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Part 2 Fundamentals of Financial Markets
C A S E
What Do the Black Monday Crash of
1987 and the Tech Crash of 2000 Tell Us
About the Efficient Market Hypothesis?
On October 19, 1987, dubbed “Black Monday,” the Dow Jones Industrial Average
declined more than 20%, the largest one-day decline in U.S. history. The collapse
of the high-tech companies’ share prices from their peaks in March 2000 caused the
heavily tech-laden NASDAQ index to fall from around 5,000 in March 2000 to around
1,500 in 2001 and 2002, for a decline of well over 60%. These two crashes have caused
many economists to question the validity of the efficient market hypothesis. They
do not believe that an efficient market could have produced such massive swings
in share prices. To what degree should these stock market crashes make us doubt the
validity of the efficient market hypothesis?
Nothing in the efficient market hypothesis rules out large changes in stock
prices. A large change in stock prices can result from new information that pro-
duces a dramatic decline in optimal forecasts of the future valuation of firms.
However, economists are hard pressed to come up with fundamental changes in the
economy that can explain the Black Monday and tech crashes. One lesson from
these crashes is that factors other than market fundamentals probably have an
effect on stock prices. Hence these crashes have convinced many economists that
the stronger version of the efficient market hypothesis, which states that asset
prices reflect the true fundamental (intrinsic) value of securities, is incorrect. They
attribute a large role in determination of stock prices to market psychology and
to the institutional structure of the marketplace. However, nothing in this view con-
tradicts the basic reasoning behind the weaker version of the efficient market
hypothesis—that market participants eliminate unexploited profit opportunities.
Even though stock market prices may not always solely reflect market fundamen-
tals, this does not mean that the efficient market hypothesis does not hold. As
long as stock market crashes are unpredictable, the basic lessons of the theory of
rational expectations hold.
Some economists have come up with theories of what they call rational bub-
bles to explain stock market crashes. A bubble is a situation in which the price of
an asset differs from its fundamental market value. In a rational bubble, investors can
have optimal forecasts that a bubble is occurring because the asset price is above
its fundamental value but continue to hold the asset anyway. They might do this
because they believe that someone else will buy the asset for a higher price in the
future. In a rational bubble, asset prices can therefore deviate from their fundamental
value for a long time because the bursting of the bubble cannot be predicted and
so there are no unexploited profit opportunities.
However, other economists believe that the Black Monday crash of 1987 and
the tech crash of 2000 suggest that there may be unexploited profit opportuni-
ties and that the theory of rational expectations and the efficient market hypoth-
esis might be fundamentally flawed. The controversy over whether capital markets
are efficient continues.
Chapter 6 Are Financial Markets Efficient?
131
Behavioral Finance
Doubts about the efficient market hypothesis, particularly after the stock market
crash of 1987, have led to a new field of study, behavioral finance, which applies
concepts from other social sciences, such as anthropology, sociology, and particularly
psychology, to understand the behavior of securities prices.
16
As we have seen, the efficient market hypothesis assumes that unexploited profit
opportunities are eliminated by “smart money.” But can smart money dominate ordi-
nary investors so that financial markets are efficient? Specifically, the efficient mar-
ket hypothesis suggests that smart money sells when a stock price goes up
irrationally, with the result that the stock falls back down to what is justified by fun-
damentals. However, for this to occur, smart money must be able to engage in short
sales, in which they borrow stock from brokers and then sell it in the market, with
the hope that they earn a profit by buying the stock back again (“covering the short”)
after it has fallen in price. However, work by psychologists suggests that people are
subject to loss aversion: That is, they are more unhappy when they suffer losses than
they are happy from making gains. Short sales can result in losses way in excess of
an investor’s initial investment if the stock price climbs sharply above the price at
which the short sale is made (and these losses have the possibility of being unlimited
if the stock price climbs to astronomical heights). Loss aversion can thus explain
an important phenomenon: Very little short selling actually takes place. Short sell-
ing may also be constrained by rules restricting it because it seems unsavory that
someone would make money from another person’s misfortune. The fact that there
is so little short selling can explain why stock prices sometimes get overvalued. Not
enough short selling can take place by smart money to drive stock prices back down
to their fundamental value.
Psychologists have also found that people tend to be overconfident in their own
judgments (just as in “Lake Wobegon,” everyone believes they are above average).
As a result, it is no surprise that investors tend to believe they are smarter than other
investors. These “smart” investors not only assume the market often doesn’t get it
right, but they are willing to trade on the basis of these beliefs. This can explain
why securities markets have so much trading volume, something that the efficient
market hypothesis does not predict.
Overconfidence and social contagion provide an explanation for stock market
bubbles. When stock prices go up, investors attribute their profits to their intelligence
and talk up the stock market. This word-of-mouth enthusiasm and the media then
can produce an environment in which even more investors think stock prices will rise
in the future. The result is then a so-called positive feedback loop in which prices
continue to rise, producing a speculative bubble, which finally crashes when prices
get too far out of line with fundamentals.
17
The field of behavioral finance is a young one, but it holds out hope that we might
be able to explain some features of securities markets’ behavior that are not well
explained by the efficient market hypothesis.
16
Surveys of this field can be found in Hersh Shefrin, Beyond Greed and Fear: Understanding of
Behavioral Finance and the Psychology of Investing (Boston: Harvard Business School Press,
2000); Andrei Shleifer, Inefficient Markets (Oxford: Oxford University Press, 2000); and Robert J.
Shiller, “From Efficient Market Theory to Behavioral Finance,” Cowles Foundation Discussion Paper
No. 1385 (October 2002).
17
See Robert J. Shiller, Irrational Exuberance (New York: Broadway Books, 2001).
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