FEATURE: EFFICIENT MARKET HYPOTHESIS
EXECUTIVE SUMMARY
• Academics and their theories have been
blamed for the recession.
• EMH and MPT have come in for most
criticism.
• They need to be taught alongside
other theories.
“A much fuller explanation of the
assets are likely to be sold. Consequences for
the economy and for asset prices follow.
Th e demand for money relative to the
behaviour of fi nancial markets is obtained current change in the stock of money helps
to explain changes in market valuation
if they are complemented by the liquidity
relative to fundamental factors. A crude
measure of this is to compare the real growth
theory of asset prices”
of the money supply in the US with the P/E
ratio of the S&P 500. Figure 1 shows this
comparison for M2 between 1960 and 1980.
Techniques that focus on variance or standard deviation may Figure 2 shows it for Money of Zero
merely manage the volatility of the return on a portfolio rather Maturity (MZM) between 1980 and 2005.
than avoid serious risk of loss. Th ere is clearly a relationship between the
An important diff erence between risk of loss and volatility money supply and the P/E ratio, although it
is that risk of loss in the short term can be very diff erent from is not one-to-one; the leads and lags at the
that in the long term. When a fi nancial bubble is building up, turning points are variable; and at times there
for example, an investment manager assessed against a target are special factors. (After 2005 the fl ow of
index may confi dently expect a sale of stock to result in money into the US from China, in
avoidance of loss in the long term but the risk of not making
profi ts in the short run can rise to such an extent that the
STATS.
opportunity has to be declined. Th e risk is illustrated only to
clearly by what happened to the late Tony Dye and P&D FIGURE 1: S&P 500 P/E AND REAL M2 GROWTH, 1960 – 1980
Fund Managers when they severely underperformed during
the tech boom.
PE on S&P 500 Annual Real M2 growth (RHS)
25 12
THE LIQUIDITY THEORY OF ASSET PRICES
20 8
MPT and EMH needs to be complemented by the (LTAP).
Briefl y, the amount of money that individuals and fi rms hold is 15 4
often diff erent from their intended holding. Some will be taking
action to increase their holding whereas others will be reducing
10 0
theirs. In the economy as a whole, one or the other can be
dominant for many months. Th e crucial point is that the supply
5 -4
of money in the economy as a whole is rarely equal to the
demand for money. If there is a surplus, some of it will be spent
0 -8
1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980
on goods and services and some will be spent on existing assets.
If there is a defi cit, some expenditure will be curtailed and some
MZM (money of zero maturity) is M2 less small-denomination time
deposits plus institutional money funds.
WWW.CFAUK.ORG PROFESSIONAL INVESTOR 21
20-2320-23 EMH.indd 21EMH.indd 21 2/6/092/6/09 14:11:2814:11:28Professional Investor Summer 09.23 23 4/6/09 15:40:52
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