Grossman & Stiglitz argued that because generating information is costly, informed investors are compensated for the costs they incur to ensure that prices adjust to information by the very fact that prices do not reflect all available information. We, thus, end up with “an equilibrium degree of disequilibrium”. In their model, there is a risky asset with a return u = q + e where (q) is observable at a cost (c) and (e) is unobservable. Informed traders know (q) while uninformed agents only observe price.
People switch from being informed to being uninformed until the expected utilities of individuals in the two groups are equated. The more individuals are informed, the more information will be contained in prices and hence the lower the gains of those with information at the expense of those without it, but also it is assumed that the costs of obtaining information are lower. This implies that the “equilibrium” may be unstable since the 2 lines which determine equilibrium (the costs and benefits of obtaining information) are both downward slopping so they may intersect more than once.A similar model in many ways is that of Black who argues that noise trading is essential in providing liquidity to the system since otherwise transactions would only occur when information or individual preferences or endowments changed. Especially in small markets this could lead to very intermittent trading if not to the disappearing of the market completely. This model, however, does not explain why does noise trading occur.Possible explanations are that some agents may enjoy trading for the sake of trading while others may think they are trading in information Those two models are interesting in that they show the inverse relationship between liquidity and efficiency and particularly the first model shows that inefficiency can occur despite rational optimising agents. A rather more radical approach rejects the EMH completely on the grounds that it is based on a “linear” view of society where people react as information is received and adjust to it immediately.
However, it is argued, that people and nature are non-linear given the heterogeneity of traders – the fact that people reason differently about the information they receive, have different horizons and different attitudes to risk. Two people receiving the same information may end up with different conclusions and though one will be wrong and lose, neither is irrational. It has been shown that people often have a tendency to make overconfident predictions and are more likely to act to reinforce trends than to forecast changes in them.Non linearity means that the effect need not be proportional to cause : the same-sized cause can have different sized effects depending on the circumstances.
This would also explain the existence of bubbles during which prices rise sharply solely due to the expectation of a higher price in the future with little relation to the “fundamentals”. Keynes’s bootstrap equilibria can also be included here. The ability to forecast the market largely depends on fractal theory and non-linear statistics.
Recent results suggest that when volatility is high the market tends to follow trends.When volatility is low, the market is contrarian : trends persist for shorter than expected periods. In both cases it means that the market is partly predictable.
Checking for inefficiency empirically is very difficult since we have to test it jointly with some model of equilibrium, an asset-pricing model. We are never certain that the instability detected in many studies reflects inefficiency or it is a result of a mispeciffication of the dividend process. There are broadly speaking three tests for efficiency, each one related to the corresponding type of the EMH we saw before.The weak form of EMH is tested by return predictability tests which examine the forecast power of past returns, dividend yields, earnings/price ratios and term-structures). Such tests are not consistent in finding either predictability or randomness in the short-run, but some “anomalies” were found such Monday returns being on average lower and returns before a holiday are higher. The predictable component of the variance of returns is even stronger for long horizons (indicating perhaps short-termism).
The problem with such tests, however, is that they suffer from the joint hypothesis problem since changes to tastes or technology are often not included on the asset-pricing model used. In event studies which test for the semi-strong EMH, an information event is examined in order to determine the speed of adjustment of stock prices. This has the advantage of being free of the joint hypothesis problem since an information event can be dated precisely and has large effects on prices so the way one abstracts from expected returns to measure abnormal daily returns is not crucial.
The results clearly indicate that on average stock prices adjust quickly to changes in public information. This may in part explain why index funds and other forms of passive management have grown more popular. The strong form of the EMH is tested by private information tests. Although insider trading is illegal, it has been found that monopolistic access to information does create opportunities for profit. On the other hand, some have found that such insider information becomes rather quickly public knowledge so the gains of insider traders are often limited.Another important criticism of the UK financial system in particular which dates to the end of the 19th century is that the City has specialised in international finance and has hence neglected British industry. Besides the point that it has been difficult to show empirically that the City has indeed “neglected” industry, the standard neoclassical argument in defending the City is that it was maximising its profits so that it was the industry’s fault which could not generate profitable and promising projects. The arguments against this view are three.
First that manufacturing is of special significance to an economy partly due to its importance for the BOP and for productivity growth but this is a huge debate I won’t get into now. Second, it is possible that once the City had specialised in international finance, partly due to the empire, it had a comparative advantage in that area which in the long-run proved unfortunate. This is unlikely to be very important since the UK financial system is too developed to claim that it was ignorant of opportunities in the domestic industry or that it lacked the expertise to detect and exploit them.Thirdly, the UK institutional arrangements were particularly prone to short-termism and hence were unable to cater for the long-run industrial projects. Indeed, probably the most common criticism of the financial markets, especially those of the UK and the US, is short-termism. The causes of short-termism are not very clear; some argue that the inefficiency of the market and private information which allows big profits to be made by speculation and arbitrage puts long-run considerations in second place.Alternatively, the institutional structure of the US and the UK is thought to encourage short-termism because fund managers are often tested on the basis of their short-run results, firms are required to publish their accounts too often so that managers are afraid of engaging in long-term projects which may jeopardise their short-run profitability, reliance on takeovers for corporate control and banks have not developed long-term links with industry.
Takeovers have often been accused of leading to short-termist behaviour aside from their effectiveness as a means of corporate control which will be examined later on.Takeovers are supposed to make managers put undue attention on the current share price of the firm which may not be fully compatible with long-run objectives perhaps due to asymmetric information : people do not know whether the fall in profits and dividends is due to bad performance or promising long-term investments. It should be noted that takeovers are not another cause of financial market inefficiency as such; they are simply another channel for the existing inefficiency of the financial markets to “worsen” the real economy.