Market Efficiency Before and

After the Crash

LAURENCE S. COPELAND*

I . INTRODUCTION

The worldwide stock market crashes of October 1987 were a cause of major
public concern at the time, because of the natural fear that they would be
followed by economic collapse, as was the case in 1929. The fact that this
pattern shows no sign of being repeated is an enormous relief for all of us.
However, it leaves the economics profession in the invidious position of
being able to explain neither what causes stock market fluctuations nor their
relevance to the real economy. The feeling is rather like that of a doctor
confronting a patient showing every sign of excellent health two years after
the first, unexplained appearance of symptoms of terminal disease. In
particular, it is hard to reconcile the crash with the prevailing orthodoxy of
market efficiency and rational expectations (which are explained in Sections I
and 11). The paradigm was already being questioned by researchers before
1987 (Section 111). It is argued here (in Section IV) that the crash effectively
left no more room for controversy.
If markets are inefficient, does that imply the need for intervention? The
argument that share prices are too important to be left to the (unregulated)
market has certainly gained ground in the last eighteen months. The case for
regulation is examined briefly here (Section V) and found unconvincing.
Specific measures of the type most often advocated seem likely to be
ineffective, at best, and possibly damaging (Section VI).

11. THE MEANING OF MARKET EFFICIENCY

The basic notion of market efficiency is deceptively simple. At its most basic
level, it does no more than express a piece of everyday wisdom familiar to
anyone who has ever been given a ‘hot tip’ on a horse or a share. Unless we

*Laurence S. Copeland is a lecturer at the School of Management, University of Manchester Institute of

Science and Technology.
Fiscal Studies

are very gullible indeed, we immediately ask ourselves the question: if the
horse is such a ‘sure thing’, why is the fact not reflected in the odds? if the
share is as good as the tipster claims, is that underlying value not already
incorporated in its market price? Often, the answer will be that both prices
already take full account of the information on which the tips were based -
the market is said to be efficient.
In fact, if we can safely ignore transactions costs (brokerage fees, bid-offer
price spreads, commissions, stamp duty etc.) as well as the costs of collecting
and processing information, the price of a security in a freely functioning
market will move more or less instantly to a level which incorporates all the
relevant facts.
More precisely, the market for a security is said to be efficient in one form
or another when the price at any moment fully reflects all the information in:
(i) its own past history (‘weak form’)
(ii) all relevant facts in the public domain (‘semi-strong form’)
(iii) all relevant facts, published or unpublished (‘strong form’)
Now it might appear simple to test whether or not these conditions actually
apply. In practice, it is far from straightforward. To appreciate the kind of
problems that arise in assessing the efficiency or otherwise of a market, take a
specific example. Suppose I hear the UK money stock has just increased by
one per cent. I subsequently read that the currency market’s reaction to the
news took the form of a two per cent appreciation in the sterling exchange
rate. Should I regard the episode as consistent with efficiency?
Plainly, the answer depends, among other things, on what I believe to be
the ‘true’ relationship between the value of the pound and our money supply.
If I take that equilibrium (‘fundamental’) relationship to be one-for-one, I
may jump to the conclusion that anything other than a one per cent fall in the
value of the pound is prima facie evidence of (semi-strong form) inefficiency.
But is my conclusion really justified? There are at least two reasons why it is
not.
In the first place, it presupposes I am correct in believing the underlying
equilibrium relationship between the exchange rate and the money stock
implies a one per cent depreciation. If this premise is wrong, the market
reaction could still be consistent with efficiency.
Secondly, as anyone with any experience of watching financial markets will
be well aware, prices anticipate events. Agents in any market hold subjective
expectations of the relevant future events, on which they can base any
decisions that have implications into the future - particularly, decisions
about whether to buy or sell the asset in question. Thus, the currency markets
will have pencilled in a figure for the monthly money supply growth long in
advance of its announcement. Indeed, the number may have been rubbed out
and altered several times in the days and weeks leading up to the
announcement. Each new consensus forecast will have been incorporated
(‘discounted’) in the exchange rate. When the news finally emerges, what

14
 Market Efficiency and the Crash
counts is the difference between the market’s most recent prediction and the
actual outturn revealed by the Bank of England. For example, the two per
cent rise in the value of the pound may reflect the fact that the market’s best
guess was a three per cent increase in the money stock, so that the news came
as a pleasant surprise.
Since the subjective expectations of market agents are inherently
unobservable, the reader might conclude at this point that the concept of
efficiency has no practical application whatever, since any movement we
observe can be rationalised after the fact by reference to market sentiment.
This is not the case, however, once the market efficiency hypothesis is
combined with a specific assumption about how expectations are formed.
Nowadays, efficiency is almost invariably associated with the so-called
Rational Expectations Hypothesis (REH), according to which the market’s
expectations are themselves optimal predictions, based on appropriate use of
all the relevant facts. In other words, however inaccurate the market’s
forecasts may turn out to be with the benefit of hindsight, they nonetheless
can be viewed as resulting from the most intelligent and sophisticated analysis
possible of all the published information. Formally, the REH can be written:

where Xet is the market’s consensus forecast at time t of the level the variable
X will take in the next period, and the right hand side is the mathematical
expectation of Xt + 1 conditional on the information set [EQN ‘Omega sub
t’] which contains all data published up to and including time t.’
Notice it is not claimed that agents actually go through the process of
making a sophisticated analysis of the data, using the full panoply of modern
techniques: econometrics, simulation models and so forth. First, the results
of this type of analysis are part of the available information set, in the form
of forecasts published free or sold by the many economic forecasting groups.
Secondly, in many cases economic agents base their forecasts on their
experience (‘feel’) of the market. Using judgement may well be quite
consistent with rationality, if it produces a forecast no less accurate than
could be achieved using more sophisticated techniques. The very fact that
judgement still figures so largely in the forecasts of the econometric
modelling groups is proof that this presumption is quite realistic.

IOn the subject of the information set used in forming expectations, it might have been rational for the
reader to expect us to distinguish between weak, semi-strong and strong rationality, paralleling in an
obvious way the definition of efficiency. This particular extension of the concept of rationality seems to
have made an appearance in the literature only very recently (Copeland (1989)).

15
Fiscal Studies
III.IMPLICATIONS

The implications of what might seem an innocuous hypothesis turn out in

practice to be far-reaching. When combined with the prevailing orthodoxies
(as equilibrium models), efficiency implies among other things:
(0 The returns on any security should exhibit no discernible pattern
which could be used by a speculator to earn excess returm2 In fact,
in the short run, the best guess of tomorrow’s price will often be
today’s price.
(ii) There should be no trading rule which could earn consistent
profits, over and above those obtainable by following a simple
buy-and-hold strategy.
(iii) Unanticipated movements in security prices will therefore be the
result of the arrival of new information. Minute by minute, hour
by hour, the torrent of information pouring out of TV and radio
broadcasts, newspapers, press conferences, wire services etc. will
be filtered, to isolate those elements which are: a) relevant to the
security in question and b) genuine ‘news’ i.e. not already
discounted in the price on the basis of previously available
information.
Notice that, as far the first proposition is concerned, weak form efficiency
requires only that there be no ‘discernible patterns’ in the time series of past
prices of the security in question. This is a much less stringent requirement
than semi-strong form efficiency, under which we have to intrepret the
‘discernible pattern’ far more broadly, to include possible interrelationships
not only between the price at t and the series of past prices (Pt-,,
Pt-*,....Pt-n), but also between Pt and past or present values of any other
variable in the universe of publicly-available information.
Strong form efficiency is even more restrictive, since the information set
includes everything relevant known to anyone at the time the price of the
security is set, including inside information. It therefore precludes the
possibility of profiting from insider trading. Of course, it is very difficult to
test directly whether strong form efficiency holds or not, though a number of
indirect tests are possible.
To some extent, the research methodology overlaps with the technology
used by regulators for investigating insider trading allegations e.g. examining

’This does not imply there ought to be no consistent pattern whatever. For example, finding that
movements in the pound/dollar exchange rate invariably reflected interest rate differentials between the
U K and USA would be absolutely consistent with efficiency. Any systematic (hence predictable)
movement over and above this would allow a speculator to earn excess profits, and would therefore be
evidence of inefficiency. Notice that in any case our conclusion is predicated on a particular view of how
the currency markets function - an equilibrium model, in fact. Note also that, by ‘speculator‘, we mean a
trader who is indifferent to risk. When we allow for the fact that most economic agents are averse 10risk,
the situation becomes somewhat more complicated.

16
 Market Efficiency and the Crash
share price movements in advance of public announcements of takeovers etc.
Insofar as it can be taken as an established fact that inside traders have been
known to profit from their informational advantage, strong form efficiency
must be taken as a dead duck. From now on, ‘efficiency’ unqualified should
be taken to refer to weak or semi-strong form.
Notice that in some financial markets insider trading is almost impossible
- what would constitute inside information in a currency market, for
example?

IV.THE EVIDENCE FROM BEFORE THE CRASH

At first, efficiency appeared to sweep all before it, with a considerable
volume of research appearing to show that, in most financial markets, excess
returns were both unpredictable and zero on average over any period, with
gains neatly balancing losses (see, for example, Copeland and Weston (1983),
Chapter 10). Moreover, by the beginning of the Eighties, the findings of
academic researchers were increasingly mirrored by attitudes among
practitioners. Perhaps the most striking demonstration of the cumulative
impact of efficiency research was to be found in the introduction of index-
tracking mutual funds in US equity markets, the logic of which is that, if on
average it is impossible for fund managers to beat the market index, they may
as well be content to mimic it.
In fact, market efficiency has haunted fund managers ever since
performance statistics came to be collected. Not surprisingly, the data
published by the industry itself show a majority of fund managers are unable
to achieve a return greater than that on the index itself, particularly when
account is taken of the management costs they impose on their investors.
Furthermore, if the market is actually efficient, fund managers are guilty of
inflating costs by overtrading, relative to the optimal buy-and-hold policy.
Nonetheless, here as elsewhere, closer examination reveals evidence of
inefficiency, since the ‘league tables’ of performance show a certain stability
over time, with successful management groups beating the index year after
year, while others consistently perform below average.
Ironically enough, at the very point when the notion of efficiency was
percolating through to the world of finance, severe doubts were beginning to
surface in the academic world itself. In particular, evidence was starting to
appear of a host of anomalies in US stock market data, many of them
corresponding more or less closely to long-standing practitioners’ lore.
Among the inefficiencies uncovered have been the following phenomena
(helpfully summarised by Jacobs and Levy (1988a); see also the readings in
Dimson (1988)):
(i) Stocks with low price/earnings (P/E)ratios tend to outperform
those with high P/E ratios (Reinganum (1981)).

17
Fiscal Studies
There is some evidence that the market provides a reward for non-
systematic (‘residual’) risk, which conflicts directly with the
predictions of the Capital Asset Pricing Model (Lakonishok and
Shapiro (1984)).
There is evidence of a number of different types of effect
associated with analysts’ forecasts (see references given in Jacobs
and Levy (1988a)). ‘Neglected’ stocks (i.e. ones covered by
relatively few analysts) appear to provide above-average returns, as
do stocks for which earnings estimates have been recently
upgraded. It may also be the case that, where earnings are expected
to grow rapidly, the impact of a negative shock is greater.
A variety of ‘calendar effects’ were documented as long ago as the
1930s, and recent research by and large supports their existence. In
particular, the tendency for returns to be highest in January is well-
established, and has been found in almost all the world’s major
stock markets, though there is some evidence that this anomaly
may in fact be confined to small firm stocks. Other anomalous
findings have been that the market tends to fall on Mondays and
rise on Fridays, to perform exceptionally well in advance of
holidays, and to follow a consistent pattern around the end of the
month (Jacobs and Levy (1988b), Dimson (1988)). A consistent
pattern of price movement has even been discovered over the
typical trading day, with exceptionally large returns concentrated
at the opening and close of business (Harris (1988)).
The returns to investment in small firms are greater than in large
ones. This anomaly is particularly evident when combined with the
phenomena listed in (i) to (iv) above i.e. for returns on small firm
stocks which have been neglected (Arbel and Strebel (1982))’ for
the return on their residual risk (Tinic and West (1986)), for the
January effect in their return (Keim and Stambaugh (1986)) and
for their P/E ratios (Banz and Breen (1986)).
Each of these phenomena appears in direct contradiction to market
efficiency. There have been a number of findings that provide a less direct
challenge to efficiency. Notably, a near-unanimous finding in recent years
has been that equity prices vary more than can be justified expost by the
variation in dividends (Shiller (1981), Grossman and Shiller (1981)). Their
results represent an indirect rather than a direct challenge to efficiency
because of the fact that they use ‘smoothed’ dividend series rather than
‘unsmoothed‘ earnings, and because they make a number of assumptions
about the process governing interest rates. Nonetheless, it is difficult to
believe these limitations could account for the whole of the excess variance
found in equity prices, particularly as the finding is indirectly supported by
evidence that stock markets systematically overreact to news items (DeBondt
and Thaler (1985), (1987)).

18
 Market Efficiency and the Crash
There is one important point to be noted about these anomalies. For the
most part, while they may be indicative either of weaknesses in the market
structure or of investor irrationality, they are not inherently very disturbing,
neither from the point of view of resource allocation nor macroeconomic
policy. As long as it is not associated with long-run mispricing of equities,
volatility need not be damaging, not least because well-developed option and
futures markets make it possible to reduce variance to any desired level. The
problem is mainly for the financial sector, with few obvious repercussions on
the rest of the economy.
The same could be said of the finding that exchange rates fluctuate more
than is warranted by subsequent movements in the fundamentals: relative
money supplies, income and interest rates (Meese and Singleton (1983),
though see also West (1987) and Honohan and Peruga (1987) for dissenting
voices). Notice this finding is somewhat less damning for efficiency than the
excess variance results for equities, because, whereas in the latter case there
can be little doubt about the identity of the relevant fundamentals, the same
is not true for exchange rates. Thus, it is possible, though unlikely, that the
apparent excess variance of exchange rates could be due to the omission of a
highly volatile fundamental variable.
Currency markets in fact provide a particularly direct way of testing
efficiency. Consider the price,ft, of a forward contract to deliver pounds for,
say, US dollars in 90 days from today. If the market functions properly,
agents have rational expectations and are indifferent to risk, the forward
price will gravitate to a level just equal to the rationally-expected future price
of dollars. In other words, we will have:

This relationship has been very thoroughly researched, the near-unanimous

conclusion being that it fails to fit the facts.3
Now a gap between the forward rate and the expected future spot is easy to
reconcile with economic theory, which predicts that, if investors are averse to
risk, they will require compensation for bearing risk in the form of a risk
premium. Unfortunately, however, the evidence appears to indicate that the
risk premium, if there is one, is probably too small and stable to explain the
volatility actually observed in spot exchange rates. Moreover, recent work
with survey data on currency market expectations suggest the failure of
equation (2) to fit the facts is due to market irrationality (Frankel and Froot
(1987)).
If correct, this conclusion would imply there are unexploited profit
opportunities in the currency markets. In practice, it is probably harder to

I Chapter 10 of Macdonald (1988) surveys the evidence.

19
Fiscal Studies
find evidence of unexploited profit opportunities in currency than in equity
markets. Nonetheless, Dooley and Schafer (1983) not only uncovered a
trading rule that made a profit out of foreign currency trading in the early
1970s, even allowing for transactions costs, but also found the same rule
remained profitable over the five years after they had first published their
results!
The evidence of irrationality, if confirmed by further work, may point to
the need to re-examine some of the well-known phenomena economists have
in the past tried to explain in structural terms. In particular, both currency
and stock markets appear to be characterised by a similar paradox in their
response to inflation.
Consider the following propositions, the first three of which are well-
established in the literature, while the fourth has only recently emerged, and
has yet to be confirmed:
(i) In low-inflation countries, Purchasing Power Parity4 is certainly
not maintained in the short run, and probably not even in the long
run (Officer (1982), Taylor (1989)).
(ii) In high (triple-digit) inflation countries, Purchasing Power Parity
holds even in the short run (Frenkel(l978)).
(iii) In low-inflation countries, (nominal) stock returns fail to keep
pace with inflation, so real returns fall. In other words, equities are
a poor inflation-hedge (Fama and Schwert (1977), Gultekin
(1983)).
(iv) In high (triple-digit) inflation countries, it seems that equity returns
keep up with inflation (Giugale (1989))
For the most part, attempts to explain the first three facts have treated
them as separate phenomena. With the sole exception of the work by
Modigliani and Cohn (1979), which explicitly cited money illusion in
discounting real cashflows at nominal interest rates, it has been taken for
granted that an acceptable interpretation must rely on market rationality.
However, juxtaposing the facts as we have done here suggests a simple, if
somewhat unpalatable answer: markets tend, at least partially, to ignore
inflation as a minor irritant, as long as it stays at a low level. Only when it
crosses a (surprisingly high) threshold of perceptibility is inflation
incorporated fully into prices in financial markets.
This suggested explanation leaves many questions unanswered, not least
how it comes about that labour markets respond quite rapidly to changes in
(low) inflation rates - it seems hardly plausible that labour markets could be
more rational than financial markets. It also pre-supposes a particular form
of myopia. After all, ‘negligible’ inflation has a cumulative effect on the

‘ Exchange rates and price levels are said to stand at Purchasing Power Parity when a unit of any
currency buys the same consumption basket wherever it is spent (See Chapter 2 of Copeland (1989)).

20
 Market Efficiency and the Crash

value of an asset. Pricing that ignores it therefore creates a larger and larger
divergence from an asset’s real value.
It is important to try to isolate the cause of these phenomena because,
unlike the inefficiencies discussed at the start of this section, the response of
financial markets to inflation is not a subject which can be shrugged off as of
no consequence for the real economy. Long run deviations from Purchasing
Power Parity imply sustained periods of over- or undercompetitive trading
conditions with consequent current account imbalances and, in addition,
unequal real rates of return on capital in the two countries involved.
Likewise, fluctuations in real returns to equity have potentially serious
implications for domestic investment.
To summarise the pre-crash situation as far as efficiency research is
concerned, a pattern had been established:
A theory of market efficiency is first formulated based on some very
simple models of equilibrium returns. After some initial successful tests,
.
more intensive empirical . . investigation reveals that the particular
efficient markets model does not fit the data as precisely as was first
thought. This in turn gives rise to new models of equilibrium returns and
..
subsequent testing . the disconfirming evidence is used to argue against
a particular model of equilibrium returns. It is not used, as it could be,
to make blanket statements about the inefficency of financial markets.
(Sheffrin (1983) p. 150, italics added)
A cynic might point to this cycle as an example of academic bigotry. As
Sheffrin (1983) says in ending his survey:
For better or worse, [researchers] have embraced efficient markets or
rational expectations as a research principle ... for deciding the validity of
models of equilibrium price determination. (p. 150, italics in original)
As we shall see, the events of October 1987 must have destroyed this
presumption that, whatever else might be wrong with our models, the
efficiency assumption is a sound foundation on which to build.

V. THE CRASH
Until the crash of October 1988, finding evidence of inefficiencies involved
careful scrutiny of time series of financial data. The crash itself seems to be
an example of inefficiency on a completely different scale, as is apparent
immediately from Figures 1 and 2, and the accompanying table.
Looking at the raw data presented here, it is clear that there are at least
three types of question to which it is difficult, if not impossible, to find an
answer consistent wth efficiency:

21
Fiscal Studies
FIGURE 1
Dailv Returns 16/10/87 to 30/10187
12.00%- in local currency (k)
10.00%-
8.00% -
6.00%-
4.00% -
2.00%-

____ Germany

UK

-
- 118.00%
6.00%l
-2o.oo%t
\i
v
-
_- USA

- 22.00% 1 I I I I I I I I I
16-0ct 20-0ct 22-0ct 26-0ct 28-0ct 30-0ct
19-0ct 2 1-0ct 23-0ct 27-0ct 29-0ct

FIGURE 2
Standard Deviation of Daily Equity Returns
monthly: March 1987 to March 1988
4.50%-
_ _ _ _ Germany
4.00%- -Japan
3.50%-
UK
_- USA
3.00% -

2.50% -

2.00% -

1.50% -

0.00% I I I I I I 1 I I I I I
8703 8 7 0 4 8 7 0 5 8 7 0 6 8 7 0 7 8708 87098710 8711 8712 88018802 8803

22
 Market Efficiency and the Crash

'tj
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62

23
Fiscal Studies
Q1. What new information could have caused Wall Street to fall by
nearly five per cent on Friday 16th October? Moreover, what
additional information could have emerged over the ensuing
weekend to explain the cataclysmic fall of over twenty per cent that
took place almost immediately on the morning of October 19th,
‘Black Monday’? Even if the falls can be rationalised, ex-post, how
can we account for the subsequent partial recovery on the
succeeding two days?
42. What explanation can be offered for the near-synchronous
movements in foreign stock markets in countries as diverse as
Singapore and Denmark? In particular, most macroeconomic
answers to Q1 would almost automatically be inadmissible as
justification for the events in the Tokyo market, which, although
placid compared to the New York Stock Exchange, nonetheless fell
by over fifteen per cent on 20th October, only to regain two-thirds
of the losses the next day.
Q3. Given that there was already evidence of excessive variance in the
years preceding the crash, as has already been mentioned, how can
one rationalise the sudden jump in volatility in all the major
markets in the second half of October 1987?
44. Any explanation has to take account of the following puzzle:
trading in currency and bond markets remained reasonably calm
before, during and after the crash. How could there be panic in one
financial market, while others traded more or less normally?
In fact, the hunt for an efficiency interpretation is virtually doomed from
the outset. None of the obvious culprits - money stocks, interest rates,
exchange rates, the level of economic activity - showed any exceptional
fluctuations immediately before the crash, nor in its aftermath to date.
Certainly, there was reason to suppose the US dollar might be about to fall
in value. But the arguments that it was overvalued in mid-October 1987
applied with equal force for most of the previous five years (and probably
still do at the time of writing): the uncompetitiveness of US manufacturing
exports, the size of the existing current account deficit, the need to attract an
inflow of capital etc. In any case, the dollar had already fallen to barely half
its 1985 value against the Deutschmark.
Arguments based on weaknesses in the US economy are in any case
incapable of explaining the worldwide plunge in equity markets, unless they
carry with them the implication of a wider cataclysm as a consequence. For
example, it was suggested by some commentators that markets were afraid of
other dramatic developments (e.g. a collapse of the US banking system),
which subsequently failed to materialise. Although this interpretation is not
inherently inconsistent with rationality, in the present case it is surely
impossible to believe that the objective probability of a banking crisis could
have varied so dramatically over such a short space of time. At the very least,

24
 Market Efficiency and the Crash
it is hard to see why the probability should have been vastly greater on the eve
of the crash than it was at the time of the collapse of Continental Illinois
Bank, or indeed at any time in the last twelve months, during which the US
authorities have been struggling with the wave of insolvencies in the Texas
banking system and in the Savings and Loan sector.
Similarly, explanations which rely on the bursting of a so-called rational
bubble seem inappropriate here.
In the first place, neither the crash nor the bull market which preceded it
had a profile to match the strict technical requirements of a rational bubble.s
For example, rational bubbles undergo a once-and-for-all collapse to pre-
bubble values, rather than the series of ‘bounces’ which actually took place.
They also rise at an ever-accelerating rate. The moment they stop
accelerating, they crash, whereas both the New York and London markets
peaked in the Summer of 1987, and were already in gentle decline by early
autumn. Secondly, relative to the fundamentals, the most ‘inflated’ bubble
was in the price of Japanese equities - where the fall was less than in London
or New York, and which recovered more rapidly and with greater vigour than
almost any other market.
On the other hand, one point in favour of this explanation is that, by and
large, the markets which had risen most in the pre-crash boom suffered most
in October (Roll (1988)). Moreover, since a bubble component in wealth
would presumably be ignored by households, the explanation would also be
consistent with the fact that there has been no fall in consumption in any of
the major economies.
It should be noted that nothing said here is intended to rule out the
possibility of an irrational bubble - though that is a subject on which the
economics profession has nothing to say, other than straightforward
description (e.g. Kindleberger (1978)).

V I . STOCK MARKET INEFFICIENCY - A SUITABLE CASE FOR REGULATION?

Within hours of the crash, calls for regulation were heard. Although, there
was very little agreement on the nature of the intervention required, there was
a clear danger that the authorities in the USA and possibly elsewhere would
accept every recommendation, however tenuous the justification, on the
grounds that doing something was bound to be better than doing nothing. In
the event, the US authorities reacted with statesmanlike circumspection, and
the Presidential Task Force on Market Mechanisms ultimately recommended
few substantial changes in the regulatory framework (Greenwald and Stein
(1988)).

’ For an explanation of the theoretical properties of rational bubbles, see Chapters 10-12 of Wachtel
(1982).

25
Fiscal Studies

In fact, the case for intervention, or rather for re-regulation, rests on the
following three propositions:
(i) The problem of stock market volatility is extremely serious.
(ii) Its cause can be correctly identified.
(iii) Regulation, of some form or other, could improve the situation.
As far as the first proposition is concerned, it takes for granted that the
cost of the volatility experienced in the unregulated market is either
intolerable, or at least substantially greater than the cost of regulation. Now
both these costs are very difficult indeed to quantify at all accurately. As far
as the cost of volatility is concerned, measurement would involve estimating
the extent to which firms’ investment plans were sensitive to gyrations in the
price of their stock, and possibly also assessing the impact of events like the
crash on the net flow of savings into equity markets. Both are major research
projects, likely to last years and, if the past is any guide at all, produce results
shrouded in controversy.
Moreover, in the same way a cyclist stops himself falling off by pedalling
faster, it is at least arguable that the way to prevent further crashes, or at least
mitigate their effects when they do occur, is to press on further with
deregulation.
For example, consider the part played by the markets for derivative
securities: futures, options etc. On the one hand, much of the comment in the
days and weeks following the crash located the source of the problem in the
interaction between the futures and cash markets. In particular, it was argued
(though without a great deal of evidence) that the problem arose from the
widespread use of portfolio insurance techniques. It was claimed that the
continuous re-balancing of holdings of equities and futures on the stock
market index required by these techniques turned into a destabilising
influence when the the futures market became illiquid in the crisis on Black
Monday.
The mechanism involved is not difficult to understand. A frequently used
technique of portfolio insurance involves hedging a cash stock position by
selling futures contracts. Large, highly diversified portfolios are often hedged
by selling futures on the market index, thereby locking in a price.
However, as stock prices fall, insurance requires that more futures are
sold. This will have the effect of reducing the price of a futures contract
relative to the underlying security or index. At this point, it is argued,
arbitrageurs will step in to buy the cheaper futures contracts and sell the
stocks short, which will push prices in the cash market even lower and in turn
provoke further sales of futures contracts, creating new arbitrage
opportunities, and leading to more selling. The possibility is thus created of a
closed-circuit downward spiral, with sales in one market generating selling
pressure in the other.
Notice this mechanism presupposes a subtle form of inefficiency. If the
market were efficient, market fundamentals would reassert their influence on

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 Market Efficiency and the Crash
the price of stocks (and hence the futures contracts they support). For
example, if the ‘news’ which started the downward movement warranted a
five per cent fall in the index, as soon as the downward spiral took prices
more than five per cent below their initial value, buyers would enter the
market so as to snap up the bargains on offer. The fact that this is deemed
not to have happened suggests market forces were swamped by irrational
panic.
Even if one accepts this analysis - and there is little or no evidence to
support it (see Rubinstein (1988)) - it is important to realise that it is not
necessarily damning as far as portfolio insurance is concerned. All it does is
identify the mechanism whereby the panic was transmitted from the cash to
the futures market. On this basis, there is no reason to suppose that the final
outcome would be any different, even if this particular transmission
mechanism could be supressed altogether.
A more persuasive conclusion would be that the futures markets need to be
expanded to the point at which they can provide liquidity even in situations
like those of Black Monday. It would in any case be difficult to envisage a
method of regulating the futures market that preserved intact the useful role
they play in providing a hedging vehicle in normal times.
In fact, the rapid growth of trading in derivatives both before and after the
crash is itself a reason for guessing that volatility may not be as serious a
problem as might appear from looking at equity markets in isolation.
Of course, another indication that the problem may be less serious than it
looked at the time comes from the boisterousness of the world economy in
1988 and 1989. At this stage, one can only speculate on the question of why
the damage to the world economy seems to have been less than even the most
optimistic forecasts in the immediate aftermath of the crash. With the
priceless advantage of hindsight, however, neither the fall in equity values
nor their volatility could have been expected to affect the real economy very
drastically.
As far as the level of equity prices is concerned, there are two main
transmission mechanisms for shocks to the real economy. In the first place,
direct and indirect equity holdings form a substantial proportion of private
sector wealth in the UK, USA and Japan. The fall in values must therefore
amount to a sudden, dramatic fall in wealth, with predictable consequences
for consumption and aggregate demand.
That consumption has remained buoyant to date is probably attributable
t o the fact that, as already noted, the crash marked the end of a bull market
of spectacular proportions, so that even by the end of 1987, equity prices
were above their levels of twelve months previously. Moreover, the prompt
response of the authorities in the USA and subsequently in the other
industrial countries in relaxing monetary conditions had the effect not only of
reducing the risk of serious damage to financial institutions, but also of
providing a compensating fillip to spending.
The second possible transmission mechanism runs via the impact of equity

27
Fiscal Studies

market shocks on the corporate sector. There were two reasons for supposing
firms might reduce the scale of their investment in the post-crash period. One
argument relies on the direct effect of changes in equity values on investment
profitability via the valuation ratio, q, which measures the market value of
installed capital relative to its historic cost (Tobin (1969)). This mechanism
was probably inoperative, or at least invisible, for the same reasons
consumption was unaffected.
More subtly, the rise in the volatility of share prices in the final quarter of
1987 might have been associated with increased uncertainty about future
equity values, and hence reduced willingness to commit funds to long term
projects. In the event, as can be seen from the graph (Figure 2), by the end of
1987, stock markets had settled down and volatility was back to pre-crash
levels.
In any case, there would appear to be some doubt about the link between
stock market prices and real investment. For one thing, firms are nowadays
free to trade in their own stock. They can therefore buy in their own shares
when prices are low, and many - including a number of blue-chip
multinationals - took advantage of the opportunity in October and
November 1987.
A complicating factor is that this development was superimposed on a
rising trend of management buyouts (MBOs), so that it is quite possible that
some of the firms retiring equities after the crash would have done so in any
case. Certainly, any management toying with the idea of ‘taking itself
private’ found the option a lot cheaper after October than before. It does not
necessarily follow that this course of action was therefore more attractive,
however. In the first place, there had been a drastic reduction in the market
value of whatever unexploited profit opportunities had provided the initial
incentive for the management to buy in its equity. Likewise, insofar as the
perceived riskiness of equity in general had risen, the same applied to the
equity of the individual firm, whether owned by its management or not.
Developments in the market for corporate control are beyond the scope of
the present article. Nonetheless, it should be noted that many commentators
have expressed concern about their effect on the solvency of both the
corporate and financial sectors in the USA (see Bernanke and Campbell
(1988)). For present purposes, we note that, if these developments are in fact
a cause for concern (which is far from clear), and if low market values of
equity encourage imprudent management, then obviously the crash will have
increased the risk in the economy. The causal relationship is very tenuous,
however.
Notice that the standard explanation given for the attractiveness of
management buy-outs relies on an agency cost argument (Jensen and
Meckling (1976)), which itself amounts to a particular type of market
inefficiency. The most plausible interpretation, and one that may be
disturbing to many observers, is that the market in the MBO firm’s stock is
strong form inefficient. The result is that management, in (presumably legal)

28
 Market Efficiency and the Crash

possession of inside information, is able to profit by buying the stock.

Whether or not stock market volatility is a serious problem, it is hard to see
how regulation can usefully be framed without first answering the question of
what causes share prices to move so erratically. As we have seen in the last
section, there is at present no satisfactory answer to that question, nor any
prospect of one in the foreseeable future. In particular, we have as yet no way
of knowing whether the crash resulted from market psychology (i.e.
irrational expectations) or shortcomings in institutional arrangements (e.g .
computer trading, margin requirements etc.), or the interaction of the two.
However, in a study of twenty-three stock markets in October 1987, Roll
(1988) finds virtually no link between market movements and institutional
arrangements, and concludes that the only general explanation - if one can
call it that - was t o be found in a world index beta. Clearly, the problem is
likely to be far more amenable to regulation if it is caused by inadequacies in
the institutional environment than otherwise. On the other hand, it is difficult
to see what can be achieved by regulation if, as seems highly probable, the
difficulty is to be located in the fickleness of market sentiment.
For all these general reasons, it is difficult to justify regulation. It is harder
still when we go on to consider in greater detail the measures which might
actually be undertaken.

VII. PROBLEMS FOR THE REGULATOR

There are a number of regulatory measures which have either been enforced
or proposed at some time in the major markets: trading limits, restrictions on
so-called program trading6, margin requirements, restrictions on market
opening hours or even compulsory shut-downs, and others. However, all the
proposed solutions have severe defects, and most seem likely to exacerbate
the problem.
(i) Any measure, like increasing margin requirements, which has the
effect of reducing the volume of trade seems likely to make matters
worse, because ‘thin’ markets are almost certain to be more, not
less volatile, other things being equal. Moreover, insofar as it
reduces the marketability of stock, it impairs the functioning of the
market as a source of funds for the corporate sector.
(ii) If the forces driving the market, at least in periods of exceptional
volatility, are essentially irrational, then preventing trading may

Which means no more than trading on the basis of automatic rules embodied in computer programs.
The only ‘innovation’ in this technique is that, instead of requiring market professionals to actually
implement a trading rule, the computer generates the buy or sell orders automatically - which makes the
furore over their use all the more incomprehensible. Interestingly, Roll (1988) finds that the five countries
where computer trading is prevalent (Canada, France, Japan, UK and USA) experienced a stock market
decline nearly seven per cent less than those eighteen countries where it is not widespread.

29
Fiscal Studies
actually magnify the panic. While a stock is ‘limit down’ or the
market is actually closed because it has moved more than the
maximum allowed under the regulations, two things are likely to
happen. First, in the absence of clear, up-to-date prices, the field
will be wide open to rumour and misinformation. In fact, there is
already considerable evidence to show that, even in normal times,
financial markets tend to be far more volatile when shut than open.
In other words, prices tend to vary more overnight or over
weekends than over the same length of time when the markets are
continuously open. In fact, the Hong Kong stock market did
actually close down for the week of 19 to 23 October, with the
unimpressive results that can be seen in Table 1. Of course, it could
always be claimed that without the shutdown the Hong Kong
market would have behaved even more erratically - it has
traditionally been more volatile than the other major markets. A
second reason for scepticism with regard to market shutdowns is
that trading may well take place off the market floor. Almost by
definition, this trading will be less-informed and therefore more
irrational than would have been the case if it had taken place on the
open market, with no unique price for securities, high transaction
costs and much greater risk. Potentially most damaging of all is the
danger that a limit rule may be destabilising by its very existence,
because traders may anticipate the close down and thereby hasten
its arrival.
This possibility is one that is familiar from the large literature on
devaluation of a fixed exchange rate. If the stock market perceives the ‘true’
value of a share as being, say, twelve per cent lower than at present, but
knows that it can only be marked down five per cent today, the effect will be
to create an artificial selling panic, since any vendor managing to dispose of
his shares today gets a price seven per cent higher than he (and the rest of the
market) believe it to be worth. In the absence of the limit, the price would fall
immediately by the full twelve per cent and most investors would simply
swallow the capital loss. With the limit in force, they are offered an
artificially high price for a short period.
It is interesting to note in this regard that the introduction of some
unspecified form of ‘circuit breaker’ mechanism into US markets was the
only suggestion for reform offered by the Brady Commission (Greenwald
and Stein (1988)). Moreover, the reasoning behind the recommendation was
based as much on fairness to individual investors as on the requirements of
the market and the economy as a whole. As two of the staff of the
Presidential Task Force put the matter:
We see nothing wrong with large price movements as long as they are
“fair” - that is, as long as there are not tremendous asymmetries of

30
 Market Efficiency and the Crash
information between, for example, specialists’ and their customers.
(Greenwald and Stein (1988) p. 17).
On these grounds, they proposed the introduction of a mechanism for
what they called ‘informative’ trading halts. Essentially, this proposal
amounts to a shutdown, during which market makers would be compelled to
divulge the state of their order books. Apart from a number of impractical
aspects - after all, the ‘inside information’ in question is integral to the
market maker’s business - it is hard to see how this proposal can help to
ensure that investors are able to trade at the best possible price.
At the same time, they argued that trading halts could help to make prices
more informative, since they would allow traders to set prices based on a
knowledge of the state of order books during the shutdown. The irony of this
proposal is that it it appears to be predicated on an acceptance of Keynes’s
famous comparison of the stock market to a beauty contest, in which:
... each competitor has to pick, not those faces which he himself finds
the prettiest, but those which he thinks likeliest to catch the fancy of the
other competitors ... (Keynes (1936), p.156).

VI11. CONCLUSIONS
It has been argued here that, while it may have been possible to paper over
the cracks in the efficiency model revealed by research on earlier periods, the
prospects of doing so look slim in the aftermath of the crash of October 1987.
Furthermore, it is at least as likely the inefficiency in currency and stock
markets results from their irrationality as from their institutional features or
structure.
At the same time, not all inefficiencies are necessarily a cause for concern.
Many have implications only for the participants in financial markets
themselves. Even where there are grounds for believing an inefficiency to be
damaging to the real economy, it is hard to see how regulation can improve
matters, particularly if the problem arises from irrationality, and it is quite
easy to visualise situations where regulation could make matters far worse.
‘What cannot be cured must be endured’ is the principle applied in
medicine whenever the effects of intervention are uncertain. It seems it
should apply to the financial markets too, with the appropriate steps taken to
make the patient (the real economy) as comfortable as possible in the
presence of the unavoidable symptoms. Among the measures indicated
would seem to be: improving firms’ access to hedging instruments, spreading
the understanding of how to cope with this type of risk and, wherever
possible, improving the flow of information to market participants.

’ i.e. marker makers, in UK terms.

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Fiscal Studies

It is probably over-complacent to suggest this symptomatic treatment is

already working. All that can be said at the time of writing is that there are no
signs that this particular crisis has had any lasting effects - except, that is,
upon the world of finance theorists. Even here the outcome will have been
beneficial, if it ultimately leads us to a better understanding of the way
markets operate.

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