On Black Monday (19 Oct 1987), the Dow Jones Industrial Average fell by 22.6%. How do proponents of the Efficient Markets Hypothesis (EMH) explain this event?

Do they actually claim that the intrinsic value of the DJIA fell by 22.6% that day? Or do they have some other explanation?

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    $\begingroup$ Some think that that what happened on the Monday was a relatively efficient and speedy recognition of the change in perceived value (essential a view of what others thought about future returns) a few days earlier but was delayed by the the weekend, a sharp fall associated with record trading in New York the preceding Friday confused by a storm in London, and other factors. $\endgroup$
    – Henry
    Dec 2, 2020 at 17:47

2 Answers 2


Do they actually claim that the intrinsic value of the DJIA fell by 22.6% that day?

Yes. As stated in Thaler (2015, Misbehaving):

although it was hard to justify what happened that week in October 1987, efficient market advocates were unwilling to rule out a rational explanation. In the spring of 1988, the University of Chicago held a conference about the crash, and one panel included Eugene Fama and me. Gene spoke first and said the market should be congratulated for how quickly it had reached its new equilibrium, meaning that something must have happened to cause people to revise down their estimates of the future returns on the stock market, and prices had adjusted immediately, just as they “should.”

When it was my turn to speak, I asked the assembled experts if they thought that the present value of dividends had fallen 20% on Black Monday, as it was called. Only a few hands went up, and Gene’s was not among them. I raised my eyebrow as if to say, “Well?” Gene shot his hand up in the air, smiling. He was not ready to concede, but kept his good sense of humor.

Here's a more direct quote from Fama (1988):

I argue that the October price drop has the look of an adjustment to a change in fundamental values. In this view, the market moved with breathtaking quickness to its new equilibrium, and its performance during this period of hyperactive trading is to be applauded. Even if one takes the opposite view that the price swing around October was in large part irrational, it is the long, orderly upside of the swing preceding October 19th that is questionable, not the crash itself. Thus, even in this view, changes in market structures and rules motivated by the crash are largely irrelevant. The loss of stock market wealth in October was traumatic. We should, however, avoid trauma-induced prescriptions about the performance of markets during the period. We should especially avoid trauma-induced prescriptions about how market mechanisms and rules should be changed.

(All bold font above added by me.)


Different proponents of efficient market hypothesis (EMH) will have different explanations because EMH does not say which fundamentals/variables should drive prices. EMH just states that prices reflect avaiable information but it does not say which avaiable information is important and which isn't.

There are actually several versions of efficient market hypothesis and answer might be slightly different for each of them (in details but not much overall). However, generally speaking efficient market hypothesis is not theory about why market prices fall or go up.

Efficient market hypothesis is a hypothesis about informational efficiency of market. As explained in Miskin & Eakins, Financial Markets and Institutions 8th ed. pp 158 :

Efficient market hypothesis (also referred to as the theory of efficient capital markets) ... states that prices of securities in financial markets fully reflect all avaiable information.

authors further explain:

The efficient market hypothesis views expectations as equal to optimal forecasts using all avaiable information. What exactly does this mean? An optimal forecast is the best guess of the future using all avaiable information. This does not mean that the forecast is perfectly accurate, but only that it is the best possible given the avaiable information.

Consequently, EMH does not say why prices go up or fall. It just says they contain all avaiable information and also refers expectations of future prices and again just says that these expectations will be the best forecasts given all publicly avaiable information. It does not even say these forecasts will be correct as they are just forecasts.

In order to say why prices increase or decrease you would have to combine EMH with some asset pricing theories that actually try to explain stock price behavior. For example capital asset pricing model (CAPM) could be used to explain what drives returns (which are changes in prices) and CAPM can be modeled together with assuming EHM but it can also stand separately. Furthermore, CAPM is just one example of a model that tries to explain asset prices, there are many more and in principle all can be combined with EHM.

For example, Stout (1997) uses EMH together with CAPM to show that in such model stocks might be sometimes undervalued (when there is large amount of uncertainity). So Stout who is proponent of EMH (at least to the extent that he uses it in his research) could say this might be because market undervalued stocks due to uncertainty. The point here is that in order to know what proponents of efficient market hypothesis think about what caused Black Friday you need to enquire about what asset pricing model they are using. Different proponents of EMH will give you different explanations because being proponent of EMH does not mean you are necessarily 'married' to single asset pricing model. For example, if someone argues stock prices are given by present value of their dividend (something that could hold whether EMH holds or does not hold) would say that Black Friday was caused by expected net present values of dividends dropping and EMH would just state that those expectations were formed by all publicly avaiable information.

  • $\begingroup$ So what new information became available on Black Monday? $\endgroup$
    – user253751
    Dec 2, 2020 at 13:05
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    $\begingroup$ @user253751 I don’t know could be various ones. According to CAPM prices respond to risk. Hence maybe people realized on Black Monday there is more risk in the market than they thought. In addition this answer does not even argue in favor of EMH. The point of this answer is that EMH doesn’t say what fundamentals (e.g. interest, growth, dividends, risk etc) actually move prices. EMH is theory about how market processes information not what information matters. EHM does not even say market is actually efficient at allocating resources it’s only about informational efficiency $\endgroup$
    – 1muflon1
    Dec 2, 2020 at 13:10
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    $\begingroup$ @user253751 for example you could create model where stock prices depend on how environmentally friendly company is (let’s assume some altruistic utility function for stock traders where utility increases with environmental friendliness so they are willing to pay more for environmental firms) and in such case stock prices would respond to the environmental friendliness of a company. EMH would just say on top of it that if EMH holds those stock prices will reflect all publicly available information about environmental friendliness. $\endgroup$
    – 1muflon1
    Dec 2, 2020 at 13:15

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