The Triumph of Speculation
The 1987 crash and the subsequent decade of intervention by Alan Greenspan (Policy and Critique lens), who consistently softened the impact of financial panics, reinforced an implicit assumption: the Federal Reserve would not allow the market to fail entirely. This “asymmetric approach”—letting bubbles run rampant on the upside but intervening to soften the bust—encouraged speculative excess. The subsequent bull market, fueled by technological optimism and a new public willingness to “buy on the dips,” led to the unprecedented valuation peaks of the dot-com era. Shiller famously warned of “irrational exuberance,” noting that price-to-earnings ratios implied returns of “just about nothing” over the next decade. Rational investors found themselves in a crisis: the market could stay irrational longer than they could stay solvent, as demonstrated by the collapse of many value-oriented funds.
Irrational exuberance drives unprecedented valuation peaks, with P/E ratios implying near-zero future returns
The Corruption of Corporate Orthodoxy
The Perils of Overvaluation
The efficient market’s conquest extended deep into corporate structure in the 1980s via the “shareholder value” movement championed by Michael Jensen. Jensen’s core premise was that efficient stock prices provided accurate signals for resource allocation, and executives needed financial incentives (like stock options) to obey them. However, the late 1990s proved that prices were far from perfect signals. Jensen later admitted that high stock prices led CEOs to “massive pain,” forcing companies to pursue unsustainable growth strategies, leading to overinvestment and outright fraud at firms like Enron and WorldCom. The stock market, rather than being an omniscient guide, became a source of instability and corruption. Jensen concluded that the belief that financial markets should always set corporate priorities had lost its most important champion.
Corporate fraud scandals demonstrate how overvaluation corrupts corporate decision-making
Fama vs. Thaler
The core academic debate culminated in the famous clash between Eugene Fama and Richard Thaler (Decision-Making and Bias lens). Fama had already been forced to concede that his original EMH/CAPM model was flawed, shifting to multifactor models that included historical market patterns like value and momentum—patterns he had previously dismissed as folklore. Thaler, equipped with psychological data showing investors often exhibited self-defeating behaviors (like chasing hot funds), championed the reality that “human nature is a mess”. The behavioralists exposed how individual flaws, such as overconfidence, generate enough trading and noise to push prices away from intrinsic value for years. Crucially, Fama and Kenneth French later published a study essentially agreeing with Shleifer and Vishny’s “Limits of Arbitrage” (Social Dynamics lens), admitting that misinformed beliefs by noise traders do not automatically disappear and can distort prices over time.
Eugene Fama shifts from EMH to multifactor models, admitting original framework was flawed
Financial Collapse and the Need for Integrity
The ultimate failure of the rational market hypothesis was the 2008 financial crisis. This collapse was rooted in the mortgage market (Technological History lens), where options-theory-based risk models were used to package subprime loans into complex securities (CDOs). These models relied on assumptions of low risk and historical data that were irrelevant to the new, highly leveraged system of Ponzi finance that Hyman Minsky had warned about. The models failed spectacularly, confirming that the quantification of risk led to a collective “false sense of security”. In the aftermath, Jensen argued that the entire structure failed because participants failed to adhere to non-market norms, such as “integrity” and “honoring your word”. The collapse demonstrated that finance is a “huge net positive for the economy,” but that mathematical rigor alone cannot regulate the system when human judgment and behavior dominate.
Financial collapse exposes failure of risk models based on rational market assumptions
The Unresolved Muddle
Where does this leave modern finance? The efficient market ideal is largely defunct as a literal description of reality, with its creator, Eugene Fama, effectively admitting he no longer knew what prices truly represented. Yet, academics and practitioners have not abandoned the mathematical edifice. As Thaler noted, the choice remains between being “precisely wrong or vaguely right”. While behavioral, experimental, and complexity-based theories have flourished, providing compelling explanations for market disturbances, they have not replaced the fundamental equilibrium framework established by Irving Fisher a century ago. The enduring lesson for investors remains practical: beating the market is extremely difficult, making index investing a “sensible place to start”. The most powerful realization is that the market is not a creature of monolithic wisdom, but a reflection of collective human emotion and error—the “Panurge’s sheep” that the first mathematicians failed to destroy.