Does the crisis expel the EMH?
Professor Jeremy Siegel wrote this opinion piece for the WSJ yesterday and I thought it was interesting. In it, Siegel defends the Efficient Market Hypothesis by pointing out that the paradigm in which most Wall Street firms made decisions during the credit boom (which in hindsight look like bad decisions) were steeped in the Great Moderation where bubbles and volatility were not the norm. As a result, there models for evaluating risk did not anticipate the level of volatility that reality has now presented. Here are a couple excerpts which I found interesting:
*The economic response to the Great Moderation was predictable: risk premiums shrank and individuals and firms took on more leverage.
*According to data collected by Prof. Robert Shiller of Yale University, in the 61 years from 1945 through 2006 the maximum cumulative decline in the average price of homes was 2.84% in 1991. If this low volatility of home prices persisted into the future, a mortgage security composed of a nationally diversified portfolio of loans comprising the first 80% of a home’s value would have never come close to defaulting.
*Our crisis wasn’t due to blind faith in the Efficient Market Hypothesis. The fact that risk premiums were low does not mean they were nonexistent and that market prices were right.
*But this does not mean that risks have disappeared. To use an analogy, the fact that automobiles today are safer than they were years ago does not mean that you can drive at 120 mph.
What’s your take? Do you believe in the Efficient Market Theory? Leave your comments below.