Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

The Efficient Market Hypothesis

Economists (to varying degrees) think that financial markets are informationally efficient, that is, today’s price already contains all publicly available information. Therefore, asset prices jump instantly in response to new public information: it’s called the Efficient Market Hypothesis (EMH). So if no one can truly predict (with 100 per cent certainty) price movements, no one can predict financial crises.

Imagine that a friend tells you that he’s certain that shares in FlowerCorp are going to double by this time next year. We hope that before selling your house and buying as many shares as possible in FlowerCorp, you’d ask him some questions.

A good first one is, ‘How do you know?’. Suppose that he replies that he read in the news that the firm was going to have a stellar set of sales next year that will push up the share price. Now you may be thinking: this sounds a bit fishy! After all, if he read it in the news, presumably many other people also read the same story: economists call this public information.

If true that the shares would double in a year’s time, people wouldn’t hang around and wait a year to buy them: they’d buy them right now! This would increase the price today. By how much? Well, by double. Thus if prices were definitely going to double next year and your friend is making this claim on the basis of public information, they’d have already doubled today!

In Figure 16-5, notice that the stock price today is relatively low (at A). If the stock price is going to double in the next year (to B) and this is public information – so that everyone knows it – the price jumps today (to C).


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Figure 16-5: Prices ‘jump’ on new information.

Another possibility is that your friend has some private information, for example he works as a lawyer or banker for the company and has access to some sensitive information not known to the general public. In this case, your friend may be telling the truth: the stock price could double but the general public just doesn’t know it yet.

Before you go out and make a pretty penny, however, remember that in most countries trading on private information of this sort is illegal and called insider dealing.

The EMH confirms that people can’t possibly make ‘free money’ by buying things below their ‘true price’ and selling overpriced things. Just as you don’t expect £20 notes to be lying in the middle of the street, don’t expect to be able to make free money in financial markets.

EMH and forecasting

EMH is a simple idea with some powerful implications. Despite newspapers being full of people’s opinions on what’s likely to happen to house prices in London, or the price of oil, or the stock price of some company, EMH means that economists are sceptical of the forecasting abilities of any individual.

After all, if markets are informationally efficient, the price of an asset already contains all publicly known information. Sure, as time passes new information will be revealed, but this is as likely to be ‘good’ news that makes the price go up as ‘bad’ news that makes the price go down.

Therefore, the best (most likely to be correct) forecast of the price of a dividend-paying asset (one that pays you an income for as long as you own it) tomorrow or next year is just today’s price (plus inflation).

For example, most shares pay dividends (a fraction of the profit earned) every year; owning a house gives you a dividend, in the form of rental income or the fact that you can live in it. This means that even if, on average, the price doesn’t rise in real terms over a year, you’re still getting a return. Some shares don’t pay substantial dividends (or even any at all), because the managers prefer to reinvest the profits. In this case, you’d expect the share price to rise on average in real terms.