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Creative uses of efficient markets

The “efficient market hypothesis” argues that markets quickly and correctly incorporate all publicly available information into prices. Under the strong version of this theory, the only reason prices of assets like stocks move is because new information becomes available. (The ideas underyling efficient markets are largely associated with the University of Chicago in the 1960s and 1970s.)

Most economists these days would say that there is a lot of truth to the arguments that markets are good at building information into prices, but that there are also other forces that affect prices, like “noise” trading, bubbles, etc.

If markets are efficient, then you can reverse the logic: any change in prices must be due to some new information. This is what an economist would call an “event study.” You look at some unexpected event, measure how much stock prices changed, and assuming that event was the only important piece of information that emerged in a short time window, the change in the share prices tells you how important the event was. For intance, recently there have been some nice academic papers looking at how the stock prices of companies with ties to political officials fluctuate in response to unexpected political events (e.g. Senator Jeffords switching parties, Representative Livingston resigning, Suharto from Indonesia getting sick).

There is an interesting article in the Economist showing how this logic landed a guy named Jamie Olis in jail.

Like all economic tools, however, one needs to be careful in how one applies and interprets “event studies.” After the Sept 11 terror attack five years ago, I was discussing with a prominent economist friend of mine about how important the attacks were. He argued (pretty convincingly) that the attacks were hugely important for the economy — the S&P 500 fell about 10% after the attacks, wiping out about $600 billion in market value. Under the logic of the efficient market hypothesis, that meant the events of Sept 11 had been an economic disaster.

The problem with the argument: three months later the S&P 500 was 4% higher than before the attacks!

There are two possible explanations for this. Maybe lots of good news hit the markets in those three months offsetting the bad news from 9-11. More likely, the price response after 9-11 was an enormous overreaction. The markets got it wrong, and slowly people caught on to this and realized that, at least in economic terms, 9-11 was not that big an event.