I found out a couple of days ago that there’s a debate within academia over EMH. Here’s how John Cochrane described it in an interview:
When house prices are high relative to rents, when stock prices are high relative to earnings—that seems to signal a period of low returns. When prices are high relative to earnings, it’s not going to be a great time to invest over the next seven to ten years. That’s a fact. It took us ten years to figure it out, but that’s what (Robert) Shiller’s volatility stuff was about; it is what Gene (Fama)’s regressions in the nineteen-eighties were about. That was a stunning new fact. Before, we would have guessed that prices high relative to earnings means we are going to see great growth in earnings. It turned out to be the opposite. We all agree on the fact. If prices are high relative to earnings that means this is going to be a bad ten years for stocks. It doesn’t reliably predict a crash, just a period of low returns, which sometimes includes a crash, but sometimes not.
Ok, this is the one and only fact in this debate. So what do we say about that? Well, one side says that people were irrationally optimistic. The other side says, wait a minute, the times when prices are high are good economic times, and the times when prices are low are times when the average investor is worried about his job and his business. Look at last December (2008). Lots of people saw this was the biggest buying opportunity of all time, but said, “Sorry, I’m about to lose my job, I’m about to lose my business, I can’t afford to take more risk right now.” So we would say, “Aha, the risk premium is higher!”
So that’s now where this debate is. We’re chewing out: Is it a risk premium that varies over time, or is it psychological variation? So your question is right, but it is not as obvious as: “Stocks crashed. We must all be irrational.”
There is another important argument widely used for efficient markets, the argument that a model like (4) with an intermediate φ cannot represent a stable equilibrium because the smart money would get richer and richer and eventually take over
the market, and φ would go to zero. In fact this will not generally happen, for there is
a natural recycling of investor abilities, the smart money people usually do not start
out with a lot of money, and it takes them many years to acquire enough wealth to
influence the market. Meanwhile they get old and retire, or they rationally lose interest in doing the work to pursue their advantage after they have acquired sufficient
wealth to live on. The market will be efficient enough that advantages to beating
the market are sufficiently small and uncertain and slow to repay one’s efforts that
most smart people will devote their time to more personally meaningful things, like
managing a company, getting a PhD in finance, or some other more enjoyable activity, leaving the market substantially to ordinary investors. Genuinely smart money
investors cannot in their normal life cycle amass enough success experience to prove
to ordinary investors that they can manage their money effectively: it takes too many
years and there is too much fundamental uncertainty for them to be able to do that
assuredly, and by the time they prove themselves they may have lost the will or ability to continue (Shiller 1984; Shleifer and Vishny 1997).
I found out a couple of days ago that there’s a debate within academia over EMH. Here’s how John Cochrane described it in an interview:
Perhaps more directly relevant to this post is this quote from Robert Shiller’s 2013 Nobel lecture:
See also Shiller on Does Covid-19 Prove the Stock Market is Inefficient?.