Efficient Market Theory: A Contradiction of Terms

Table of Contents
Table of Contents i
Abstract 2
Discussion 1-1
References A-1


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

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 ™, 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.