The efficient market hypothesis (EMH) is one of the most contentious topics in all of financial economics. You could spend years reviewing the mountain of literature, both pro and con, that dissects the subject into ever finer slices without reading the same paper twice. As a practical matter, EMH has been helpful for investors, namely, making the case for indexing. Indexing isn’t perfect and some investors can do better, but passive investing has a history of more or less working as advertised: delivering middling performance over time relative to a wide range of actively managed results, and at low cost.

But even the posted results don’t convince some critics, who argue that the success of indexing is due to factors beyond what the theory allows. This is an endless debate, in part because of the so-called joint hypothesis problem. For example, let’s say you set out to prove or disprove EMH. You run the numbers through a model and come to a conclusion. But no matter the result, you’re never quite sure if your model is flawed or the markets are inefficient. How would you know which story applies? Well, you’d need corroborating evidence, i.e., a third model, and one that’s flawless. Otherwise, you’ll need to make a decision based partly on gut instinct. So much for definitive answers in deconstructing Mr. Market’s rules for asset pricing.
That leaves us with the thankless task of using one or more flawed models, reviewing financial history and reading the research for figuring out what seems to work best. I did some of that in my book Dynamic Asset Allocation. Poring over decades of financial theory and empirical research, I argue that markets tend to be mostly efficient over the medium- to long-term horizons, but with the caveat that there’s enough non-random pricing evidence to support some amount of active asset allocation.
None of this persuades EMH critics. But what’s puzzling is that some (all?) opponents of efficiency assume that market prices are more or less correct as the basis for arguing the opposite. For instance, consider the debate over dividends, which goes back to the early 1980s, when Professor Robert Shiller published his widely quoted paper “Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?” The idea here is that the market is inefficient because stock prices move too much relative to the comparatively smooth changes in dividends. In other words, the stock market prices dividends in a haphazard manner that’s of questionable efficiency.
That view can’t be dismissed, but 30 years of thinking through the problem has spawned a rainbow of interpretations. That includes the possibility that fluctuating dividend yields (i.e., prices bounce around a lot while actual dividends are fairly tame) can offer some value in forecasting equity market return without indicting EMH. An important paper emphasizing this perspective is Professor John Cochrane’s 2008’s “The Dog That Did Not Bark: A Defense of Return Predictability.” Summarizing his analysis, Cochrane writes:

If returns are not predictable, dividend growth must be predictable, to generate the observed variation in divided yields. I find that the absence of dividend growth predictability gives stronger evidence than does the presence of return predictability.

And if you graph the data, Cochrane’s point looks plausible. Consider, for instance, the chart below, which compares the trailing 12-month dividend yield on the S&P 500 and its predecessors over the decades vs. the subsequent 10-year value of $1 invested in the S&P at a given dividend yield. For instance, the trailing stock market yield in March 2000 was roughly 1.2%. A $1 investment in the S&P at that point would be worth about 80 cents a decade later.

Overall, there’s chart shows a fairly strong relationship between current yield and subsequent return. Higher yields tend to be linked with higher returns in future years, and vice versa. It’s not perfect but it’d be foolish to ignore the strategic connection between valuation and performance. Is dividend yield a silver bullet? No, of course not, but neither is anything else. You need to look at a mix of data to generate productive estimates of the expected return for stocks. But surely dividend yield deserves to be one of the variables.
Is the yield/return relationship evidence that the market is inefficient? Not necessarily. The fact that stock prices are less than perfectly random doesn’t invalidate EMH. In other words, EMH’s legitimacy doesn’t rely on the random walk theory, even though many academics used to argue just that. But financial economics no longer sees markets in those terms. Expected risk premiums can bounce around in an efficient market, as explained in A Non-Random Walk Down Wall Street. Yes, EMH may still be flawed (or irrelevant), but you can’t prove it by showing that market prices aren’t perfectly random.
At the same time, some critics of EMH use the fluctuating dividend yield (and other wandering metrics of “fundamental” value) to argue that the market’s irrational. When dividend yield rises or falls to some level (invariably a subjectively defined level), some investors are inspired to claim that stocks are overpriced or underpriced. That may or may not be true, although the choice of words can be misleading.
It’s widely accepted that expected returns on assets change, reflecting the prevailing conditions. EMH never argued that expected return would remain constant. Rather, it only says that market prices reflect known information about companies, the economy, etc. Accordingly, the market also reflects an assumption about expected return and risk. Sometimes the market prices the future at a high or low discount rate. Is it correct? Sometimes, sometimes not. Par for the course in divining the future.
Here’s the key question: Is it proper to use the market’s prices (and by extension dividend yield) to claim irrational pricing? Perhaps not, since that assumes that the underlying prices are rational–somethng that EMH critics are loathe to accept. Simply put, it’s a stretch to claim that market prices are irrational and then use the same prices to make a rational analysis of expected return.
As an example, let’s say a stock market index is priced at 100 and it’s paid $1 in dividends over the past 12 months. That is, the dividend yield is 1%. After poring over the index’s history, you discover that 1% is low—the lowest in 50 years, in fact. In turn, you declare that the market’s irrational. Prices are too high (or, if you prefer, yields are too low). The market’s gone off the deep end, ergo, EMH is irrelevant. Maybe, but it’s hard to make the case based on this analysis.
If market prices are useful and providing some degree of insight, how can we use those same prices to conclude that the market’s irrationally overvalued? If you really believed that market prices are worthless, you’d pay no attention to dividend yield because that would be irrelevant too.
And there’s another problem. If you think the market’s undervalued because market prices are irrational, buying stocks and hoping to sell at future irrational prices sounds like gambling rather than investing.
In fact, the anti-EMH crowd respects market prices, even if they don’t come out and say so. Some strategists hedge their bets in the terminology. For example, Andrew Smithers is no fan of EMH. Yet in his book Wall Street Revalued: Imperfect Markets and Inept Central Bankers he writes of a “moderately efficient market” and the “imperfectly Efficient Market Hypothesis.” He argues that “the case against the EMH leads naturally to the idea that the markets rotate around value rather than remain perfectly tied to it.”
Yet an updated interpretation of EMH and modern portfolio theory (MPT) sounds similar, as I outline in my own book. In fact, supporters and detractors of the current reading of EMH and MPT are generally in agreement, even if the rhetoric suggests otherwise. Market prices are relevant in some degree, which means that related measurements like dividend yield, book value, price-to-earnings ratio, etc. provide valuable information for estimating expected return.
Where the consensus breaks apart is deciding why expected return fluctuates. The anti-EMH group says it’s due to irrational pricing in the market. Of course, if you really believed that, you’d question the associated dividend yield and p/e ratio and therefore avoid stocks entirely. But the anti-EMH folks don’t go that far, which suggests that they may not be thoroughly and irrevocably opposed to EMH after all.