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Monday, March 22, 2010

Is There Still A Question Whether or Not Bubbles Can Occur ? And Why You Should Index Whether or Not You Believe They Occur

I am preparing my class to write a book review of  Justin Fox's The Myth of the Rational Market. Reviewing that material for class and my work as well as the fascinating paper by Alan Greenspan with his reflections on the crisis and the reply from Gref Mankiw all set my wheels going over whether there really is still a debate over whether the market is rational and the old saw of market efficiency.

So a few thoughts:

Mankiw's comments  ( a brief selection below) on the greenspan paper are in many ways are more interesting than Greenspan's esp the academic point Mankiw draws in challenging Greenspan about bank leverage. You can read it all on his blog.

What struck me was how Mankiw considered a "classical" economist closer to the Chicago school than the Keynesians could make this comment below , And he is making it as a point of agreement with Greenspan certainly someone not associated with the concept that markets can get prices "wrong" For both it just seems a "given" (a favorite term for economists) that bubbles and market irrationality are a part of economic life.
To begin with, Alan refers to recent events in the housing market as a “classic euphoric bubble.” He is certainly right that asset markets can depart from apparent fundamentals in ways that are often hard to understand. This has happened before, and it will happen again. When the bubble bursts, the aftershocks are never pleasant.
Quite a statement for a "neoclassical " economists

I checked my copy of Investments by Wilson and Ibbootson one of the top finance textbooks. Their definition of inefficient markets is where price does not equal value. Obviously what is described above is a market where that is the case. Ergo makets can be inefficient for a long period of time.

Now on to "rational markets'. To me it seems clear that a market where prices depart from markets in ways that are often hard to understand is almost by definition not rational

So to me it is rather clear that the idea that markets are (always) rational/efficient can indeed be labelled a myth. Maybe to be more charitable one could call it a model, a theoretical paradigm to be used as a starting point for analysis but clearly not a representation of how markets behave in the real world. Fama has a great paper on capm and these issues and basically declares that the behavioral explanation for risk not matching return is plausible. He favors the explanation that there are additional risk factors in addition to beta (size and book to market). But I'll leave those interested to read the great paper. But spoiler alert he states that in terms of using it operationally capm is useless. He still thinks it's worth teaching as an explanatory model however.

Now here is where the confusion in terms often occurs and I think I have fallen into the trap as well., Behavioral economists (i think it was Richard Thaler of the University of Chicago) acknowledge that they can point to human behaviors in markets that can lead to bubbles and busts. But they have no models to tell us when these will occur, how long they will last and how far they will go. He admits that they cannot provide any propositions that will lead to profitable activity by knowing when to short a frothy market. This is where the traditional economists' critiques of the behaviorialists come in:

The behavioralists are criticized as having a collection of tendencies in human economics behavior "anecdotes"
but no model of economic activity

The behavioralists reply that the traditional (efficient/rational market model) have a model for how financial markets work that is comprehensive but doesnt match how real people behave in the real world of financial markets. As noted Fama (the originator of the efficient market hypothesis) agrees that real world prices do not fit those predicted by capm.

I think they're both right

Following Thaler I have used the expression weak form efficient market to express the view that while there may be irrational behavior in the markets it is impossible to systematically profit from that knowledge and generate excess returns (alpha).

But strictly speaking using academic terminology I was incorrect. tTe weak form of the efficient market theory states that the current price reflects all  historical information (semi strong means it reflects all public information, strong price reflects all information public or private).

Which leads me to the conclusion that one not need believe in a an "efficient market" or a "random walk" in terms of a normal distribution of prices to believe that no one consistently beat the market = there is no alpha or as I like to say (after Taleeb) there are no geniuses.

Taleeb certainly spends much of his writing attacking premises of emh and its cousing the capital asset pricing model. Yet he also has written a womderful book called Fooled By Randomness eviscerating the idea that there are investment geniuses that can consistently beat the market.

Going one step further I noted in an interview I heard with Justin Fox the interesting point he made. One can believe in the case for indexing and the near impossibility of beating the market without at all believing that the markets are efficient (price = value) or rational. The absolute price level and movement of the market is irrelevant to the believe in the absence of consistent alpha producers.

The argument for indexing is based on the costs, explicitly in terms of fees,  less apparent but still real are additional costs in terms of transactions costs and in most cases taxes. If one wants to capture the return of the asset class with the same risk level of the asset class  (it's beta) one must purchase a low cost index instrument. It doesnt eliminate bubble or bust risk. It also doesnt tell us anything about how much of that asset class one should hold

The argument for indexing is based on cost and style purity it has nothing to do with market efficiency (rationality ) in the sense that price=value

If you think equity makets (or any other asset class) are wildly irrational price separates from value all the time bubbles and busts occur but you still want exposure to that asset class then the only correct way to do it (with style purity and low cost) is through an index instrument.

That holds :

If you believe markets are rational (price always = value) ...if there are any of you still out there.

or

You're like Greenspan, Mankiw and me and think that "euphoric bubbles" are as much a part of financial life as blizzards are part of weather in buffalo ny.

Of course there is another issue as well. 

Knowing that you should index tells you nothing about what the asset mix within your portfolio should be, Because no one really has a definition of what "the market" is. CAPM used the S+P 500 and a riskless asset. Clearly the investment universe is far larger than that.


More on that later.

1 comment:

雞排 said...

未來屬於那些相信他們美好夢想的人。 ..................................................