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I'm narrowing this question on Reddit's r/investing to North America. But don't hesitate to discuss other Five Eyes (FVEY) – Australia, Canada, New Zealand, UK, US. I'm posting here because I prefer self-contained answers. I hate scrolling reddit's long-winded dialogue!

It's common to postulate that

  1. stock market indices are semi-strong efficient, so that "all available information about a company has already been priced in".

  2. in the long term, indices such as the S&P500 and NASDAQ100 are expected to grow, so that investing in them will usually profit you in the long term.

  3. How are these two postulates compatible? Doesn't semi-strong Efficient Market Hypothesis mean that the market semi-strong-efficiently values X's share price, so that on average, X's share price remains steady?

  4. News may arrive in the future and affect this semi-strong-efficient stock price, but shouldn't such news average out to 0? Because there's no reason to expect more negative news that positive news, or vice versa? If there was, such news should have already been priced into X's current share price.

  5. As an example, let's postulate that the market behaves semi-strong-efficiently and values X's stock at 100 tomorrow. This means X's stock today should also be Net Present Value of 100, correct? If not, then X's stock is undervalued today, and thus not semi-strong-efficiently valued by the market.

  6. Similarly, if X's share price is expected to value 1000 next month, this 1000 should also be reflected into today's share price, so that today's share price is the Net Present Value of 1000.

  7. This comment mentions "discount rate (risk free rate plus the equity risk premium", but Discount Rate is already incorporated into Net Present Value. Correct?

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  • $\begingroup$ Hi, welcome to Economics.SE. We have policy against posting duplicate questions. Very similar questions to this were already asked in the past on this site. You should have first look at them to see if they answer your question and if not consider explaining in your question why because this looks like something that without explanation of differences with past questions might be closed by users due to similarity. See similar questions here $\endgroup$
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    Commented Nov 5, 2020 at 10:47
  • $\begingroup$ or here as examples. Also please have a look at out help center about other rules here. $\endgroup$
    – 1muflon1 ♦
    Commented Nov 5, 2020 at 10:48
  • $\begingroup$ One can argue that the question is different because it refers to market efficiency. Anyway, the answer is that market efficiency suggests that the price should generally go up - by a rate equal to the risk-free rate plus the risk premium, so there is nothing else to say. $\endgroup$
    – Brian Romanchuk
    Commented Nov 5, 2020 at 12:59
  • $\begingroup$ @user31121: Brian's answer was right on but a little compact. What he is saying is that, it does grow, but you're taking risk when you're invested in it. Market Efficiency says that you can't profit in the market WITHOUT taking risk so ME is not contradictory to the market growing on average. ME basically says ( there are 2 or 3 different forms of it but I'm not gonna go into that level of detail ) that you can't make money with certainty. Of course, many hedge funds disagree with the notion of ME because they profit in the market pretty consistently. $\endgroup$
    – mark leeds
    Commented Nov 5, 2020 at 22:10

3 Answers 3

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The composition of a stock market index is not fixed but changes over time. Moreover, it usually changes so as to increase/decrease the weight of good/poor performers.

For example, the S&P500 assigns weights to 500 large companies that meet various criteria, including at least a $8.2B cap.* These weights change over time. In fact, companies can even be dropped (e.g. recently Macy's) or added (e.g. Netflix, Google, and Facebook were not on the index in 2000 but are today).

So, suppose we're transported back 20 years to 2000-11-06. Consider the 500 stock prices that were included in the S&P500 on that day. It is true that the EMH would have predicted that those 500 stock prices would, on average, not have grown in the following 20 years (ignoring inflation). However, the EMH would not have said anything about the S&P500 Index, whose composition may and indeed did change.

(We can repeat this same thought experiment for the 500 stock prices included in the S&P500 today: The EMH predicts that, ignoring inflation, these 500 stock prices will not change over the next 20 years. However, the EMH says nothing about what the S&P500 will be in 2040.)

So, if we expect economic growth and creative destruction, then we also expect the S&P500 (and any other index whose composition is allowed to change) to keep growing over time, even if we do not expect any individual stock price to grow.

*See e.g. "S&P U.S. Indices Methodology, Aug 2020" PDF.

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The efficient market hypothesis allows for markets to grow. Markets usually grow thanks to economic growth, because more productive firms are more valuable. There is no economic law that says the market should grow. They are expected to grow because they historically grew for a long period and because there is no expectation that economic growth will stop soon.

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    $\begingroup$ But why doesn't the current price already account for this expected growth? $\endgroup$
    – user20574
    Commented Nov 6, 2020 at 20:49
  • $\begingroup$ @user253751 this is explained in the KennyLJ answer. Saying stock market grows is not saying that all individual stock grow. Also, using all available information is not the same as being able to predict future - traders might know there will be economic growth and stock market will grow but they might have no idea which companies will be affected by this more and which less. Nokia was destroyed by technological change while Apple was made international giant. The market grows because growth on average makes companies more valuable but many are destroyed in process as well. $\endgroup$
    – csilvia
    Commented Nov 7, 2020 at 12:18
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Efficient market hypothesis does not hold as a working assumption because stock market trades are made with respect to subjective and uncertain forward-looking evaluations of buyers and sellers. Since projections of forward earnings per share and price to earnings ratios are subjective and uncertain it is absurd to assume that all such information is priced into the market. If one applies the EMH it is only a tautology, that is, a statement of belief or that it is true because one holds it to be true.

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  • $\begingroup$ "Efficient market hypothesis does not hold as a working assumption" Too confident? I have read about behavioral finance and economics, and personally don't believe in the EMH. But I'm not confident enough to write it doesn't hold. $\endgroup$
    – user31121
    Commented Jan 16, 2021 at 21:31
  • $\begingroup$ The Abstract of the following 20 page paper argues that the EMH is non-falsifiable. The efficient market hypothesis: problems with interpretations of empirical tests: bib.irb.hr/datoteka/822287.alajbeg-bubas-sonje.pdf. I will read the paper several times then maybe edit my answer to clarify why EMH seems to be a tautology, working assumption, or statement of truth rather than a hypothesis that can be tested by factual evidence. I imagine a bunch of statistics experts arguing you can't ride random breaking waves on a surfboard then some kids roll down and prove you can surf those waves. $\endgroup$
    – SystemTheory
    Commented Jan 16, 2021 at 22:29

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