Does Covid-19 Prove the Stock Market is Inefficient?

Our brains are hardwired to avoid discomfort so it’s difficult to hold two competing ideas in your head at once. Politics are obviously impacted by this cognitive dissonance but it happens in the markets too.

So it is with the debate about the efficient market hypothesis. Many investors think about market efficiency in terms of black and white. The way I see it, markets are kind of efficient but also prone to bouts of irrationality because human beings are pulling the strings.

Robert Shiller and Burton Malkiel are two of the most well-known market thinkers on each side of the aisle for this debate. Shiller is in the behavioral camp while Malkiel is in the efficiency camp. There’s room for both sides in this one but it’s still interesting to hear their thoughts on how the market generally works.

Jonathan Stern and Carter Duncan have a new website called Pairagraph which offers a debate format that allowed Malkiel and Shiller a platform for a back and forth on how their ideas color the wild market swings we’ve seen this year.

I like this idea of looking at competing views so Stern gave me permission to reprint that debate here.




Robert Shiller: The gyrations of the world’s stock markets around the time of the onset of the coronavirus, Covid-19, pandemic have seemed illogical to many observers. The S&P 500 stock price index set an all-time record high on February 19, 2020, after over a month’s news of the epidemic. The World Health Organization had already labeled it a “public health emergency of international concern” on January 30 when the epidemic had already spread from China to 18 countries. This peak was a few days after news that the epidemic in China had already attacked 66,000 victims and caused 1,500 deaths.

Wouldn’t you think the “smart money” and people on their toes would have seen trouble coming by then? Were they even paying attention?

From that high, the S&P 500 fell 34% to a low on March 23, 2020.

Maybe that drop could be justified from the dire pandemic narratives that were circulating then. But from there, with stay-at-home orders proliferating around the world, the S&P 500 rose 30% to April 30, 2020, amidst nightmarish figures, over three million cases worldwide and over 200,000 deaths.
Wouldn’t you think that there wasn’t much good news that would justify such a massive rebound? How can we explain what drove the market so rapidly up?

The economics profession has an explanation for this difficulty based on the idea that markets are “efficient.” If markets are perfect, prices will incorporate all publicly available information about the future. Speculative prices will be a “random walk,” to borrow a phrase from the physicists and statisticians. The changes in prices will look random because they respond only to the news. News, by the very fact that it is new, has to be unforecastable, otherwise it is not really news and would have been reflected in prices yesterday. The market is smarter than any individual, the theory goes, because it incorporates information of the smartest traders who keep their separate real information secret, until their trades cause it to be revealed in market prices.

Burton Malkiel’s classic book A Random Walk Down Wall Street, first edition 1973, almost a half century ago, has been a long-term best seller, with 12 editions and over 1.5 million copies sold. It made the term “random walk,” a household phrase, although in truth it did not say that stock prices were exactly a random walk.

I wrote books that presented evidence for a seemingly very different idea about speculative prices, Irrational Exuberance, 2000, and Narrative Economics: How Stories Go Viral and Drive Major Economic Events, 2019. Speculative prices may indeed statistically resemble a random walk, but they are not so tied to genuine information as random walk theorists say. They are driven by somewhat predictable epidemics of popular narratives. The contagious stories about the coronavirus had their own internal dynamics only loosely related to the information about the actual truth.

I wonder how Burt would interpret this strange market behavior around the time of the coronavirus.


Burton Malkiel: Robert Shiller deserves enormous credit for enhancing our understanding of how both investor sentiment and fundamental information about individual companies and the economy influence stock prices. He correctly elucidates how some investors make consistent and predictable errors in the processing of information and how the propagation of narratives about the stock market can become self-fulfilling. He uses the extraordinary volatility of the market in response to the COVID-19 pandemic as an example of the market’s apparent irrationality. In my judgment, however, none of this insightful work implies that markets are inefficient.

The Efficient Market Hypothesis incorporates two fundamental tenets. It first asserts that public information gets reflected in asset prices without delay. If a pharmaceutical company now selling at $20 per share receives approval for a new drug that will give the company a value of $40 tomorrow, the price will move to $40 without delay, not slowly over time.

It is, of course, possible that the full effect of the new information is not immediately obvious to market participants. Some participants may vastly underestimate the significance of the drug, but others may greatly overestimate it. Therefore markets could underreact or overreact to news. The COVID-19 pandemic presents an excellent example of how investor sentiment and the difficulty of predicting the extent and severity of the resulting economic disruption can intensify market volatility. But it is far from clear that systematic underreaction or overreaction to news presents an arbitrage opportunity promising traders extraordinary gains. It is this aspect of EMH that implies a second, and in my view the most fundamental, tenet of the hypothesis: In an efficient market, no arbitrage opportunities exist.

EMH does not imply that prices will always be “correct” or that all market participants are always rational. There is abundant evidence that many (perhaps even most) market participants are far from rational. But even if price setting was always determined by rational profit-maximizing investors, prices (which depend on imperfect forecasts) can never be “correct.” They are “wrong” all the time. EMH implies that we can never be sure whether they are too high or too low. And any profits attributable to judgments that are more accurate than the market consensus will not represent unexploited arbitrage possibilities.

In my view the most compelling evidence that our stock markets are extremely efficient is that they are extraordinarily hard to beat. If market prices were generally determined by irrational investors and if it were easy to identify predictable patterns in security returns or exploitable anomalies in security prices, then professional investment managers should be able to beat the market. There is abundant evidence that they do not. Direct tests of the actual returns earned by professionals, who are compensated with strong incentives to outperform, should represent the most compelling evidence of market efficiency.

A true market inefficiency ought to be an exploitable opportunity. If there’s nothing investors can exploit in a systematic way, then it’s very hard to say that information is not being properly incorporated into stock prices and that our stock markets are not remarkably efficient.


Robert Shiller: Burt’s concluding line is “If there’s nothing investors can exploit in a systematic way, then it’s very hard to say that information is not being properly incorporated into stock prices and that our stock markets are not remarkably efficient.” I wonder what he means by “systematic.” How do we be systematic in assessing whether the coronavirus epidemic will cause a serious disruption of business? We have never seen such a massive epidemic-inspired worldwide shutdown of business. Nor have we ever seen the sudden demand to facilitate social distancing, which threatens to upend many business models.

I don’t think he is saying we should not use our judgment, our intelligence, our general knowledge, to try to consider what the new world situation means. In fact, good judgment matters. Economists Judith Chevalier and Glenn Ellison have shown that managers who had MBA degrees in fact earned return 0.63% a year more. That means 21% more total over thirty years. That’s something, though one has to ask if this is the best use of their education and intelligence.

Even in the case of the Covid-19 stock market, the advantage to being alert to the epidemic may have been small, so far at least. The S&P 500, after rebounding, as of April 30, is down only 14% from its peak in February. As of April 30, we are just back to the stock market level of last September. No disaster yet. And maybe we weren’t all that wrong in our allocation of attention February 19. We naturally focused more on implications for the health and welfare of our families. We were starting February 19 to shop to stock up, hearing in the news many stories from Asia of panic buying, of emptying of stores of food, hand sanitizer, toilet paper and other essentials. If instead we really all made a serious effort right then to think through the implications of the epidemic on the market, we might have brought the price down right then. But of course we didn’t.

Most institutional investors apparently didn’t either. Professionals cannot just abandon the strategy they have promised their clients just because they “think” that the epidemic would hurt business.
It does not appear that it is impossible to beat the market somewhat. I have been saying that the efficient markets theory, and the random walk theory are half-truths. Burt says almost the same thing in his 12th edition, which now includes a chapter on behavioral finance. He paraphrases Mark Twain: “I conclude that reports of the death of efficient markets hypothesis are vastly exaggerated.” Not wrong, just exaggerated.

How do Burt and I differ? I am not sure. I am apparently more likely to advise people to take a look at their portfolio right now, and to consider lightening up a little on risky or stick-in-the-mud holdings, if they haven’t already. The coronavirus pandemic remains a time of fundamental change, it is far from over, and let’s not forget that.


Burton Malkiel: Bob’s basic question is whether we should consider altering our portfolio in light of today’s high valuations and uncertainty about the economic outlook. My answer is yes and no. If our capacity for risk has changed because we are less certain about future employment, or if our tolerance for risk is less than we previously thought, then it would be appropriate to reduce risk. But if we want to reduce risk because we think stock prices are too high or because we believe we can accurately forecast future economic conditions, I would say emphatically “no.”

Some historical perspective is useful. Even during one of the most spectacular “bubbles” in stock market history (the bubble of the late 1990s, considered damning evidence against EMH), most investors who tried to time the market made egregious mistakes. In 1996, Bob (with John Campbell) presented an excellent paper to the Federal Reserve showing that earnings multiples possessed substantial ability to predict future rates of return. Since these multiples were then at all-time highs, the work implied a likelihood of low or even negative returns. This work influenced Federal Reserve Chair Alan Greenspan to make a famous speech questioning whether the stock market was at bubble levels and whether investors were exhibiting “irrational exuberance” in view of the economic outlook. The stock market rallied strongly for four years thereafter, and long-term investors who bought stocks after the speech earned generous rates of return.

We now know (ex post) that market prices were at bubble levels in late 1999 and early 2000. No one was able accurately to identify the timing of the bubble in advance. In fact there is substantial evidence that both individual and institutional investors who try to time the market invariably do the wrong thing. They buy at market tops when optimism reigns, and they sell at market bottoms when pessimism is rampant. And while some investors have made excess returns over certain periods, there is no evidence that such returns persist.

In 2007, legendary investor Warren Buffett offered a $1 million bet that an index fund would outperform a basket of hedge funds over the next decade. Protégé Partners took up the challenge. Result: Their selected basket of hedge funds returned 2.2% per year while the index fund returned 7.1%. The index also beat Buffett’s portfolio. In his will, Buffett has directed that 90% of his estate should be invested in index funds.

It is probably useful to think of the stock market in terms of “relative” rather than absolute efficiency. Andrew Lo suggests that few engineers would contemplate testing whether a given engine is perfectly efficient. But they would attempt to measure the efficiency of that engine relative to a frictionless ideal. Similarly, it is unrealistic to require our financial markets to be perfectly efficient in order to accept EMH. Perhaps the difference between Bob and me is one of degree. I believe that our markets come very close to the EMH ideal. Bob is more skeptical. In any event, I hope his stocks are invested in low-cost index funds.

This post originally ran at Pairagraph.

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