|
|
|
 
Efficient Market Theory: A Contradiction of Terms
Table of Contents
Table of Contents i
Abstract 2
Discussion 1-1
References A-1
Abstract
According to the Efficient Market Theory, it should be extremely difficult
for an investor to develop a "system" that consistently selects stocks that
exhibit higher than normal returns over a period of time. It should also
not be possible for a company to "cook the books" to misrepresent the value
of stocks and bonds. An analysis of current literature, however, indicates
that companies can and do "beat the system" and manipulate information to
make stocks appear to perform above average. An understanding of the
underlying inefficient "human" factors in the market equation is necessary
in order to account for the flaw in Efficient Market Theory.
Efficient Market Theory: A Contradiction of Terms
Efficient Market Theory (EMT) is based on the premise that, given the
efficiency of information technology and market dynamics, the value of the
normal investment stock at any given time accurately reflects the real
value of that stock. The price for a stock reflects its actual underlying
value, financial managers cannot time stock and bond sales to take
advantage of "insider" information, sales of stocks and bonds will not
depress prices, and companies cannot "cook the books" to artificially
manipulate stock and bond prices. However, information technology and
market dynamics are based upon the workings of ordinary people and diverse
organizations, neither of which are arguably efficient nor consistent.
Therefore, we have the basic contradiction of EMT: How can a theory based
on objective mechanical efficiency hold up when applied to subjective human
inefficiency?
As a case in point, America Online (AOL) offers a classic example of how
investors can be misled by a company that uses the market system against
itself. AOL, up until early November of this year, used an accounting
system that effectively "cooked their books" and provided misleading
figures on the company's performance. Instead of accounting for its
promotion expenses and costs as a regular expense, as normal companies do,
AOL spread them over two years. This let AOL report annual profits based on
revenue figures derived from denying actual expenses (as cited in Newsweek,
November 11 edition).
By deferring those costs, AOL over the years reported profits $385 million
greater than they would otherwise have been. The company then used these
non-existent profits to promote itself as a money-making opportunity for
both stockholders and potential investors, artificially increasing its
stock prices. This accounting practice is perfectly legal, but the
information was kept private for over two years. The company has recently
announced that, effective immediately, promotion expenses will be charged
to earnings as the expenses are incurred, the way a normal company does.
AOL will also take a one-time special charge of $385 million for the
"deferred" promotion costs.
This effectively negated all profits reported by the company over the years
and put them in a negative net cash flow situation. As a result, AOL's
stock is currently listed at 35 ª, down from a high of 71 in May. This
example clearly outlines a major flaw in Efficient Market Theory: If EMT
relies heavily on information as the basis for determining market value,
what happens if the information is manipulated? As a counterpoint, the
clear assertion in the Newsweek article is that most normal companies do
not use such accounting practices, however legal, to falsely report
superior performance. EMT states: Fundamental analysis cannot produce
investment recommendations that will enable an investor consistently to
outperform a buy-and-hold strategy in managing a portfolio (Malkiel, 1990).
The corollary of the theory must also then be true. An investor cannot be
hurt by the market because the stock value of a poor or overvalued
performer already reflects that fact in its price. The available
information would indicate to investors that certain stocks are overvalued
and subject to rapid decline. The availability of public information did
finally force AOL into disclosing the ruse and changing its accounting
practices, and coincidentally, lower the stock value to its true worth.
The argument that Efficient Market Theory was working in AOL's case is that
the investors were protected from precipitous loss because the system
adjusted the stock price to reflect the actual value of AOL stock. The
previously high price did indicate the value of the stock based on the
accounting practices then in effect, however misleading they may have been.
At the moment that the company decided to change the accounting practices,
the value of the stock then was corrected to the actual lower value. This
could, reasonably, be viewed as a repudiation of EMT.
|
|
|
