Only that which is rational is real
CNBC reports
Greenspan … added that the financial crisis could not have been foreseen.
“It is just not feasible to forecast a financial crisis,” he said. “A financial crisis by definition is a sharp abrupt, unexpected decline in asset prices.”
Notice that he says if it is unexpected, then it *can’t* be forecast. That is if the risk bearing capacity weighted average investor doesn’t forecast something then it isn’t forecastable. Greenspan is asserting that financial markets are efficient by definition. He displays no willingness to allow data or evidence any role in answering the question.
Only that which is rational is real. The key policy relevant question is answered by definition, that is, by authority. Efficient is whatever markets are, and also what they should be, therefore markets are what they should be – by definition.
This is dogma, this is faith, this is medieval thinking. Galileo lived in vain. The enlightenment arrived in the Fed when Bernanke replaced Greenspan.
via Atrios. More ranting after the jump.
Also “Former Federal Reserve Chairman Alan Greenspan said that the recent stock market decline is “typical” of a recovery,” If a decline is typical then it is forecastable. If a decline is typical during a recovery, then financial markets are inefficient. I see no basis for the claim (which, I amdit, was constructed with only one actually quoted word).
Note how the efficient markets hypothesis is switched on and off for convenience. Something which could have been prevented with tighter regulation must have been unpredictable. Something which might or might not alarm people was predictable and isn’t news. I am fairly sure that no one believes that financial markets are efficient. It is just a debating trick. It can be assumed at will in order to make absurd arguments. It is absurd and has high status, for some reason, so it is a license to make clearly false claims which are not dismissed.
If markets were not efficient then the profit margin on arbitrage would large. But its not large.
If Market were not efficient you could achieve returns in excess of average market returns on a risk adjusted basis given the available public information. But again, you can’t do this (and if you could I wonder why you would be reading this).
Where is the evidence of market inefficiency? I think its all in the minds of people that don’t know the definitions and/or do analysis poorly.
The way to make money by correctly predicting a downturn is to short. The brokerage houses write the rules on shorting, and, during a bubble, they make sure those rules make you bankrupt before you make a killing. Because if shorting were easy money, too many people would do it, and they couldn’t make as much money by inflating and bursting a really big bubble.
The evidence of market efficiency is and has been for decades that stocks with low price earnings ratios earn higher beta adjusted returns that stocks with high price earnings ratios. This anomaly is as old as the CAPM. The first result was that average returns on such stocks were higher. This was not with beta adjustment, because the concept of market beta had not been introduced.
Similarly high Q stocks have lower beta adjusted returns than low Q stocks.
I am not attempting to profit from these market inefficiencies, because I don’t have much money to invest, am not much interested in money and am very very lazy.
I think you will find evidence that I understand the concept of an Efficient Market if you search for authors of articles in The Journal of Finance. If you did that rather than simply asserting that I don’t know the definition or do analysis poorly, you might not make a total fool of yourself.
Oh and also the Journal of Political Economy which is known to have a strong liberal bias.
You are making two elementary errors. First, if markets were efficient then the appropriately risk adjusted gain from any attempt to beat the market would be zero. Not small zero. Large enough to interest you is not an analytic category.
More importantly you are not thinking about the difference between levels and differences. Returns are close to those which would obtain under efficient markets do not imply asset prices close to those under efficient markets. Often an asset price matters, not just the return on that asset (notably many houses were constructed because the price was high — if this high price was due to irrationality, then this would be a costly distortion of decisions even if the return on housing was close to what it should be). I assure you my assertion is simple math. I checked that simple math over 20 years ago when I proof read a manuscript published in a top journal.
You haven’t kept up with the literature. You are making claims along the lines of 2+2=5, that is, your comment is a mathematical error. I repeat, my claims are summaries of papers published in top mainstream economics journals. The author of the paper was Larry Summers, although Robert Shiller made the same point.
Now note I said I didn’t believe that anyone believes in the efficient market hypothesis. It has strong implications. Many commenters here who think they believe in the efficient markets hypothesis perceive those implications to be absurd claims. Behavior which would not be optimal if the efficient markets hypothesis were true is not considered odd at all, because it is universal, because no one believes the hypothesis enough to work out its implications and invest accordingly. I don’t know you, but I wouldn’t be surprised if I could get you to agree with a claim inconsistent with the EMH (which to me is obviously inconsistent). If not, then I would have to update my post to note that there is someone who really believes in it.
Easy is not the same as possible and the EMH requires it to be impossible. Also it need not be possible to make a killing — just a higher appropriately risk adjusgted return.
The statement that the efficient markets hypothesis is not so very far from the truth that I should devote my life to trying to beat the market is not the same as the statement that it is true. It doesn’t even imply that it is close enough to true that, as a citizen, I should support regulations which would be optimal if it were true. How close is close enough depends on the question.
For another example, the EMH might be close enough to true that an individual investor should just buy and hold the market, but far enough from the truth that a broker dealer should try to beat the market.
In reading More Money than God, its obvious that parts of the market are not efficient, and some bright person discovers this, makes a killing until everyone jumps onto that technique, at which point the market niche becomes barely profitable and the niche has become efficient. It is precisely this discovery that is financial innovation.
So the big issue may be on what time constant the market is efficient. It clearly is not on a short time frame or innovators would not make their killings, but may well be on a multi year basis as distortions are adjusted away. (Now if you could patent business practices, then markets could remanin inefficient for a long time as the inventor reaps the inefficiency)
That is also being tried..patents on business methods. See Supreme Court posts.
If EMH is true how is it possible that Goldman had a perfect quarter (all trading days profitable)? If EMH is true why to the big banks have trading desks and trade the firms’ money at all? How is it possible for them to make billions of dollars trading the firm’s account?
Either the efficient market hypothesis is false, or our financial markets are not efficient. I took a few economics classes along with a few physics classes while in college 20 years ago, and when we were taught the efficient market theory, it sounded a lot like a physics problem that begins, “Assume a frictionless surface.” It’s an abstraction, a thought experiment in a simplified world that allows certain concepts to be taught and understood more easily. But no physicist would project that simplified, perfect, IMAGINARY environment onto the real world.
I’m sorry, but if a theory demands perfection, it’s wrong.
Robert,
Again you seem pretty sure of yourself for someone commenting outside of his speciality. And you don’t have any convincing scientific evidence and you don’t have a pile of money to prove your conjectures are correct. Here is Fama again.
http://www.newyorker.com/online/blogs/johncassidy/2010/01/interview-with-eugene-fama.html
Back to the efficient markets hypothesis. You said earlier that it comes out of this episode pretty well. Others say the market may be good at pricing in a relative sense—one stock versus another—but it is very bad at setting absolute prices, the level of the market as a whole. What do you say to that?
People say that. I don’t know what the basis of it is. If they know, they should be rich men. What better way to make money than to know exactly about the absolute level of prices.
So you still think that the market is highly efficient at the overall level too?
Yes. And if it isn’t, it’s going to be impossible to tell.
For the layman, people who don’t know much about economic theory, is that the fundamental insight of the efficient market hypothesis—that you can’t beat the market?
Right—that’s the practical insight. No matter what research gets done, that one always looks good.
What about the findings that long periods of high returns are followed by long periods of low returns?
Now, there is no evidence of that…The expected return on stocks is just a price—the price people require to bear the market risk. Like any price, it should vary from time to time, and maybe it should vary in predictable ways. I’ve done a lot of work purporting to show there’s a little bit of predictability in overall market returns, but that branch of the literature has so many statistical problems there’s not a lot of agreement.
The problem is that, almost surely, expected returns vary through time because of risk aversion—wealth, everything else varies through time. But measuring that requires that you have a good variable for tracking (risk aversion) or good models for tracking it. We don’t have that. The way that people do it, including me, is by using kind of ad hoc variables to pick it up. All the argument centers on whether what’s picked up by these variables is really what’s there, or whether it is just kind of a statistical fluke. There’s a whole issue of the Review of Financial Studies with people arguing very vociferously on both sides of that. When that happens, you know that none of the results are very reliable