While I was working on the conference we gave yesterday about the Nobel Prize in Economics 2013 awarded to Fama, Shiller and Hansen, I came up with an idea that, to the best of my knowledge, has not been highlighted before. In short, the EMH as it is interpreted today faces a conflict to refute simultaneously two of the most relevant concepts in the behaviorist literature: the excess volatility (Shiller 1981) and the limits of arbitrage (Shleifer and Vishny 1997).
The original EMH interpretation (Fama 1970) did not account for investors' risk appetite. Prices would reflect fundamentals, and a 'sufficient number' of rational arbitrageus that correctly interpret those fundamentals ensure that possible price deviations from rationality are removed. Two challenges to the opposite view, one by behaviorists, other by rationalists, would follow. First, Shiller (1981) went to highlight markets are too volatile to be justified only by fundamentals. After some debate, rationalists responded (e.g., Fama-French 1989) arguing that volatility and some evidence of return predictability would be a consequence of changes in the discount factor due to (rational) changes in the appetite for risk of investors.
Second, a classic argument that rationalists used against the ‘anomalies’ reported by behaviorists was “how would price inefficiencies survive to the presence of rational arbitrageurs?” Shleifer and Vishny (1997) responded arguing that real world arbitrage is risky, and limited, because arbitrageurs are risk averse and their ability to bear losses due to mispricing is limited.
To defend itself against excess volatility, the EMH needs, on one hand, that changes in prices are justified by changes in investors' risk appetite. But this, on the other, is the same as accepting arbitrage is risky. The original interpretation of a 'rational arbitrageur' now does not make sense: now, arbitrageurs should be able to (i) correctly interpret fundamentals and (ii) correctly anticipate investors changes in risk appetit -otherwise their efforts to correct mispricings might be offset by changes in risk appetite in the contrary direction.
The EMH struggles between two choices: refuting excess volatility, or refuting limits to arbitrage. Refuting both, simultaneously, is not possible.
What may be their choice? Well, in my opinion, their choice has already been made. The rationalist choice has been to substitute an old artifact by a new artifact. The old artifact was the idea of a sufficient number of rational arbitrageurs. Honestly, if that idea is correct, if there are some clever guys that know at any moment what the correct price should be... why do we need markets? We need to know who those guys are and choose them as our leaders, our Presidents, our Kings for life!! Bye bye democracy!!
The new artifact follows. Under the current EMH interpretation, for a given fundamental asset value, many different prices may be correct: it depends on the risk appetite of the investors. In consequence, the new EMH does not need the figure of an arbitrageur anymore, because EMH does not say today what we believed the thing was about: EMH does not say “prices are unbiased estimations of the fundamental value, given information available” any more. Rationalists and the EMH are actually saying: “whatever the market prices, that’s the fundamental value”. Pleased to meet you, market fundamentalists.