The empirical evidence undermining EMH is growing by the year. For much of the history of financial markets, the idea of market efficiency has co-existed with a darker view that stock prices can at times disconnect from underlying economic reality. The events of the last three decades have only fed this sceptical view.
“The seeds of doubt were first sown widely on October 19, 1987, when the Dow Jones Index of industrial stocks mysteriously lost twenty three percent of its value in a single trading session. More recently we have seen the appearance and subsequent bursting of a remarkable price bubble in technology stocks that rivals the famous Dutch Tulip Bulb Craze of 1637. To some extent, the entire stock market seemed to have been caught in the turbulence: in the Spring of 2000, the Standard & Poors 500 Index of 500 leading companies topped 1,500.7 By October 2002, the S&P Index was hovering near 775, a nearly fifty percent decline in value.” (Stout, 2003, p.635)
In the light of such repetitive patterns, it is impossible for a discerning analyst to not suspect a breach in the Efficient Market Hypothesis. With powerful data repository systems and automated mathematical tools at the disposal of the analyst, it is possible today to look critically at the flawed assumptions and lack of rigor in the works of earlier generation of financial market experts who promoted EMH. As author Lynn A. Stout propounds in her journal article, the gaping holes of the EMH apparent to “anyone who cared to look for them within a few years after the theory was first developed and disseminated…one need not have waited several decades to develop this suspicion. Nor need we have suffered through the Crash of 1987 and the 1990s tech stock bubble to find enlightenment.” (Stout, 2003, p.636)
Gilson and Kraakman’s pioneering work on the financial markets was condensed and presented in their article The Mechanisms of Market Efficiency (published in 1984). This work went a long way in justifying common criticisms of EMH. For a minority of EMH contrarians, it offered a meticulous and detailed enquiry into the Achilles’ heel of efficient market theory, namely, ‘how exactly does information flow into prices’. The EMH is only valid when market prices fully account for all available information pertaining to a stock. But, as Gilson and Kraakman point out, information is expensive to obtain, process, and verify. Consequently, it is near impossible for all market participants to “actually acquire, understand, and validate all the available information that might be relevant to valuing securities. Efficient market theory nevertheless predicts that even though information is not immediately and costlessly available to all participants, the market will act as if it were.” (Stout, 2003, p.635) This assertion is not true because arbitrageurs can ‘correct’ market prices only to a certain extent. In other words, arbitrageurs are not a homogenous lot, but instead comprised of distinct groups with different priorities and goals. In this context, as Gilson and Kraakman observe, “the answer could be found in the complex interaction of at least four imperfect price-moving market mechanisms: “universally informed trading;” “professionally informed trading;” “derivatively informed trading” (including both “trade decoding” and “price decoding”); and “uninformed trading.” (Stout, 2003, p.637) The fact that market transactions are carried out today in fast digital networks with an abundance of relevant information has not altered this arrangement in any significant way.