EFF: Stock prices depend on two factors: expected profitability and the expected returns investors require to hold stocks. Both can vary dramatically through time. Thus, widely different levels of the market at different times are quite consistent with market efficiency. Indeed, they are required for market efficiency. This might well be a tough sell, but it's Finance 101.
KRF: Dick is referring to the behavior of stock prices during the tech boom and bust of 1995-2001. Gene is certainly right that market efficiency requires prices to adjust to new information about future cashflows and discount rates. The critical question is whether rational expectations of cashflows and discount rates could justify the high valuations of tech stocks in 2000. With the false precision of hindsight - a behavioral bias many of us suffer - the answer seems obvious. But events are more complicated when you are living through them. Some investors were convinced tech stocks were grossly overpriced in 1999 and 2000, but others were equally certain that extraordinary growth opportunities would push prices even higher. Behavioral finance teaches us that investors tend to be overconfident about their ability to identify mistakes in the market. Given this overconfidence, and the disagreement about tech stock valuations among investors in 1999 and 2000, we should resist the temptation to conclude that anyone with any sense should have known tech prices were too high then, or that we will be able to spot such "obvious" mistakes the next time.
Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.