Red-Blooded Risk: The Secret History of Wall Street

Efficiency versus Equilibrium

A crucial point in interpreting tests of efficient markets theory was described by Eugene Fama, known as the father of efficient markets: “Every test of market efficiency is a joint test of market efficiency and market equilibrium.” In simpler words, you can't test whether the market is doing what it is supposed to do without first specifying what it is supposed to do. That's true for testing markets, but not for exploiting markets. Suppose you see something sell at $80 that you think should be worth $100. If markets are in equilibrium but inefficient, you can buy at $80 and make profits. If markets are efficient but out of equilibrium, you might not be able to buy more at $80, and anyway $80 is the correct price given current market structure. In this case, you figure out why people are selling at $20 less than your estimate of economic value and find a way to accommodate their needs for less than $20. These are entirely different strategies for exploiting the same apparent mispricing.

It was the frequentists, the blackjack card counters, who adopted the idea that markets are inefficient, but always in equilibrium. Prices can be wrong in an economic sense, too high or too low, but you can buy or sell as much as you want at the posted price. In that case, you make money by computing the correct price for securities. You don't worry who is on the other side of the transaction. You're transacting with some abstract thing called the “market,” just as ...