Financial markets have been jittery lately, with sundry prices and rates jumping up and down.
This included 2 percent drops in U.S. stock indexes on Jan. 24 and Feb. 3, neither of which was related to news on any underlying fundamental. Exchange rates have been even more volatile.
All this prompted a reader to ask: Does this situation support generally accepted econ theory, especially the "efficient-markets hypothesis," or is it evidence that these theories are flawed?
That is a great question, because it relates directly to the financial debacle that has unfolded over the past six years.
The quick answer, for me, is that recent history undermines efficient-markets theory. But that theory is more nuanced than it might seem at first examination and, at some levels, at least, embodies great insight.
The core of the efficient-markets hypothesis is that at any given time, the price of something, whether it be an acre of farmland, a Turkish lira or a share of stock, represents a collective rational assessment of all the factors that might affect its price. This includes expectations of what may happen in the future as well as what is going on right now.
If a current market price, say of our farm, correctly takes into account all available relevant information, then that price will change only if new information becomes available.
When it does, the theory asserts, that new information will be digested quickly and correctly to arrive at a new price based on the changed situation.
This is driven by the fact that there are thousands -- or millions -- of people who have a financial stake in any major financial market. They stand to win or lose money based on how well they assess the values of assets and how these values will change in reaction to changes in the physical world, such as drought or tsunamis; the political world, such as new farm bills or political unrest in the Mideast; or social and cultural milieus, like a new craze for Greek-style yogurt or the desire of Brazilian women to have fewer than two children rather than the average of six their mothers did.
Because so many people have a financial stake, there always are myriad people looking for any scrap of new information and trying to interpret it in the most intelligent way. Hence the market price, at any point in time, fully reflects all the information available and is "efficient."
If this is true, a well-informed reader might ask, why did we have two 2 percent stock market drops within a few days? Were U.S.-traded corporations really worth $450 billion less on Jan. 24 or Feb. 3 than the day before? There was no important new fundamental information on either of these days, just a change in sentiments about existing data.
And why did the exchange values of the currencies of several emerging-market nations gyrate even more in the last few weeks? Again, nothing happened in Turkey, Argentina or Thailand that was not part of a trend developing over months or years. There was no change in "information," just in how it was digested.
So does this represent a rebuttal of the efficient markets theory? I think it does to the extent that the theory assumes that the evaluation of information is dominated by rational analysis, and that the decision to buy or sell anything is driven primarily by objective weighing of objective data.
The alternative explanation would be that, as in most other areas of human life, emotions and intuition rather than reason play a big role in making choices. Indeed, these irrational factors often dominate. Fear, greed, the desire to emulate others or the tendency to place greater weight on information that validates our hopes or fears all are irrational impulses but very common in decision-making.
These factors are a much better explanation of gyrations in stock and foreign exchange markets than dispassionate weighing of new, concrete events. Chalk up a few points for the critics of efficient-market theory.
On the other hand, the theory is not as naive as it may at first seem. Its advocates never argued that the market is always correct in its evaluation nor that events always unfold as the majority might expect.
Moreover, it is obvious that at any given point in time, different people have greatly different interpretations of the values of things and where these values are headed. They cannot all be right nor all wrong.
Efficient-markets theory recognizes that market prices often turn out to be "wrong" after the fact. Some people's earlier judgments are validated and some refuted. But, advocates argue, this proof and disproof is random.
Sometimes a particular analyst's conclusions are proved right and others wrong. But no one can consistently "beat the market," by always making better estimates of the values of things than the market equilibrium price. Yes, some individuals may have a long run of success. But in the longer run, market-outcome prices better reflect real values than the estimates of any individual. This is the case even if irrational factors enter in.
This is probably true. As someone who has followed Latin American affairs in great detail for 45 years, I can identify times when I clearly had better judgment about how economic affairs were going to play out than did financial markets. But at other times I saw things erroneously.
If I had started with $1 million when I first went to Brazil as an 18-year-old and had invested based on my evaluations of the region's economic trends, would I be any richer than if I had put the same amount into a diverse portfolio of U.S. stocks and bonds?
What if 10 people as well informed and experienced in the region as me had done so? I'd like to think I would be sitting pretty, but honesty compels me to say that neither I nor a group of people as well-informed as me could have beaten the average by much, if at all.
St. Paul economist and writer Edward Lotterman can be reached at email@example.com.