isolating emerging countries from global interest rate disturbances. Changes in the slope of the U.S. yield curve, including changes generated by a “twist” policy, affect domestic interest rates in emerging countries. I also provide a detailed case study for Chile.     

The Effect of Listing Price Strategy on Transaction Selling Prices

While true underlying home values are expected to be randomly distributed, actual residential listing prices tend to be highly clustered. Particularly, more than 75 % of the homes in our sample are associated with a round or “just below” round asking price. This study provides a theoretical and empirical examination of how the thousands digit in a home’s asking price is related to the final transaction price relative to its true underlying value. Our findings suggest that, on average, homes listed using a “just below” pricing strategy are associated with the greatest discount negotiated relative to the asking price. However, the higher initial degree of list overpricing reflected in “just below” pricing compared with other strategies more than offsets the greater discount. Therefore, “just below” is the most effective pricing strategy for the seller in terms of a greater dollar yield relative to value. These empirical findings have economic significance and are robust across both “buyer” and “seller” housing markets, new versus existing homes, and across multiple home price ranges.     

Valuation in Emerging Markets: A Simulation Approach

Most of the foundations of valuation theory have been designed for use in developed markets. Because of the greater, and in some cases different, risks associated with emerging markets (although recent experience might suggest otherwise), investors and corporate managers are often uncomfortable using traditional methods. The typical way of capturing emerging-market risks is to increase the discount rate in the standard valuation model. But, as the authors argue, such adjustments have the effect of undermining some of the basic assumptions of the CAPM-based discounted cash flow model. The standard theory of capital budgeting suggests that estimates of unconditional expected cash flows should be discounted at CAPM discount rates (or betas) that reflect only “systematic,” or “nondiversifiable,” market-wide risks. In practice, however, analysts tend to take what are really estimates of “conditional” expected cash flows—that is, conditional on the firm or its country avoiding a crisis—and discount them at higher rates that reflect not only systematic risks, but diversifiable risks that typically involve a higher probability of crisis-driven costs of default. But there is almost no basis in theory for the size of the increases in discount rates. In this article, the authors propose that analysts in emerging markets avoid this discount rate problem by using simulation techniques to capture emerging-market risks in their estimates of unconditional expected cash flows—in other words, estimates that directly incorporate the possibility of an emerging-market crisis and its consequences. Having produced such estimates, analysts can then discount them using the standard Global CAPM.     

Default Premiums in Commodity Markets: Theory and Evidence

We model the effect of nonperformance risk on forward and futures pricing and look for evidence of nonperformance risk in precious metals futures prices from the “Hunt Brothers”episode. Changes in default premiums are measured and related to the sequence of events in the metals markets during this period. Results suggest first that ex ante costs of nonperformance can be a significant, priced factor in commodity markets and second that the arrival of new information is often associated with changes in these costs. The evidence has implications for both theoretical and empirical research on commodity markets.     

Macroeconomic Implications of “Deep Habits” in Banking

Recent empirical evidence shows that price‐cost margins in the market for bank credit are countercyclical in the U.S. economy and that this cyclical behavior can be explained in part from the fact that switching banks is costly for customers (i.e., from a borrower hold‐up effect). Our goal, in this paper, is to study the “financial accelerator” role of these countercyclical margins as a propagation mechanism of macroeconomic shocks. To do so, we apply the “deep habits” framework in Ravn, Schmitt‐Grohé, and Uribe (2006) to financial markets to model this hold‐up effect within a monopolistically competitive banking industry. We are able to reproduce the pattern of price‐cost margins observed in the data, and to show that the real effects of aggregate total factor productivity shocks are larger the stronger the friction implied by borrower hold‐up. Also, output, investment, and employment all become more volatile than in a standard model with constant margins in credit markets. An empirical contribution of our work is to provide structural estimates of the deep habits parameters for financial markets.     

Momentum and Foreign Investors: Evidence from the Korean Stock Market

Abstract:

We examine whether the price impact of foreign investors on the Korean stock market from December 2000 to February 2007 generated a momentum phenomenon. In our empirical results, foreigners seem to have exerted a significantly positive impact on prices in “up” markets (periods of positive stock returns), but have had little impact on prices in “down” markets (periods of negative returns). We document that the impact of foreigners’ trades is concentrated in large companies. Most importantly, when the market is in the up state, the returns of stocks of large companies that were positively affected by foreign investors in the previous six-month period continue to increase in the subsequent six-month period. As a result, the subsequent six-month return on a past “winner” stock portfolio is significantly higher than that on a past “loser” stock portfolio. This brings to mind a momentum phenomenon that has been reported not to exist in the Korean stock market.     

Asset Returns,Discount Rate Changes,and Market Efficiency

The primary purpose of this paper is to reconcile the previous findings of discount rate endogeneity with the presence of discount rate announcement effects in securities markets. The crux of this reconciliation is the distinction between “technical” discount rate changes that are endogenous and “nontechnical” changes which contain some informative policy implications. In essence, we attempt to separate expected discount rate changes from unexpected changes, or equivalently, the expected component of discount rate changes from the unexpected component. If markets are efficient, the former should have no announcement effects while the latter may be associated with an announcement effect. Accordingly, the focus of the empirical analysis is on the interaction between discount rate exogeneity, the specific monetary policy regime, and accouncement effects. In addition, we examine whether the behavior of these markets in the postannouncement period is consistent with the rapid price adjustment implied by market efficiency.     

GAMBLING, SPECULATION, AND INSURANCE: WHY THEY CONTINUE TO BE CONFUSED AND CONDEMNED

Governments and the media have often attacked financiers for “speculating” in their countries' currencies, thereby forcing them to make drastic and sometimes painful changes in monetary and fiscal policies. This article argues that such accusations have no basis in economic theory, and that “such rhetoric should be seen for what it is: an attempt by politicians and policy-makers to divert attention and blame from their own mismanagement.” More generally, the author argues that the failure of the general public to understand the social benefits of financial activies such as trading in government bonds, commodity futures, and, more recently, financial derivatives has led throughout history to “prejudice, bad laws, and bad regulations.” Much as the charging of interest and certain forms of insurance were proscribed by the medieval Church, agricultural commodity futures were attacked in the 19th century (and in much of the 20th as well) in the U.S. and elsewhere as thinly disguised forms of gambling. Moreover, the same restrictions that were imposed on gambling and futures markets during the 19th and early 20th centuries are now imposed in many Third-World countries. Instead of encouraging the use of forward markets by small producers and traders, and promoting the development of organized commodity markets and banks in local centers, most less-developed countries today support national and international “stabilization” measures such as buffer stocks and regulations like price floors, price ceilings, and crop quotas. Meanwhile, in Western nations, governments continue to accuse financial markets of “destabilizing speculation” and of a myopic obsession with short-term profitability—even as the U.S. IPO market continues to assign record values to companies that have yet to show profits. Viewed in this light, the media and regulatory assaults on the junk bond markets in the late 1980s and on derivatives in the early 1990s are only the latest in a long line of misguided attacks on financial innovation.     

Managing for Value 2.0

In Finance 101, future corporate managers are taught that the social mission of public companies is to maximize their own longrun (or “intrinsic”) value by investing in all positive net present value (NPV) projects—that is, projects that are expected to earn at least their opportunity cost of capital. In markets that are reasonably efficient, provided management does an effective job of communicating its business plan and its progress in meeting its strategic goals, companies that follow this “NPV rule” can expect to be rewarded with increases in their share prices, at least in the longer run. But in the real world, of course, the pursuit of earnings and other “key performance indicators” (KPIs) often leads to managerial shortsightedness and destruction of value. To explain why—and to help companies avoid this outcome—this article presents an approach that envisions the intrinsic value of the company as an invisible “blue line” that moves through time on a graph, while showing observable key performance indicators, including revenue and earnings (and even the current stock price), as “red lines” on the same graph. The root of the problem is the failure of many companies to distinguish between their KPIs and the underlying drivers of value. KPIs, to be sure, are reflections of important aspects of the business; but however important and useful for strategic planning, they should not be used in performance evaluation or compensation plans for top management as surrogates for the underlying value of the business. Genuine value creation requires systems and a corporate culture that compel managers to pursue all projects that promise to earn the opportunity cost of capital—while treating earnings and other KPIs as means to creating value rather than ends in themselves.     

The Squam Lake Report: Fixing the Financial System*

In these excerpts from The Squam Lake Report, fifteen distinguished economists analyze where the global financial system failed, and how such failures might be prevented (or at least their damage better contained) in the future. Although there were many contributing factors to the crisis—including “agency” problems throughout the financial system and a bankruptcy code poorly suited for reorganizing financial firms—at the core of the problem is a potential conflict between the risk-taking proclivity of financial institutions and the interests of the economy at large that must be managed at least in part through more effective regulation. The Squam Lake Report provides a nonpartisan plan to transform the regulation of financial markets in ways designed to limit systemic risk while preserving—to the extent possible and prudent—the economies of scale and scope that justify the existence of today's large financial institutions. To reduce the risks that large banks will fail, the authors call for higher capital requirements based on more effective assessments of the risks of bank assets and liabilities, as well as a new systemic regulator that should be part of the central bank. To reduce the costs of failure when it occurs, the authors propose that banks be required to create “living wills” laying out their plan to sell assets or shut down operations in the event of financial trouble. As part of that plan, regulators are urged to “aggressively encourage” banks to issue “contingent” debt capital securities that convert into equity.     

Picking Your Tick: Toward a New Theory of Stock Splits

Thanks to stock splits, the average nominal share price has been amazingly stable in the United States. The average NYSE share price has fluctuated within the $30 to $40 range since the late 1930s—a period in which most consumer prices have increased by a factor of 10 and the S&P index has risen over 1,500%. Why has this nominal price been so stable when every other price has increased so much? And why do typical stock prices vary so greatly among different countries? For example, the median nominal stock price ranges from about $2 in Hong Kong and $7 in the U.K., to $103 in France and over $600 in Switzerland. The author's recent research suggests that typical stock prices vary across countries in ways that reflect primarily differences in how markets in each country set their “tick” rules—the rules governing the minimum price variation that can occur in a stock (in the U.S., for example, the tick was recently reduced from $1/8 to $1/16). Companies, on average, appear to respond to the resulting differences in tick size by adjusting the number of their shares outstanding so that the tick size relative to the nominal share price remains relatively constant. In fact, a tick size equal to about 25 basis points of the median share price “appears to be a universal norm” across global markets. This article explores how and why a company might wish to affect the relative tick size for its stock by splitting—and, in so doing, it suggests a “new theory” of stock splits. The theory also suggests that the optimal tick size for any given company will vary according to its size, visibility, and riskiness.     

A Look Back at Merton Miller's “Financial Markets and Economic Growth”

The author begins by agreeing with Miller's characterization of the fragility of U.S. banks and of the shortcomings of the Asian model of bank finance‐driven growth. The article also expresses “emphatic agreement” with Miller's arguments that the protection of banks through deposit insurance, regulatory forbearance, and other forms of “bailout” have created costly moral‐hazard problems that encourage excessive risk‐taking. And the author endorses, at least in principle, Miller's main argument that the development of capital markets that do not require the direct involvement of banks should make economies if not less prone to financial crises, then at least more resilient in recovering from them. But having acknowledged the limitations of bank‐centered systems and the value of developing non‐bank alternatives for savers and corporate borrowers, the author goes on to point to the surprising durability of some banking systems outside the U.S.—notably Canada's, which has not experienced major problems since the 1830s. And even more important, the author views banks and capital markets not as “substitutes” for one another, but as mutually dependent “complements” whose interdependencies and interactions must be recognized by market participants and regulators alike.     

A Look Back at Modern Finance: Accomplishments and Limitations

In a conversation held in June 2016 between Nobel laureate Eugene Fama of the University of Chicago and Joel Stern, chairman and CEO of Stern Value Management, Professor Fama revisited some of the landmarks of “modern finance,” a movement that was launched in the early 1960s at Chicago and other leading business schools, and that gave rise to Efficient Markets Theory, the Modigliani‐Miller “irrelevance” propositions, and the Capital Asset Pricing Model. These concepts and models are still taught at prestigious business schools, whose graduates continue to make use of them in corporations and investment firms throughout the world. But while acknowledging the staying power of “modern finance,” Fama also notes that, even after a half‐century of research and refinements, most asset‐pricing models have failed empirically. Estimating something as apparently simple as the cost of capital remains fraught with difficulty. He dismisses betas for individual stocks as “garbage,” and even industry betas are said to be unstable, “too dynamic through time.” What's more, the wide range of estimates for the market risk premium—anywhere from 2% to 10%—casts doubt on their reliability and practical usefulness. And as if to reaffirm the fundamental insight of the M&M “irrelevance” propositions—namely, that what companies do with the right‐hand sides of their balance sheets “doesn't matter”—Fama observes that “we still have no real resolution on the key questions of debt and taxes, or dividends and taxes.” But if he has reservations about much of modern finance, Professor Fama is even more skeptical about subfields now in vogue such as behavioral finance, which he describes as “mostly just dredging for anomalies,” with no underlying theory and no testable predictions. Although he does not dispute that a number of well‐documented traits from cognitive psychology show up in individual behavior, Fama says that behavioral economists have thus far failed to come up with a testable theory that links cognitive psychology to market prices. And he continues to defend the concept of “efficient markets” with which his name has long been closely associated, while noting that empirically based asset pricing models such as his (with Ken French) “three‐factor” CAPM have produced much better results than the standard CAPM.