Efficient Market Hypothesis: Blind Alley of the 20th Century?

Our book “Trades, Quotes & Prices” came out in print almost 5 years ago. Our aim was to discuss empirical facts of financial markets and introduce a wide range of models, from the micro-scale mechanics of individual order arrivals to the emergent, macro-scale issues of market stability.
 

We rooted all our discussions in the empirical behaviour of real markets, with the hope to provide a new perspective on topics as diverse as optimal trading, price impact, the fragile nature of liquidity, and most importantly, why and how prices move and why people trade at all.
 
The widespread availability of high-quality, high-frequency data has indeed revolutionised the study of financial markets. By describing not only asset prices, but also market participants actions and interactions, this wealth of information offers a new window into the inner workings of the financial ecosystem. Just as the atomic hypothesis allowed Maxwell and Boltzmann, 150 years ago, to understand how the macroscopic world is described by thermodynamics, trades and quotes are the elementary units from which price dynamics emerges.  
 
I am actually particularly pleased with the way the ideas developed in our book perfectly dovetail with the recent “Inelastic Market Hypothesis” of Xavier Gabaix and Ralf Koijen, which is in my view one of the most interesting and disruptive piece of work in financial economics. Several of my past posts already touched upon this topic, but I cannot resist mentioning it again, not least because IMH provides a clear and convincing interpretation for a host of interesting “anomalies” for which Efficient Market Theory is totally clueless. 
 
The IMH is the long-term epitome of what we called in our book the order-driven theory (ODT) of markets: prices move primarily because people trade, whatever the reason they are trading, and much less because of unexpected news that change the elusive “fundamental value” of assets. Although very compelling for anyone who has a practical experience of markets, such a conclusion is still considered as blasphemy in many economics departments. But as Fisher Black wrote in his 1985 gem “Noise”:

“I recognize that most researchers will regard many of my conclusions (on the importance of noise in determining prices) as wrong, or untestable, or unsupported by existing evidence. [… ] In the end, my response to the skepticism of others is to make a prediction: someday, these conclusions will be widely accepted.’’

I am ready to make a bet that, ten years from now, the conclusions of the IMH/ODT (a more sophisticated and explicit version of Black’s vision) will be “widely accepted”.

In fact, re-reading “Noise” today (which I highly recommend), I cannot fathom why so many people haven’t heeded Black and still believe that EMH is roughly correct. In my view, EMH is one of the most momentous intellectual blind alley of the XXth century.

#markets  #microstructure #noise #quotes #prices #quantitativefinance #impact #data