The efficient market hypothesis (EMH) cannot explain economic bubbles because, strictly speaking, the EMH would argue that economic bubbles don't really exist. The hypothesis's reliance on assumptions about information and pricing is fundamentally at odds with the mispricing that drives economic bubbles.

Economic bubbles occur when asset prices rise far above their true economic value and then fall rapidly. The EMH states that asset prices reflect true economic value because information is shared among market participants and rapidly incorporated into the stock price.

Key Takeaways

  • The efficient market hypothesis cannot explain economic bubbles since according to the theory, economic bubbles can't exist.
  • Economic bubbles occur when asset prices rise far above their true economic value and then fall rapidly.
  • The EMH states that asset prices reflect their true economic value since information is shared among market participants and rapidly priced into the stock price.

Understanding Efficient Market Hypothesis 

Efficient market hypothesis is a theory that holds the belief that stock prices are accurately priced and reflect all of the available information in the market. Efficient market hypothesis assumes that the market is efficient, meaning that investors have access to all of the necessary information to make informed investment decisions. As a result, outperforming the market is not possible since stocks are already accurately priced under EMH. 

Under the EMH, there are no other factors influencing underlying price changes, such as irrationality or behavioral biases. In essence, then, the market price is an accurate reflection of value, and market bubbles are simply notable changes in the fundamental expectations about asset returns.

According to the efficient market hypothesis, there's no way for investors to identify value stocks or stocks that are trading at a cheaper price than what they're worth. Instead, if investors want to outperform the market, the only way they can achieve higher returns would be to purchase high-risk investments. However, investors such as Warren Buffett have been able to consistently outperform the overall market by identifying value stocks when they're unpopular with most investors.

Efficient Market Hypothesis and the Financial Crisis

Nobel Prize winning economist Eugene Fama is one of the pioneers of EMH. Fama has argued that the 2008-2009 financial crisis, in which credit markets froze, and asset prices dropped precipitously, was a result of the onset of a recession rather than the burst of a credit bubble. The change in asset prices reflected updated information about economic prospects.

The definition of a bubble is that the right price is fundamentally different from the market price, meaning that the consensus price is wrong. Fama has said that for a bubble to exist, it would have to be predictable, which would mean that some market participants would have to see the mispricing ahead of time. He argues that there is no consistent way to predict bubbles. Since bubbles can only be identified in hindsight, they cannot be said to reflect anything more than rapid changes in expectations based on new market information.

Efficient Market Hypothesis and Bubbles

Whether bubbles are predictable is subject to debate. Behavioral finance, a field that attempts to identify and examine financial decision making, has uncovered several biases in investment decision making, both on an individual and market level. There are several reasons why a market and investors could act inefficiently and as a result, misinterpret a bubble as a bull market.

Market Information

All investors review information differently and could, therefore, apply different stock valuations. Also, some investors might exhibit inattentiveness to certain kinds of information. For example, stock prices take time to respond to new information and the investors who act quickly on the information could earn more profit than those who act on the information later. 

Human Emotions

Stock prices can be affected by human error and emotional decision making. Herding behavior is when all market participants act in the same way to the information available. The herd instinct could be applied to the correction in the S&P 500 following information about the 2020 coronavirus outbreak. Although the fear could be justified, the fear of losing money prompted many traders and investors to sell equities leading to widespread declines in markets across the globe.

Human Bias

Confirmation bias can occur when investors only accept and research information that supports their view of the investment. If an investor is bullish on a stock, only articles and research that support the bullish view would be considered. As a result, the investor might miss or avoid pertinent information that might cause the stock's price to decline. These biases have been shown to exist, but determining the incidence and level of a particular bias at a particular time has its challenges.

Special Considerations

Of course, it should be noted that the EMH doesn't demand that all market participants are right all the time. However, one of the theory's core tenets revolves around the idea of market efficiency. Given that market participants share the same information, the consensus price should accurately reflect an asset's fair value because those who are wrong transact with those who are right. Behavioral finance, on the other hand, argues that the consensus can be wrong.

Whether it is predictable or not, some have argued that the financial crisis represented a serious blow to the EMH because of the depth and magnitude of the mispricings that preceded it. However, proponents of efficient market hypothesis would likely disagree.