By Robert Folsom
Editor's Note: The following article discusses Robert
Prechter's view of the Efficient Market Hypothesis. For more information,
download this free 10-page issue of Prechter's
Elliott Wave Theorist.
When a maverick idea becomes
vindicated, there's a good story to tell. It usually involves a person (or small
group of people) who courageously challenge the orthodoxy of the day -- and,
over time, the unorthodox yet better idea prevails.
A "good story" of this sort has
surfaced during the current financial crisis. A chapter of the story appeared in
a recent New York Times article, "Poking Holes in a Theory on Markets." The
theory in question is the efficient market hypothesis (EMH), which the article
suggested is so hazardous that it "is more or less responsible for the financial
crisis." This quote tells you most of what you need to know:
"In the last decade, the
efficient market hypothesis, which had been near dogma since the early 1970s,
has taken some serious body blows. First came the rise of the behavioral
economists, like Richard H. Thaler at the University of Chicago and Robert J.
Shiller at Yale, who convincingly showed that mass psychology, herd behavior
and the like can have an enormous effect on stock prices — meaning that
perhaps the market isn't quite so efficient after all. Then came a bit more
tangible proof: the dot-com bubble, quickly followed by the housing bubble.
Quod erat demonstrandum."
In case your Latin is rusty,
Quod erat demonstrandum means "which was to be demonstrated." Its
abbreviation (QED) appears at the conclusion of a mathematical proof. In this
case, the massive financial bubbles of recent years are the proof that refutes
the efficient market hypothesis, which argues that markets move in a "random
walk" and are not patterned.
Similar articles in the financial
press have reported the demise of the EMH. Just this week an Economist magazine
blog included this bold declaration:
"No one has yet produced a
version of the EMH which can be tested and fits the evidence. Thus, the EMH must
logically be discarded, as a valid hypothesis must be testable."
QED, indeed -- I agreed years ago
that the random walk was implausible. But I didn't come to this view because of
behavioral economists, although their work over the past decade has certainly
been valuable. Instead, I was persuaded by the work of someone who first
challenged the financial orthodoxy more than three decades ago, specifically
April 1977. As a young technical analyst at Merrill Lynch in
New York, his research circulated among several of Merrill's clients. His name
for these studies was the Elliott Wave Theorist: the April '77 study
was a detailed analysis of the 1975-76 stock market, which offered this comment
on the random walk model:
"If market moves are
arbitrary (as the random walk proponents suggest), then internal components
would rarely 'make sense' mathematically, and then only by statistically
insignificant fluke occurrences. However, there seems to be enough evidence
that mass psychology, as recorded in the Dow Jones Industrials, form patterns
that are uncannily interrelated....At least this much can be fairly reliably
stated as a result of this work: This idea that the market is a 'random walk'
is probably false."
Robert Prechter left Merrill soon
after; he has published the Elliott Wave Theorist in every month since.
Every issue has, in one way or another, "convincingly showed that mass
psychology, herd behavior and the like can have an enormous effect on stock
So while there may be a good story
to tell about behavioral economists, I trust you see why I believe there is a
vastly better one to tell.
The "enormous effect" of "mass psychology" and "herd behavior" is exactly what
explains the financial downturn that began in late 2007. Prechter's Elliott
Wave Theorist anticipated the crisis and warned subscribers beforehand.
Likewise, he alerted them to the bear market rally that began last March.
For more information from Robert
Prechter, download a FREE 10-page issue of
The Elliott Wave Theorist. It challenges current recovery hype with
hard facts, independent analysis, and insightful charts. You'll find out why the
worst is NOT over and what you can do to safeguard your financial future.
is a financial writer and editor for Elliott Wave International. He has covered
politics, popular culture, economics and the financial markets for two decades,
via print, radio and the Internet. Robert earned his degree in political science
from Columbia University in 1985.