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
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.)