if a smart guy like Burton Malkiel had to wait for the Internet bubble to end to realize we had been in one

TO BE NOTED: From the NY Times:

"Talking Business

Poking Holes in a Theory on Markets

By JOE NOCERA

For some months now, Jeremy Grantham, a respected market strategist with GMO, an institutional asset management company, has been railing about — of all things — the efficient market hypothesis.

You know what the efficient market hypothesis is, don’t you? It’s a theory that grew out of the University of Chicago’s finance department, and long held sway in academic circles, that the stock market can’t be beaten on any consistent basis because all available information is already built into stock prices. The stock market, in other words, is rational.

In the last decade, the efficient market hypothesis, which had been near dogma since the early 1970s, has taken some serious body blows. First came the rise of the behavioral economists, like Richard H. Thaler at the University of Chicago and Robert J. Shiller at Yale, who convincingly showed that mass psychology, herd behavior and the like can have an enormous effect on stock prices — meaning that perhaps the market isn’t quite so efficient after all. Then came a bit more tangible proof: the dot-com bubble, quickly followed by the housing bubble. Quod erat demonstrandum.

These days, you would be hard-pressed to find anybody, even on the University of Chicago campus, who would claim that the market is perfectly efficient. Yet Mr. Grantham, who was a critic of the efficient market hypothesis long before such criticism was in vogue, has hardly been mollified by its decline. In his view, it did a lot of damage in its heyday — damage that we’re still dealing with. How much damage? In Mr. Grantham’s view, the efficient market hypothesis is more or less directly responsible for the financial crisis.

“In their desire for mathematical order and elegant models,” he wrote in his firm’s quarterly letter to clients earlier this year, “the economic establishment played down the role of bad behavior” — not to mention “flat-out bursts of irrationality.”

He continued: “The incredibly inaccurate efficient market theory was believed in totality by many of our financial leaders, and believed in part by almost all. It left our economic and government establishment sitting by confidently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments led to our current plight. ‘Surely, none of this could be happening in a rational, efficient world,’ they seemed to be thinking. And the absolutely worst part of this belief set was that it led to a chronic underestimation of the dangers of asset bubbles breaking.”

(Mr. Grantham concluded: “Well, it’s nice to get that off my chest again!”)

I couldn’t help thinking about Mr. Grantham’s screed as I was reading Justin Fox’s new book, “The Myth of The Rational Market,” an engaging history of what might be called the rise and fall of the efficient market hypothesis.

Mr. Fox is a business columnist for Time magazine (and a former colleague of mine) who has long been interested in academic finance. His thesis, essentially, is that the efficient marketeers were originally on to a good idea. But sealed off in their academic cocoons — and writing papers in their mathematical jargon — they developed an internal logic quite divorced from market realities. It took a new group of young economists, the behavioralists, to nudge the profession back toward reality.

Mr. Fox argues, echoing Mr. Grantham, that the efficient market hypothesis played an outsize role in shaping how the country thought and acted in the last 30-plus years. But Mr. Fox parts company with him by also arguing that the effect wasn’t necessarily all bad. As for the question of whether an academic theory hatched in Chicago led to the financial crisis, suffice it to say that some questions can never be answered definitively. Which isn’t to say they shouldn’t be asked.

•

“There are no easy ways to beat the market,” Mr. Fox said when I spoke to him a few days ago. If you want to point to the single best thing the efficient market hypothesis taught us, that is the lesson: we can’t beat the market. Indeed, the vast majority of professional money managers can’t beat the market either, at least not on a regular basis.

As Mr. Fox describes it, much of the early academic work that led to the efficient market theory was aimed at simply showing that most predictive stock charts were glorified voodoo — just because a pattern had developed didn’t mean it would continue, or even that it had any real meaning. Dissertations were written showing how 20 randomly chosen stocks outperformed actively managed mutual funds. (Hence the phrase “random walk,” to connote the near impossibility of beating the market regularly.) Mr. Thaler, the Chicago behavioralist, says that evidence on this point — “the no free lunch principle,” he calls it — is clear and convincing.

In time, this insight led to the rise of passive index funds that simply matched the market instead of trying to beat it. Unless you’re Warren Buffett, an index fund is where you should put your money. Even people who don’t follow that advice know they should.

As it turns out, Mr. Grantham was an early advocate of index funds, mainly for unsophisticated investors who have no hope of beating the market. But he also believes that professionals should do better precisely because, as he puts it, “the market is full of major league inefficiencies.”

“There are incredible aberrations,” he told me over lunch not long ago. “The U.S. housing market in 2007. Japan in the 1980s. Nasdaq. In 2000, growth stocks were three times their fair value. We were quoted in The Economist in 2000 saying that the Nasdaq would drop by 75 percent. In an efficient world, you wouldn’t have that in a lifetime. If the market were truly efficient, it would mean that growth stocks had become permanently more valuable.”

As Mr. Grantham sees it, if professional investors had been willing to acknowledge these aberrations — and trade on the fact that the market was out of whack — they should have been able to beat the market. But thanks to the efficient market hypothesis, no one was willing to call a bubble a bubble — because, after all, stock prices were rational.

“It helped mold the ‘this time it’s different’ mentality,” he said. Indeed, professional money managers who tried to buck the tide wound up losing their jobs — because everybody else was making money by riding the bubble for all it was worth. Meanwhile, government officials, starting with Alan Greenspan, were unwilling to burst the bubble precisely because they were unwilling to even judge that it was a bubble. “Our default reflex is that the world knows what it is doing, and that is extravagant nonsense,” Mr. Grantham said.

But as much as I’ve admired Mr. Grantham’s writings over the years, I think the truth, in this case, is a little more subtle. Given the long history of bubbles, I suspect this crisis would have taken place with or without the aid of the efficient market hypothesis. People thought “it’s different this time” in the 1920s, long before anyone was writing about efficient markets. And over the course of history, professional money managers have been just as fearful of bucking the trend as they were during the Internet bubble.

Mr. Fox sees it somewhat differently. On the one hand, he says, the efficient market theoreticians always assumed that smart market participants would force stock prices to become rational. How? By doing exactly what they don’t do in real life: take the other side of trades if prices get out of whack. Their ivory tower view reflected an idealized market that simply doesn’t exist.

On the other hand, Mr. Fox says, what was truly pernicious about the efficient market hypothesis is the way it allowed us to put asset prices on a pedestal that they never deserved. Stock options — supposedly based on a rational price — became prevalent in part because higher stock prices were supposed to be the rational reward for good performance.

Or take the modern emphasis on market capitalization. “At some point in the early 1990s (or maybe it was in the late 1980s), market capitalization became accepted as the best measure of a company’s importance,” Mr. Fox wrote me in an e-mail message. “Before then it was usually profits or revenue. I think that’s a classic example of the way efficient market theory seeped into popular discourse and shaped how we perceived the world. It wasn’t entirely stupid — profits and revenue are flawed, limited measures, and market value does tell you something useful about a company. But it was another one of the ways in which asset prices came to rule the world, which eventually turned out to be a bad thing.”

•

A few days ago, I called Burton G. Malkiel, the Princeton economist, to ask him what he thought of Mr. Grantham’s theories. Mr. Malkiel is the author of “A Random Walk Down Wall Street,” surely one of the greatest popularizers of any academic theory that’s ever been written.

“It’s ridiculous” to blame the financial crisis on the efficient market hypothesis, Mr. Malkiel said. “If you are leveraged 33-1, and you’re holding long-term securities and using short-term indebtedness, and then there’s a run on the bank — which is what happened to Bear Stearns — how can you blame that on efficient market theory?”

But then we started talking about bubbles. “I do think bubbles exist,” he said. “The problem with bubbles is that you cannot recognize them in advance. We now know that stock prices were crazy in March of 2000. We know that condo prices were nuts.”

I thought to myself: if a smart guy like Burton Malkiel had to wait for the Internet bubble to end to realize we had been in one, then maybe Mr. Grantham has a point after all."

economists have no robust system of determining which statements about economics are true, and which are not

TO BE NOTED: From the Atlantic Business Channel:

"May 1 2009, 8:54 am by Charles Davi

The Sorry State Of The Dismal Science

John Authers' recent interview with University of Chicago professor Richard Thaler is a fine example of what I hope are broader trends in economic thought. To some, it might seem like just another interview. But Authers undoubtedly recognizes its significance. Thaler is a professor at the University of Chicago, which is the birth place of the Efficient Market Hypothesis, and Authers is a well-respected columnist for the Financial Times, which is arguably the voice of the free market in the press. And yet, there they are, casting doubt upon the very theories underpinning a generation of thought that have made the University of Chicago the epicenter of free market ideology. In the language of soda-pop-economics, this interview is a "black swan."

It seems Authers is leaning ever closer towards a world view informed by behavioral economics. While I haven't done any empirical research into Authers' work, I do read his column, The Short View, religiously (personally, I recommend you do the same). And as the recent downturn developed, I noticed several articles that suggest he's come to question at least some of the assumptions underlying the old free market dogmas, particularly the Efficient Market Hypothesis. In my opinion, this is a welcomed development. And I sincerely hope it is part of a broader trend away from grandiose theories about how humans make decisions and towards precise theories which are supported by real-world observations.

Those that have toiled through my writing in the past know that I am a big fan of free markets. Yet, I am not a big fan of the EMH. And in general, I find a lot of economic theory, particularly macroeconomic theory, to be little more than hand-waving. There's an almost priestly air about it that makes me deeply suspicious of its validity. In gentler terms, Economics lacks a rigorous epistemological theory. That is, economists have no robust system of determining which statements about economics are true, and which are not. This is in stark contrast to say, mathematics. A statement about an alleged mathematical truth is verifiable (putting Gödel and Turing aside for the moment). If you tell me that you have discovered a new mathematical truth, you can sit down and in a finite number of words, provide a logical path from assumptions we both agree are true to your new found conclusions that I must accept as true, else I reject either the assumptions or logic itself. Now, I understand that economics can never be a purely deductive sport, since it is complicated by the nuance and uncertainty of, well, reality. But that doesn't mean we can't do better than simply assuming away all of human ridiculousness.

The economics that assumes rational behavior on the part of humanity is, in my opinion, dead. It is simply at odds with everyday experience. It's arguable that the desire for wealth is itself an inherently irrational impulse for most of the developed world, given that our needs would likely be satisfied on public assistance. That said, those who are able to control their behavior and act rationally do a much better job at generating and accumulating wealth. But once they get the money, they go and do something absurd with it, like buy a fleet of planes. So while reason and deferred consumption might be the means by which we accumulate wealth, the end goal of accumulating wealth seems to be driven by a need to express dominance, or at least an antisocial impulse to be free of society's constraints. This view finds support in popular culture, which often equates wealth with conspicuous consumption, sexuality, and control. All of this suggests that somewhere buried under all of those pinstripes is a real brute.

If I am correct, and there is a sea change taking place in how economists view human behavior and the markets humans create, then there may be a lot of quackery in the short term. That is, during the intellectual power vacuum that will follow the demise of the old Chicago School, a few crackpots might temporarily seize power as we trace our way from the four humors to phlogiston. But when we finally get our Lavoisier, this time let's remember to keep his head on, despite our penchant for the irrational."

That which as no practical implications; has no implications for economic theory.

From The Money Illusion:

"Richard Rorty and the efficient markets debate

I use the efficient markets hypothesis in my research and in my blog. Once I started looking at the world through the EMH lens, I found it much easier to understand the relationship between policy and the financial markets—particularly in my research on the Depression. Here I’d like to do three things; indicate why I believe markets are more efficient than they seem, acknowledge that there are events that look like market inefficiency, and then argue that those perceived inefficiencies, even if real, don’t have the policy implications that many people assume they have.

Last Sunday I discussed cognitive illusions, aspects of economic theory that are highly counter-intuitive. I regard the EMH as one such economic theory—strange, but (almost) true. Let’s start with all of the studies showing market inefficiency. Many of these studies show that there are market patterns, or anomalies, that seem inconsistent with the EMH. But how do we know these aren’t just coincidence? One answer is that we can use statistical tests, such as the example of the correlation between equity returns on Wall Street and rainy days, which I discussed a few days ago. But are those statistical tests reliable? They tell us that certain events would be extremely unlikely to occur by chance, but what does that mean?

If I go to Vegas and observe the numbers 17-34-23-1-23-5-31-7-15-25 show up on a roulette wheel, I could argue that the odds were more than one in a quadrillion against that exact combination showing up on that particular wheel at that time. In response, anti-EMH types would argue that anomaly studies don’t just find patterns, they find interesting patterns. But there are lots of interesting patterns, far more than you might think at first glance. I’m always noticing interesting patterns in random strings of digits. Indeed the “uninteresting” string of numbers that I just listed, are actually very interesting—can you see how?

I am not an expert on EMH research, so let me just say that as long as asset prices seem to follow a path even close to the random walk predicted by theory, I am not going to be very impressed by academic studies finding “statistically significant” anomalies.

But of course there is a much more powerful argument for the anti-EMH position; the large asset price movements we occasionally see that don’t seem to have any fundamental explanation. Some of the most famous are the 1929, 1987, and 2000 stock market bubbles, as well as the 2006 housing bubble. Of course there are many more, but I think you will agree that these are some of the primary examples that EMH opponents point to. I’d like to consider these events from several perspectives, beginning with the question of fundamentals.

1. The 1929 bubble is the easiest to explain with fundamentals. Studies have shown that stocks were not grossly overpriced in 1929, and the collapse has a very good “fundamental” explanation—the Great Depression.

2. I know of no explanation for the 1987 bubble. The collapse (comparable to 1929) occurred when the overall economy was doing fine. Some argue for “computer trading,” as if computers have free will. I am not saying they are wrong, but then the correct term would be “really stupid computer programmers.” If correct, this is a good argument against the EMH position. But even here, one must be careful not to push things too far. At the time EMH opponents probably assumed more than just a inexplicable price change—they probably assumed that the bubble’s peak represented irrational exuberance. Were stock prices too high before the 1987 crash? We had no way of knowing then, and we still don’t really know. There is enormous uncertainty about what the stock market should be trading at, based on “fundamentals.”

I find it interesting that anti-EMH hypotheses often seem to be in conflict with each other. Some talk about “irrational exuberance” at various market peaks. Others point to the extraordinarily high average rate of return on long term equity investments in the U.S., which greatly exceeds the return on bonds (even adjusting for the higher risk on stocks.) Of course this latter anomaly implies that stock prices in the U.S. were far too low throughout much of the 20th century. So which is it? Is the stock market often way too high? Or way too low? And why do we hear so little discussion of “negative bubbles?” Is there even a word for the concept?

The 2000 bubble seems about half way between 1929 and 1987, there were some fundamentals involved, and traders certainly were looking at firms where there was great uncertainty (unlike say GM or Ford in the 1950s and 1960s.) But even so, in retrospect the valuations look far to high at the peak. Once again, however, a cautionary note for the anti-EMH crowd. Didn’t Robert Schiller mention the famous “irrational exuberance” phrase to Greenspan in 1996, before the stock bubble occurred? If so, this shows how hard it is to offer useful investment advice, even if you sense the market is overvalued. Those that exited in 1996 would have missed both the peak and subsequent crash. I also recall reading that Galbraith predicted a crash in January 1987, far too early to help stock investors.

It is widely assumed that the 2006 housing bubble was irrational, and perhaps in part it was. But again, let’s not get too overconfident. In fact irrational overconfidence—the same psychological trait that may generate bubbles, also generates an excessive level of confidence that we can spot bubbles. We all tend to remember when we make a correct prediction, or even have a correct hunch. But how often do we remember our failures? And if we forget the failures, do we grossly overestimate our batting average?

How many remember frequent predictions of bubbles, that turned out not to be bubbles? I have already argued that even today we don’t know for sure that stocks were overvalued in 1929, 1987, or 1996. There are respectable models that show they were fairly priced. (The 2000 NASDAQ is different.) How many people recall all the predictions of coastal housing bubbles during the long divergence after 1980, when an enormous gap gradually developed between housing prices in Middle America, and housing prices in LA/SF/NYC/Boston? Guess what, those bubble predictions were wrong. The housing price gap never really closed. Of course in any rapidly rising markets there are some pullbacks, and when these pullbacks occurred, the EMH opponents crowed “I told you so” about the ridiculous prices in coastal markets. But each new cycle the gap got wider, and in the long run the pessimists were wrong, even this crash hasn’t significantly narrowed the gap.

The housing bubble in 2004-2006 was partly driven by rapid immigration from Latin America (as was the bubble in Spain itself!), and also by a perception (which turned out false) that coastal zoning constraints were spreading into interior markets. Many Hispanic immigrants were snapping up older ranch houses, allowing native born Americans to move on to bigger McMansions. The immigration crackdown in 2007 dramatically slowed this immigration (as did the worsening economy.) Population growth estimates going several years forward fell sharply, hurting housing speculators. Ground zero of the sub-prime bust is in working class areas of the Southwest and Florida. Any guess as to who bought homes in those areas? In addition, after 2006 nominal GDP growth slowed gradually, and then very sharply, to a rate far below the level any rational investor could have anticipated in 2006. Even today, few people seem to realize the impact that going from plus 6.5% to negative 6.5% nominal growth has on housing prices. This didn’t trigger the collapse, but it dramatically deepened it.

I am certainly not arguing that fundamentals can fully explain the sub-prime crisis. There may have been some irrationality, especially in interior southwestern markets where land was still fairly plentiful. I’m sure that lots of explanations that have been offered (such as the Black Swan problem) have some merit. Consider this, however, if investors are foolish to ignore the risk of Black Swan events, why should we trust prob. values in anomaly studies?

More importantly, even if the anti-EMH position seems correct in a few cases, I will argue that it does not have the policy implications that many assume. So let’s ask ourselves this question; what are the policy implications of the anti-EMH position? And is there any evidence in the famous anomalies to support these policy implications?

It seems to me that there are two basic policy implications of the anti-EMH position, investors can do better than indexed stock funds, and regulators should prevent market bubbles that are likely to be disruptive to the broader economy. And I see zero evidence to support either of these policies, even if one accepts the view that many recent market anomalies cannot be explained by fundamentals. Let’s start with the easy case—managed stock funds.

EMH opponents argue that asset price movements are somewhat predictable, due to various market anomalies. We have a highly competitive investment industry made up of some of the smartest people from the best universities who are working day and night to outsmart markets. And many of them do. The problem is that they are not successful enough to push me away from indexed funds. A few managed funds will do better than indexed funds, but (ex ante) we don’t know which ones. So I don’t think there are any investment opportunities (open to the general public, i.e. me), that can reliably beat indexed funds. And don’t tell me that mutual fund X or hedge fund Y did such and such. Ex post there are lots of investments that have done very well, but that information is of no value to investors unless excess returns are serially correlated, and I don’t believe they are.

The big public policy issue, of course, is not whether indexed funds are a good investment, but rather whether the sub-prime fiasco shows the need for tighter regulation. I am really surprised by how many people seem to simply assume that the recent crisis shows the need for better regulation. You already know some of my objections to this view—the pro-regulation position is usually based on the assumption that the housing crisis somehow caused the current recession. This is despite the fact that virtually every cutting edge macro text says that monetary policy determines NGDP growth. And yet the moment a crisis hits we get a sort of mass amnesia, and reputable economists are suddenly assuming that the rapidly falling NGDP is not a failure of central banks, but rather of commercial banks. As if it is suddenly the job of commercial bankers to manage monetary policy!

I know that nobody will buy this argument, so I should just give it up. But even if I am wrong, even if the commercial bankers are 100% to blame for the current recession, the sub-prime fiasco does not support the anti-EMH argument for tighter regulation. I don’t doubt that one can find some arguments for regulation (moral hazard, too big to fail, etc.), but what I do deny is that any of these arguments are related to market inefficiency, to the anti-EMH position.

One can look at the sub-prime fiasco from a theoretical perspective, or a empirical perspective, but what one cannot do is compare an ideal regulatory scheme to actual banking practices. No one doubts that we would be better off if we could go back in time and install a regulation banning sub-prime mortgages in 2004. But if we had that ability, the bankers would have also known what was coming, and would never had made the loans in the first place.

[I hope no one gives me the silly moralistic argument that the villains got off Scott-free, while innocent investors were left holding the bag. The villains are exactly the people who have lost $100s of billions of dollars, even after the bailouts. I know it is never that way in Hollywood movies, but real life is different. This never would have happened (even without regulation) if bankers could have seen into the future.]

So the anti-EMH argument for regulation must be based on the following; bankers are irrational and make lots of foolish loans. Regulators are rational and can see that these loans are too risky, and can protect bankers from hurting themselves. At a theoretical level this doesn’t even pass the laugh test. But what happened in practice? What position did the “regulators” take in this crisis? First we need to define “regulators,” who are much more than just the low-paid Federal bureaucrats that oversee the banking industry. Regulators are the watchmen, those who watch the watchmen, and those who watch those who watch the watchmen. In other words:

1. The President
2. Congress
3. The Fed
4. The media
5. Most academics
6. Nouriel Roubini

Guess how many of these institutions warned us about the sub-prime crisis. Now guess how many were encouraging banks to behave even more recklessly than they did. Unless we plan on making Roubini dictator of the world, there is zero evidence from the sub-prime crisis that simply giving regulators more power would have helped. And how do we know that even Roubini wasn’t just lucky, and might miss the next fiasco?

This is a good time to trot out my favorite philosopher, Richard Rorty. In a recent book he quoted an old pragmatist maxim; “that which has no practical implications, has no philosophical implications.” I would re-word that slightly for the current discussion:

That which as no practical implications; has no implications for economic theory.

Thus Rorty suggested that it was pointless to argue about whether something is an objective fact or a justified belief, as we have no access to an extra-human perspective, and thus can never resolve the debate. To take another example, imagine two people looking at Mt. Monadnock. One says “That’s a very small mountain.” The other says “No, that’s just a big hill.” Pointless debate, isn’t it? Now imagine two economists look at the tech bubble. One says “boy, those rational investors made a big mistake,” whereas the other says “no, the investors were irrational.” Another pointless debate.

The only aspect of the EMH/anti-EMH debate that is of any interest is the policy implications. Are there any practical implications to the anti-EMH position? I have no trouble looking at some of the bubbles we considered here and saying: “Boy, those investors sure seemed irrational.” But it doesn’t help, because unless the anti-EMH people can find some interesting policy implications (investment advice for me, or public policy advice that will sway my vote), I would just as soon toss the anti-EMH theory away. I have found the EMH to be very useful in all sorts of ways mentioned in previous posts. The anti-EMH position? Not so much.

(To forestall some objections based on a misunderstanding of my argument, let me reiterate that I am not saying the sub-prime crisis does not point to the need for tighter regulation, I am saying that any regulation that comes out of this crisis would have to be justified on grounds other than market inefficiency, unless you can convince me that future regulators will be able to predict markets better than future financiers.)"

Me:

1. Don the libertarian Democrat
   22. March 2009 at 08:43

   I want to throw some philosophy into the discussion, and, to do so, I’m going to rough the edges up a bit to keep from writing a treatise. Although I agree with Rorty about theories/positions being more or less useful/practical, I approach the world from a different position.

   If your read Rorty, you will notice that he spends a lot of time talking about Dewey, Quine, Sellars, Ryle, Davidson, and Dennett. In my mind, all these philosophers are behaviorists. As Rorty says:

   http://plato.stanford.edu/entries/rorty/

   Rorty provides this view with a label: “Explaining rationality and epistemic authority by reference to what society lets us say, rather than the latter by the former, is the essence of what I shall call ‘epistemological behaviorism,’ an attitude common to Dewey and Wittgenstein.” (PMN 174)

   To me, “Word And Object” was the best place to see this expounded. Now, in economics, there seems to be a problem differentiating causal explanation from correlative explanation. I think that’s because, to the behaviorist, there’s no difference. There are simply correlations of behavior. Consequently, when tax cuts were passed last year, and didn’t work out as expected, behaviorists are stuck. The results are the results. That doesn’t mean that they don’t offer other explanations, but they offer non-behaviorist ones and fudge the issue a lot. This explains their fascination with biology, especially Darwin, and avoidance of math and physics. The latter two are a barrage of anomalies for the behaviorist. I would argue that confirmation bias is also a major problem for behaviorists.

   Is this a fair assessment? Probably not. I’m trying to be succinct, and I have a different view. But as I told Nick Rowe, behaviorism does seem to be the philosophy underlying much of modern economics. Anyway, since I approach economics through philosophy, but one centered on intentionality, I would be interested in how economists view their theories philosophically, if they do.

"Anything that purports to describe the last 18 months as 'efficient' seems like a cruel joke,"

TO BE NOTED: From Market Watch:

MARKET SNAPSHOT

Market meltdown refutes 'efficient markets' theory

Factors behind the market's undoing were clear to many, says analyst

By Kate Gibson, MarketWatch

Last update: 4:28 p.m. EDT March 18, 2009

NEW YORK (MarketWatch) -- The stock market's recent collapse calls into question the soundness of one cornerstone of modern financial theory -- the idea of "efficient markets" -- since all the components that conspired to produce the mess were in plain sight, contends one analyst.

"Anything that purports to describe the last 18 months as 'efficient' seems like a cruel joke," said Nicolas Colas, chief market strategist at BNY ConvergEx Group.

The premise behind the term holds that available information about a given security is quickly baked into its price, yet Colas says in the latest market decline, stock prices ignored the news until the situation threatened the likes of a Lehman Brothers.

"All the factors that created the market's collapse were hiding in plain sight in brokerage firm 10-K filings and news reports about the housing and mortgage markets. Hundreds, if not thousands, of individuals knew the risks in the collateralized debt obligations and credit default swaps marketplaces. Many of them even work in one place -- New York City," said Colas.

"We suspect the academic community will have a hard time explaining away the destruction of half of the value of the U.S. stock market in a little over a year after it took 70 years to create much of that same wealth," the analyst said.

The recent market collapse also discredits the common wisdom of near-certain returns if one holds stocks for five to 10 years.

"That's another one we can throw out the window, but you can flip the coin, if you've made your 10% for 10 years, then get out," said Colas.

Colas also rejects the notion of using math as an investment edge, saying those who believe they can call on market bottom based on S&P 500 earnings estimates and "some notion of a 'normal' P/E" should reconsider. "The reason the market bottomed is not because we hit some magical P/E ratio," the analyst said.

Instead, Colas advises trying to devise a more complete picture of where corporate valuations may end their fall, looking at current economic and business fundaments to help determine what fundamental scenario might develop as the recession wanes.

"What I've tried to say is don't baseline your expectations on the notion that markets are as efficient as the academic world wants to believe, think for yourself," said Colas.

On Wednesday, stock restarted the prior session's rally after the Federal Reserve surprised the market by saying it would buy $300 billion in longer-term Treasurys to help the ailing economy. Read The Fed.

"The logical implication is that a mixed economy will outperform both central planning and laissez faire"

John Quiggin reminds me of Jimi Hendrix pronouncing Surfer Music dead:

"Refuted economic doctrines #1: The efficient markets hypothesis

By jquiggin | January 2, 2009

I’m starting my long-promised series of posts on economic doctrines and policy proposals that have been refuted or rendered obsolete by the financial crisis. There will be a bit of repetition of material I’ve already posted and I’ll probably edit the posts in response to points raised in discussion.

Number One on the list is a topic I’ve covered plenty of times before (in fact, I was writing about it fifteen years ago), the efficient (financial) markets hypothesis. It’s going first because it is really the central microeconomic issue in a wide range of policy debates that will (I hope) be covered later in this series. Broadly speaking, the efficient markets hypothesis says that the prices generated by financial markets represent the best possible estimate of the values of the underlying assets."

Here's where I stand. I propound a form of Behavioral Finance:

(((((("Criticism and behavioral finance

Price-Earnings ratios as a predictor of twenty-year returns based upon the plot by Robert Shiller (Figure 10.1,^[11] source). The horizontal axis shows the real price-earnings ratio of the S&P Composite Stock Price Index as computed in Irrational Exuberance (inflation adjusted price divided by the prior ten-year mean of inflation-adjusted earnings). The vertical axis shows the geometric average real annual return on investing in the S&P Composite Stock Price Index, reinvesting dividends, and selling twenty years later. Data from different twenty year periods is color-coded as shown in the key. See also ten-year returns. Shiller states that this plot "confirms that long-term investors—investors who commit their money to an investment for ten full years—did do well when prices were low relative to earnings at the beginning of the ten years. Long-term investors would be well advised, individually, to lower their exposure to the stock market when it is high, as it has been recently, and get into the market when it is low."^[11] This correlation between price to earnings ratios and long-term returns is not explained by the efficient-market hypothesis.

Investors and researchers have disputed the efficient markets hypothesis empirically and theoretically. Behavioral economists attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidence, overreaction, representative bias, information bias, an inability to use configural rather linear reasoning, and various other predictable human errors in reasoning and information processing. These have been researched by psychologists such as Daniel Kahneman, Amos Tversky, Richard Thaler, and Paul Slovic. These errors in reasoning lead most investors to avoid high-value stocks and buy growth stocks at expensive prices, which allow those who reason correctly to profit from bargains in neglected value stocks and the overreacted selling of growth stocks.

Empirical evidence has been mixed, but has generally not supported strong forms of the efficient markets hypothesis^{[3] [2]} low P/E stocks have greater returns. In this paper he also refuted the assertion by Ray Ball that these higher returns could be attributed to higher beta,^[12] whose research had been accepted by efficient market theorists as explaining the anomaly^[13]:151 in neat accordance with modern portfolio theory.

Speculative economic bubbles are an obvious anomaly, in that the market often appears to be driven by buyers operating on irrational exuberance, who take little notice of underlying value. These bubbles are typically followed by an overreaction of frantic selling, allowing shrewd investors to buy stocks at bargain prices. Rational investors have difficulty profiting by shorting irrational bubbles because, as John Maynard Keynes commented, "Markets can remain irrational longer than you can remain solvent." Sudden market crashes as happened on Black Monday in 1987 are mysterious from the perspective of efficient markets.

Another anomaly exists in the form of the investors who beat the market soundly on a long-term basis, including Peter Lynch, Warren Buffett, George Soros, and John Templeton. Warren Buffett has commented that "I'd be a bum on the street with a tin cup if the markets were always efficient".

Burton Malkiel, a well-known proponent of the general validity of EMH, has warned that certain emerging markets such as China are not empirically efficient; that the Shanghai and Shenzhen markets, unlike markets in United States, exhibit considerable serial correlation (price trends), non-random walk, and evidence of manipulation.^[14]

Behavioral psychology approaches to stock market trading are among some of the more promising alternatives to EMH (and some investment strategies seek to exploit exactly such inefficiencies). But Nobel Laureate co-founder of the programme—Daniel Kahneman—announced his skepticism of investors beating the market: "They're [investors] just not going to do it [beat the market]. It's just not going to happen."^[15] Richard Thaler has started a fund based on his research on cognitive biases. In a 2008 report he identified complexity and the herd behavior as central to the global financial crisis of 2008.^[16]"))))))

Back to Quiggan:

"The hypothesis comes in three forms.

The weak version (which stands up well, though not perfectly, to empirical testing) says that it is impossible to predict future movements in asset prices on the basis of past movements, in the manner supposedly done by sharemarket chartists. While most of what is described by chartists as ‘technical analysis’ is mere mumbo-jumbo, there is some evidence of longer-term reversion to mean values that may violate the weak form of the EMH.

The strong version, which gained some credence during the financial bubble era says that asset prices represent the best possible estimate taking account of all information, both public and private. It was this claim that lay behind the proposal for ‘terrorism futures’ put forward, and quickly abandoned a couple of years ago. It seems unlikely that strong-form EMH is going to be taken seriously in the foreseeable future, given the magnitude of asset pricing failures revealed by the crisis.

For most policy issues, the important issue is the “semi-strong” version which says that asset prices are at least as good as any estimate that can be made on the basis of publicly available information. It follows, in the absence of distorting taxes or other market failures that the best way to allocate scarce capital and other resources is to seek to maximise the market value of the associated assets. Another way of presenting the semi-strong EMH is to say whether or not markets are perfectly efficient, they’re better than any other possible capital allocation method, or at least, better than any practically feasible alternative."

Here's a similar list and explanation:

(((((("There are three common forms in which the efficient-market hypothesis is commonly stated — weak-form efficiency, semi-strong-form efficiency and strong-form efficiency, each of which have different implications for how markets work.

[edit] Weak-form efficiency

• Excess returns cannot be earned by using investment strategies based on historical share prices.
• Technical analysis techniques will not be able to consistently produce excess returns, though some forms of fundamental analysis may still provide excess returns.
• Share prices exhibit no serial dependencies, meaning that there are no "patterns" to asset prices. This implies that future price movements are determined entirely by information not contained in the price series. Hence, prices must follow a random walk.

[edit] Semi-strong-form efficiency

• Semi-strong-form efficiency implies that share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on that information.
• Semi-strong-form efficiency implies that neither fundamental analysis nor technical analysis techniques will be able to reliably produce excess returns.
• To test for semi-strong-form efficiency, the adjustments to previously unknown news must be of a reasonable size and must be instantaneous. To test for this, consistent upward or downward adjustments after the initial change must be looked for. If there are any such adjustments it would suggest that investors had interpreted the information in a biased fashion and hence in an inefficient manner.

[edit] Strong-form efficiency

• Share prices reflect all information, public and private, and no one can earn excess returns.
• If there are legal barriers to private information becoming public, as with insider trading laws, strong-form efficiency is impossible, except in the case where the laws are universally ignored.
• To test for strong-form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time. Even if some money managers are consistently observed to beat the market, no refutation even of strong-form efficiency follows: with hundreds of thousands of fund managers worldwide, even a normal distribution of returns (as efficiency predicts) should be expected to produce a few dozen "star" performers."))))))

Back to Quiggan:

"In fact, they are in the nature of swindles. "

Skidelsky on the New Straits Times:

"ECONOMICS, it seems, has very little to tell us about the current economic crisis( TRUE ). Indeed, no less a figure than former United States Federal Reserve chairman Alan Greenspan recently confessed that his entire "intellectual edifice" had been "demolished" by recent events. Scratch around the rubble, however, and one can come up with useful fragments. One of them is called "asymmetric information".

This means that some people know more about some things than other people. Not a very startling insight, perhaps. But apply it to buyers and sellers. Suppose the seller of a product knows more about its quality than the buyer does, or vice-versa. Interesting things happen -- so interesting that the inventors of this idea received Nobel Prizes in economics.

In 1970, George Akerlof published a famous paper called The Market for Lemons. His main example was a used-car market. The buyer doesn't know whether what is being offered is a good car or a "lemon". His best guess is that it is a car of average quality, for which he will pay only the average price.

Because the owner won't be able to get a good price for a good car, he won't place good cars on the market. So the average quality of used cars offered for sale will go down. The lemons squeeze out the oranges.

Another well-known example concerns insurance. This time it is the buyer who knows more than the seller, since the buyer knows his risk behaviour, physical health and so on.

The insurer faces "adverse selection", because he cannot distinguish between good and bad risks. He, therefore, sets an average premium too high for healthy contributors and too low for unhealthy ones. This will drive out the healthy contributors, saddling the insurer with a portfolio of bad risks -- the quick road to bankruptcy.

There are various ways to equalise the information available -- for example, warranties for used cars and medical certificates for insurance. But, since these devices cost money, asymmetric information always leads to worse results than would otherwise occur.

All of this is relevant to financial markets because the "efficient market hypothesis" -- the dominant paradigm in finance -- assumes that everyone has perfect information and, therefore, that all prices express the real value of goods for sale( IT'S A MODEL ).

But any finance professional will tell you that some know more than others, and they earn more, too. Information is king. But just as in used-car and insurance markets, asymmetric information in finance leads to trouble.

A typical "adverse selection" problem arises when banks can't tell the difference between a good and bad investment -- a situation analogous to the insurance market.

The borrower knows the risk is high, but tells the lender it is low( THIS IS FRAUD ). The lender who can't judge the risk goes for investments that promise higher yields. This particular model predicts that banks will over-invest in high-risk, high-yield projects, i.e. asymmetric information lets toxic loans onto the credit market.

Other models use principal/agent behaviour to explain "momentum" (herd behaviour) in financial markets.

Although designed before the current crisis, these models seem to fit current observations rather well: banks lending to entrepreneurs who could never repay, and asset prices changing even if there were no changes in conditions.

But a moment's thought will show why these models cannot explain today's general crisis. They rely on someone getting the better of someone else: the better informed gain, at least in the short-term, at the expense of the worse informed. In fact, they are in the nature of swindles( THAT'S EXACTLY WHAT THEY ARE ). So these models cannot explain a situation in which everyone, or almost everyone, is losing -- or, for that matter, winning -- at the same time.

The theorists of asymmetric information occupy a deviant branch of mainstream economics. They agree with the mainstream that there is perfect information available somewhere out there, including perfect knowledge about how the different parts of the economy fit together.

They differ only in believing that not everyone possesses it. In Akerlof's example, the problem with selling a used car at an efficient price is not that no one knows how likely it is to break down, but rather that the seller knows well how likely it is to break down, and the buyer does not( FRAUD ).

And yet the true problem is that, in the real world, no one is perfectly informed. Those who have better information try to deceive those who have worse( FRAUD ); but they are deceiving themselves that they know more than they do.

If only one person were perfectly informed, there could never be a crisis -- someone would always make the right calls at the right time.

But only God is perfectly informed, and He does not play the stock market.

"The outstanding fact," John Maynard Keynes wrote in his General Theory of Employment, Interest and Money, "is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made." ( TRUE )

There is no perfect knowledge "out there" about the correct value of assets, because there is no way we can tell what the future will be like( TRUE )

Rather than dealing with asymmetric information, we are dealing with different degrees of no information. Herd behaviour arises, Keynes thought, not from attempts to deceive, but from the fact that, in the face of the unknown, we seek safety( THAT'S THE MAIN POINT. SAFETY ) in numbers. Economics, in other words, must start from the premise of imperfect rather than perfect knowledge. It may then get nearer to explaining why we are where we are today. "

I'm wondering why he assumes that there are no laws concerning business transactions?

"Keynes’s prescriptions were guided by his conception of money, which plays a disturbing role in his economics."

Robert Skidelsky on Keynes again in the NY Times:

"Among the most astonishing statements to be made by any policymaker in recent years was Alan Greenspan’s admission this autumn that the regime of deregulation he oversaw as chairman of the Federal Reserve was based on a “flaw”: he had overestimated the ability of a free market to self-correct and had missed the self-destructive power of deregulated mortgage lending. The “whole intellectual edifice,” he said, “collapsed in the summer of last year.”

I have to admit that it is astonishing.

"What was this “intellectual edifice”? As so often with policymakers, you need to tease out their beliefs from their policies. Greenspan must have believed something like the “efficient-market hypothesis,” which holds that financial markets always price assets correctly. Given that markets are efficient, they would need only the lightest regulation. Government officials who control the money supply have only one task — to keep prices roughly stable."

It is very important to understand, or tease out, beliefs from policies. For me, this is the difference between Politics and Political Theory and Political Economy and Economics. I don't believe markets are efficient. I do believe that the Fed's main function is to keep prices roughly stable, with a bias towards slight inflation.

"I don’t suppose that Greenspan actually bought this story literally, since experience of repeated financial crises too obviously contradicted it. It was, after all, only a model. But he must have believed something sufficiently like it to have supported extensive financial deregulation and to have kept interest rates low in the period when the housing bubble was growing. This was the intellectual edifice, of both theory and policy, which has just been blown sky high. As George Soros rightly pointed out, “The salient feature of the current financial crisis is that it was not caused by some external shock like OPEC raising the price of oil. . . . The crisis was generated by the financial system itself.”

This is not very clear. I don't see a lot of explanatory power here. Is the decline in housing prices like the price of oil? Is the tsunami of foreclosures like OPEC or is it part of the financial system itself? I also don't credit the power of low interests rates as the most important cause of the current crisis. Deregulation might have had a part in this drama as well, but I need a little more explanation of what that part entails.

"This is where the great economist John Maynard Keynes (1883-1946) comes in. Today, Keynes is justly enjoying a comeback. For the same “intellectual edifice” that Greenspan said has now collapsed was what supported the laissez-faire policies Keynes quarreled with in his times. Then, as now, economists believed that all uncertainty could be reduced to measurable risk. So asset prices always reflected fundamentals, and unregulated markets would in general be very stable."

So Laissez-Faire Policies entail believing that:
1) All uncertainty can be reduced to measurable risk ( Don't agree )
2) Asset prices always reflect fundamentals ( Don't agree. This involves perception and interpretation )
3) Unregulated markets are generally stable ( We don't have an unregulated market. I could say something banal and pronounce that well-regulated markets are stable. I guess that I just did, for all the lack of specificity and essentially tautological reasoning good it does me )

What's with the focus on Greenspan? Is this going to all be about Central Banks?

"By contrast, Keynes created an economics whose starting point was that not all future events could be reduced to measurable risk. There was a residue of genuine uncertainty, and this made disaster an ever-present possibility, not a once-in-a-lifetime “shock.” Investment was more an act of faith than a scientific calculation of probabilities. And in this fact lay the possibility of huge systemic mistakes."

I agree with Keynes here. Strangely, I thought that Hayek agreed with this.

"The basic question Keynes asked was: How do rational people behave under conditions of uncertainty? The answer he gave was profound and extends far beyond economics. People fall back on “conventions,” which give them the assurance that they are doing the right thing. The chief of these are the assumptions that the future will be like the past (witness all the financial models that assumed housing prices wouldn’t fall) and that current prices correctly sum up “future prospects.” Above all, we run with the crowd. A master of aphorism, Keynes wrote that a “sound banker” is one who, “when he is ruined, is ruined in a conventional and orthodox way.” (Today, you might add a further convention — the belief that mathematics can conjure certainty out of uncertainty.)"

I should say that I'm a big fan of his writing style, which favorably disposes me to him. I would say:
1) People fall back on Narratives
2) That the future follows from the past must in some sense be true, since day follows from night. I thought that Keynes believed that it was very hard to predict the future in various situations, not all situations. In other words, some events are easier to predict than others.
3) I would say that we are part of a society. Run with the crowd is too Mechanistic for my taste.
4) Math cannot conjure certainty from uncertainty, if I understand what he means.

"But any view of the future based on what Keynes called “so flimsy a foundation” is liable to “sudden and violent changes” when the news changes. Investors do not process new information efficiently because they don’t know which information is relevant. Conventional behavior easily turns into herd behavior. Financial markets are punctuated by alternating currents of euphoria and panic."

This all adds up to people aren't omniscient. I don't think that all markets are euphoric then panicked, then euphoric and then panicked, and I certainly don't believe that this is inevitable. If I did, then that would go a long way towards predicting it.

"Keynes’s prescriptions were guided by his conception of money, which plays a disturbing role in his economics. Most economists have seen money simply as a means of payment, an improvement on barter. Keynes emphasized its role as a “store of value.” Why, he asked, should anyone outside a lunatic asylum wish to “hold” money? The answer he gave was that “holding” money was a way of postponing transactions. The “desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future. . . . The possession of actual money lulls our disquietude; and the premium we require to make us part with money is a measure of the degree of our disquietude.” The same reliance on “conventional” thinking that leads investors to spend profligately at certain times leads them to be highly cautious at others. Even a relatively weak dollar may, at moments of high uncertainty, seem more “secure” than any other asset, as we are currently seeing."

I'm a bit disturbed by this paragraph. I save money in order to have it in case I need it in the future for some unseen event. I find living in general disquieting, money much less so.

"It is this flight into cash that makes interest-rate policy such an uncertain agent of recovery. If the managers of banks and companies hold pessimistic views about the future, they will raise the price they charge for “giving up liquidity,” even though the central bank might be flooding the economy with cash. That is why Keynes did not think that cutting the central bank’s interest rate would necessarily — and certainly not quickly — lower the interest rates charged on different types of loans. This was his main argument for the use of government stimulus to fight a depression. There was only one sure way to get an increase in spending in the face of an extreme private-sector reluctance to spend, and that was for the government to spend the money itself. Spend on pyramids, spend on hospitals, but spend it must."

I call this a fear and aversion to risk and the accompanying flight to safety. I get the point, which is why I believe that a stimulus is worth a shot, after trying lowering interest rates. Is this supposed to be controversial?

"This, in a nutshell, was Keynes’s economics. His purpose, as he saw it, was not to destroy capitalism but to save it from itself. He thought that the work of rescue had to start with economic theory itself. Now that Greenspan’s intellectual edifice has collapsed, the moment has come to build a new structure on the foundations that Keynes laid."

That's basically my purpose. I believe that theories are of limited value, even Keynes' theories. I must not be in Greenspan's camp since I don't find any of this puzzling. As for Keynes, as I've said before, his theories will, in fact, end up being of limited worth as to specifics. We are looking to Keynes as a part of our Narrative that helps us deal with the present. It happens that the policies we're throwing at this crisis resemble Keynes enough that we are conjuring up his ghost to help us deal with it. That's fine. That's how we deal with crises. But we are essentially embarked on a trial and error ride that is more pragmatic than ideological, which is how it should be. It seems to me that what I've just stated is very Keynsian, if by that cognomen is meant one who uses what's truly valuable in Keynes' thought.