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

For example, one of the pioneers of EMH, economist Eugene Fama, argued that the 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.

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. Because 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.

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. Inattentiveness to certain kinds of information, confirmation bias and herding behavior are a few examples that might be related to economic bubbles. These biases have been shown to exist, but determining the incidence and level of a particular bias at a particular time is not so straightforward.

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.

The definition of a bubble is that the right price is fundamentally different from the market price, meaning that the consensus price is 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, Fama would likely disagree.

  1. What does the Efficient Market Hypothesis have to say about fundamental analysis?

    Find out what the efficient markets hypothesis has to say about fundamental analysis and how recent finance research has ... Read Answer >>
  2. What are the primary assumptions of Efficient Market Hypothesis?

    Find out about the key assumptions behind the efficient market hypothesis (EMH), its implications for investing and whether ... Read Answer >>
  3. How Does an Efficient Market Affect Investors?

    The efficient market hypothesis refers to aggregated decisions of many market participants. Read Answer >>
  4. What lessons did the tech bubble crash give to investors in the Internet sector?

    Learn how investors contributed to the dot-com bust and how Internet services and investing has changed since the market ... Read Answer >>
  5. Has the Efficient Market Hypothesis been proven correct or incorrect?

    Explore the efficient market hypothesis and understand the extent to which this theory and its conclusions are correct or ... Read Answer >>
  6. What does 'froth' mean in terms of the real estate market?

    On May 20, 2005, while addressing the Economic Club of New York, the now former Federal Reserve chairman Alan Greenspan commented ... Read Answer >>
Related Articles
  1. Insights

    What Is Market Efficiency?

    The efficient market hypothesis (EMH) suggests that stock prices fully reflect all available information in the market. Is this possible?
  2. Investing

    Economic Bubble: Toil And Trouble!

    You might like the idea of profiting from a bubble, but you’d probably like to avoid suffering from its aftermath. Here is how an economic bubble works.
  3. Insights

    Five Of The Largest Asset Bubbles In History

    The five bubbles discussed here were among the biggest in history; their lessons should be heeded.
  4. Investing

    Efficient Market Hypothesis: Is The Stock Market Efficient?

    Deciding whether it's possible to attain above-average returns requires an understanding of EMH.
  5. Insights

    Some Industries Are More Bubbly Than Others

    Investors who want to avoid future bubbles should learn from the past in order to protect their investments.
  6. Investing

    Investing During Market Bubbles and Bursts

    Don’t fear bubbles and don’t avoid certain markets because some people believe they may burst.
  7. Insights

    4 Reasons Why Irrational Exuberance Lasts

    20 years ago, Alan Greenspan gave his famous "irrational exuberance" speech, but asset bubbles take a long time to pop.
  8. Insights

    Lessons Learned: Comparing The Japanese And U.S. Bubbles

    Find out what the Japanese and U.S. bubbles can tell us about recovering from financial chaos.
  9. Insights

    What Causes Bubbles?

    A look at how asset bubbles are formed according to different schools of thought.
  1. Bubble Theory

    Bubble theory is an economic hypothesis that irrational investors ...
  2. Semi-Strong Form Efficiency

    Semi-strong form efficiency is a form of Efficient Market Hypothesis ...
  3. Efficient Market Hypothesis - EMH

    The Efficient Market Hypothesis - EMH is an investment theory ...
  4. Speculative Bubble

    A speculative bubble is a spike in asset values within a particular ...
  5. Echo Bubble

    Echo bubble is a post-bubble rally that becomes another, smaller ...
  6. Housing Bubble

    A housing bubble is a run-up in home prices fueled by demand, ...
Trading Center