26 ATaleofTwoMarkets
The quality of information digested by the market may be just
as low as the quality of information that goes into the decisions of
Keynes’s beauty contest judges. Tobin has many followers who think
he’s right, including Nobel Prize winners William F. Sharpe and Ken-
neth Arrow of Stanford.^11 If it is true that many traders act as Keynes
described, the semistrong form of EMT has to be further subdivided
between strict informational efficiency and a more refined notion of
fundamental efficiency.
Informational efficiency describes a market in which all public
information about a stoc kis reflected in the price of that stoc kwith-
out regard to the quality of that information. Thus, information that
concerns the fundamental value of a stoc kis reflected, but so is
information wholly unrelated to that fundamental value, such as who
won the Super Bowl. Fundamental efficiency is the more narrow but
more ambitious idea that stoc kprices are accurate indicators of in-
trinsic value because they reflect only information concerning fun-
damental business values.^12
The issue becomes whether the capital markets can distinguish
among kinds of information so that only information about funda-
mental value is impounded and reflected in prices. That revives the
basic question of whether humans behave rationally. EMT says it
does not matter if individual actions are not rational because any
individual irrationality will be corrected by others acting rationally.
In effect, irrationally is “assumed out” of the EMT model.
The informational-fundamental distinction, however, is so intu-
itively and empirically potent that it had to be confronted. The result
was the face-saving shelter of euphemism: The economist Fischer
Black, borrowing a term from the field of statistics, renamed irra-
tional behavior noise, thus enabling self-respecting economists to
discuss the issue and try to model it.^13
Noise theory is supported by substantial empirical evidence and
a well-developed intellectual foundation. Noise theory models hold
that stoc kmar kets are infected by a substantial volume of trading
based on information unrelated to fundamental asset values (noise
trading). These models attempt to explain both why noise trading
occurs and why its effects persist.
The most common noise theory model says, for example, that
noise trading is conducted by ill-informed investors who act on sen-
timent rather than rational analysis. Their actions move prices away
from fundamental values. The price-value gap persists despite the
presence of sophisticated arbitrageurs because they are risk-averse