A few comments on the EMH

Two arguments are commonly made against the EMH:

1.  It is obviously wrong

2.  Statistical studies have refuted it

1.  Let’s start with the first point.  People say that the housing market was obviously a bubble.  When I point out that if it so easy to see when markets are overextended, then it should be easy to beat the market (if you can wait it out, and have enough capital.)  People say “But Warren Buffett does that, and he does beat the market.”  Here is Warren Buffett on the housing bubble:

The billionaire said Moody’s erred by rating so many mortgage-related bonds as triple-A, though 300 million other Americans also made the same mistake. “Look at me. I was wrong on it too,” Mr. Buffett said.

Inflated real-estate values turned out to be a “four-star bubble,” not a “bubble-ette,” as Mr. Buffett previously concluded.

Of course a huge negative shock to NGDP can easily turn a bubble-ette into a 4 star bubble, so I’m willing to cut Mr. Buffett some slack.  BTW, I suppose Buffett does deserve credit for predicting the bubble-ette, my point is that it was almost impossible to predict the massive housing bust, and I still think that those who did just got lucky.

Part 2.  Poor, poor pitiful Protestants

I grew up in a Protestant family, but until now had never realized that this group is an underprivileged minority group, er, I mean underprivileged majority group.  Over 51% of Americans are Protestants, and yet not one Supreme Court member is Protestant.  I believe that the odds of that happening randomly are less than 2 in 1000.

Now I suppose some of you will try to convince me that it’s just a coincidence.  But you can’t fool me; I studied “statistical significance” in college.  I know a statistically significant finding when I see one.  It would be like arguing that all those “market anomaly” studies are wrong, because they rely on tests of statistical significance.

If you are especially clever you might say I have the wrong sample.  What matters is not the Protestant share of the total population, but rather their share of the grads from elite colleges, from which we choose our Supreme Court justices.  And only 25% of students at Ivy League schools are Protestant.  Here’s my response to that: “Oh yeah, well that just shows that the Ivy League schools are also prejudiced against Protestants.”

If the average American WASP woke up in 1910 to find that 6 out of 9 Supreme Court justices were Catholic, they would have been terrified that Rome was in control of our Court.  And I can’t even imagine the reaction if you told them that the other three justices were Jewish.  But in 2010, only a few reactionaries like me have even noticed.  One hundred years from now people will be amazed to read in a history book that back in 2010 Christians, Jews, Hindus and Moslems didn’t get along in many parts of the world.  People who are told this will say; “Eh, what was that all about?”

(Note, whenever I post some nonsense like this, I feel obligated to quickly cover it up with something more substantive.  I look forward to reactions to my next post—which should be controversial.)


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32 Responses to “A few comments on the EMH”

  1. Gravatar of marcus nunes marcus nunes
    3. June 2010 at 19:04

    Funny that Justice Sotomayor doesn´t argue that the complete absence of protestants in the SC is an example of DISCRIMINATION. After all, in the case of the NJ white firemen that passed a promotion exam she voted for cancelling the exam result because not enough minority firemen passed.
    Maybe because the SC is now a wholy “minority” SC that´s ok.

  2. Gravatar of John Hall John Hall
    3. June 2010 at 20:26

    I think people get upset when you say that you can’t beat the market, but they forget the part where you say can’t beat the market (tending toward the obviously wrong part) over the long-term without taking on additional risks (pretty reasonable).

    The example about Buffett not predicting the housing boom is a little ridiculous to me. It’s one thing to deny that housing was in a bubble, but it was quite another to defend rating agencies who assumed housing prices would never fall (even though they did in the early 90s and 80s).

    One issue with the whole thing is that most portfolio managers are not judged on 3 or 4 factor alpha they generate. If you take on some other risk factors, such as low P/E or some sort of consistent growth measure, and adjust your portfolio while keeping your beta close to 1, then you have improved your returns relative to benchmark (which might actually be negatively exposed to some factor that actually is quite powerful). The finance professor might tell you that you just took some different risk (which is probably true), but you have still outperformed your benchmark.

    One interesting thing is the evidence of regime-switching in most asset markets. In one regime, there might be low volatility and strong returns and in another there might be high volatility and mixed returns. In different regimes you would want different asset allocations. If you can estimate the probability you are in one regime and estimate the transition probabilities to another regime, then you can get rough estimates of conditional returns and have dramatically different portfolios. In this case, you need not have a view on the specific returns, just a determination if you are in one regime or another (much easier to do). And since portfolio optimization is normally quite sensitive to changes in returns, this can make large impacts to asset allocation and substantially improve performance. (see Ang and Bakaert). In this way, you might say we are in a high return regime now, I will take advantage of it. When I am no longer confident we are in a high return regime, the conditional mean of returns will likely fall and I will probably reduce my allocation to this sector. I need not be able to predict the regime, nor even be able to predict returns. So far as I can tell, EMH is still satisfied since you can’t predict returns, but asset allocations might change substantially over time. However, if you earn better returns than the market, the finance professor would again say you have taken advantage of these regimes and if we include a regime change factor when we calculate your alpha, you no longer have alpha. And then I say, if I do anything to generate extra returns will you create a factor for it. If so, then the whole value of saying there’s no excess return is meaningless.

    So I come back to the EMH and I say factor models do a pretty good job of explaining returns. However, there are ways to take advantage of the difference between your benchmark’s factor exposure and the historical returns of a factor (though I don’t think factors that performed well in the past will necessarily perform well in the future). You probably take on additional risks along the way, but most managers will be measured based on performance relative to 1 benchmark or their peers and certainly not an 8 factor alpha.

  3. Gravatar of Jon Jon
    3. June 2010 at 21:44

    Agreed. What people don’t seem to get their heads around is

    1) that when the market errs in hindsight that error was not known with certainty by the public, and therefore could not have been corrected by a democratic government.

    2) when on individual exhibits a run of knowing better than average, the market rewards said person with more influence.

    3) even the titans of finance disagree.

  4. Gravatar of Jlonsdale Jlonsdale
    3. June 2010 at 22:51

    What proponents of EMH usually argue:

    1. Well, we couldn’t find a way to beat the market.
    2. These mutual funds aren’t beating the market.
    3. Individual investors underperformed the market.
    4. Anything that actually does beat the market is actually a separate risk factor (and now might be part of our model of the market)!

    Arguments #2 and #3 make very good points about how difficult it is to outperform a liquid index like the S&P 500. When a market is large and liquid most of the information is priced in. (I remember a study that suggested less liquid indices like the Russell 2000 are actually easier to outperform than the S&P 500, this is partially because a manager does not have to sell their winners when they become too big for the index.)

    Argument #1 is arguing from the researcher’s own ignorance, so it is more a proof of why they are not actively managing money than a proof of market efficiency.

    Argument #4 seems to be a way to just define away contrary evidence.

    Overall, it is difficult to make money in the market but that does not make the EMH true. The Adaptive Market Hypothesis, which admits these inefficiencies exist but looks at how they slowly get priced out of the market. Examples of inefficiencies include the convexity arbitrage between eurodollar and swaps that existed in the early 90’s, earnings surprise strategies and many other quant strategies whose returns have fallen somewhat monotonically over time as others have tried to apply the same strategies. The AMH seems more correct than the EMH, but has the disadvantage of reducing the allowable level of snarkyness from its proponents because it makes it harder to outright dismiss theories of a temporary inefficiency.

  5. Gravatar of Ted Ted
    4. June 2010 at 00:11

    I think you are setting up a straw man. I don’t know anyone who serious argues that the EMH is false in the housing market because of pricing anomalies. The objections usually come from the fact that quite a few studies have suggested that housing prices don’t follow a random walk, which immediately rules out the EMH.

    Although, interestingly, John Campbell has recently argued that the market is inefficient only if the home sale is “forced” due to foreclosures or other reasons and unforced sales are efficient. Thus, possibly, the forced sales are dragging down the estimates of a random walk and the market is efficient after all, but I caution that interpretation until further research, especially since Campbell’s sample only includes Massachusetts.

    But anyone, the point is that a lot of evidence suggests that the EMH doesn’t hold in the housing market because the random walk hypothesis doesn’t hold, which is why a lot of people suggest it’s not an efficient market. It’s not so much about pricing anomalies. I would be interested to see more research done in the vein of Campbell’s though.

  6. Gravatar of The Window Washer The Window Washer
    4. June 2010 at 01:09

    , my point is that it was almost impossible to predict the massive housing bust, and I still think that those who did just got lucky.

    Scott,
    You are so wrong there I want to make fun of your ivory tower. I’ve loved reading you for quite some time but I couldn’t let that pass and had to comment.
    I’m not a writer so it would take too long to explain here, but if you want to give me a call I’ll explain how I called the housing Bubble. Simple math did it. I was looking for products to short housing in 06 but you couldn’t get one unless you were a hedge fund. So yes there were working class people that saw the same thing, it was just the hedge boys that got to make 20x on a short.
    I couldn’t let that one pass. Feel free to contact me; I would be honored to teach you something I’ve learned a lot from you. Mostly how fun it is to drop a “I presume in nominal terms.” or some such thing into a volley of MBAspeak.
    Thanks.
    R

  7. Gravatar of The Window Washer The Window Washer
    4. June 2010 at 01:17

    Ted,

    John should look at the FHA statement on appraisals from last summer. They pointed out that the reason foreclosures could be left out in the past was because they were outliers. It was more of a liquidity issue due to a lack of opportunity for someone else buying at the same price due to supply. If he doubts this tell him to look at a Supreme Court ruling in the Cartwright case on Fair Market Value. I think it was in 72′
    R

  8. Gravatar of Filip Filip
    4. June 2010 at 01:28

    You did get your sample wrong, but not in the way you assume in your self-correction: SCOTUS justices NOW are not representative of the total population (or of the graduate population) but if you include all justices throughout the history of the Supreme Court – as you should do – you’ll get a more balanced picture. Anyway, I understand this wasn’t your main point.

  9. Gravatar of RobbL RobbL
    4. June 2010 at 02:45

    Scott,
    1. it is only polite to spell out an abbreviation the first time that you use it.

    2. It is not discrimination against protestants on the supreme court. It is right wing abortion politics.

  10. Gravatar of Jim Caserta Jim Caserta
    4. June 2010 at 02:58

    There were two assumptions of environment factors that drove any idea of the housing market being rationally priced:
    1. Low/no-doc, rev-am loans would continue to be available, as would large cash-out refi (these went towards a lot of down-payments in bubble areas)
    2. Those loans were based on securitizations that were predicated on continued home-price appreciation

    We have witnessed an explosion in the size and types of securitizations, with mortgage securitizations leading the way. We were on the March 22 call with Fitch regarding the sub-prime securitization market’s difficulties. In their talk, they were highly confident regarding their models and their ratings. My associate asked several questions. “What are the key drivers of your rating model?” They responded, FICO scores and home price appreciation (HPA) of low single digit (LSD) or mid single digit (MSD), as HPA has been for the past 50 years. My associate then asked, “What if HPA was flat for an extended period of time?” They responded that their model would start to break down. He then asked, “What if HPA were to decline 1% to 2% for an extended period of time?” They responded that their models would break down completely. He then asked, “With 2% depreciation, how far up the rating’s scale would it harm?” They responded that it might go as high as the AA or AAA tranches. Adding to this appraisal, in a recent study by Joshua Rosner, managing director of investment research firm Graham Fisher & Co., and Joseph R. Mason, associate finance professor at Drexel University, “Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions,” they say, “the senior levels of these structures are probably not as safe and secure as the rating companies have said, as an investor would assume, or as regulators are counting on.” In an interview, Mr. Rosner commented that whether the top-rated classes of these securities are downgraded, “depends on home price appreciation. It is a strong possibility that there could be downgrades.”

    http://www.fpafunds.com/news_070703_absense_of_fear.asp

    There also developed two different types of housing markets: the normal one where most houses were for people to live in, and the other where you had 85% of Miami condo sales going to investors not occupants. You shouldn’t finance those two markets the same as default behaviors are wildly different, and you shouldn’t expect prices for both markets to work the same.

    There is also the issue of time lag (phase delay in feedback system terms). If you delay the time when someone needs to pay the true price for a good (I/O or neg-am), the stability of the price feedback mechanism degrades. My second idea from this is that markets DO get prices right…eventually. My evidence is South Florida where prices are pretty reasonable, all things considered and 50% off peak prices, on average. It’s hard to say it’s at an equilibrium because supply of homes > demand for people to live in them full time, but prices are moving to the point where a lot of properties are being bought with little or no financing.

    You can say that markets get prices right, but you can’t claim that they are always instantaneously correct. No feedback system has zero delay in its closed-loop response (no system has zero delay in its open-loop response either).

  11. Gravatar of Indy Indy
    4. June 2010 at 05:05

    Contrarian View: Who says the EMH didn’t work for houses?

    Look at current prices for low-end units in Las Vegas, Detroit, Phoenix, and Central California. Why, they look quite reasonable in terms of affordability, median-debt-to-median-neighborhood-household-income ratios, and in line with long term trends. There was a slight aberrational period, it’s true, but it all looks pretty much corrected at this point. It hasn’t completed for all prices at all tiers everywhere yet – but it’s probably on it’s way.

    If you plotted a wage-adjusted 10-year-averaged graph, it would look nice and smooth and reasonable – like a 1-year averaged-graph of prices in Dallas, Texas or Lawrence, Kansas would look.

    So, ok, we had a good 5 to 10 year period where if you increase the granularity it looks like those prices jumped ridiculously far off their long-term trend line before being corrected and restored to equilibrium – but that’s interpretable as mere “volatility risk” right?

    And anyway, what is the “price” of a house really? There’s the asset valuation, of course, but what really matters to an average unsophisticated purchaser is the burden of the short-term sequence of payments as a fraction of their total income.

    All the ultra-clever toxic mortgage innovations, (enabled / encouraged further by ultra-low-interest rates) were specifically designed to decouple the first few years of minimum monthly payments from the principal value of the mortgage as much as possible.

    This hyper-leveraging is why, in certain Option-ARM infested zip-codes in California, average payments only went up 10% while average prices doubled. If you ran the EMH on “average minimum monthly payments” I think you’ll find a much smoother and less bubbly curve too – the bubble is asset prices being mostly a leverage effect.

    Isn’t there a theory somewhere that says, ceteris peribus, when the cost of extra leverage goes down, and it’s availability goes up, then the price of assets bought with debt will go up – since the bidding price reflects the cost of servicing of the debt – which should remains the same?

  12. Gravatar of scott sumner scott sumner
    4. June 2010 at 05:22

    Marcus, Yes, that is interesting.

    John, I am not knowledgeable enough to comment on your entire post, but I do want to comment on this:

    “(though I don’t think factors that performed well in the past will necessarily perform well in the future).”

    This is an important point. It means that investment advice based on past performance of stocks is not valid. Housing is a good example. In 2006 someone could have said “housing prices never fall nationwide.” But we now know that that advice, based on past performance of US housing markets, was not valuable.

    Jon, All good points.

    Jlonsdale, Elsewhere I’ve argued that the only natural experiment that tests the EMH is whether measured excess returns of sophisticated investors are serially correlated. That’s a sort of meta-test. All other tests are contaminated by data-mining. And the meta test suggests markets are pretty efficient, albeit not perfectly efficient. The top couple percentiles do seem to slightly outperform the market. Maybe I’ll do a post on that.

    Ted, I think you misunderstood my point. I was implicitly considering the hypothesis that the predictability of housing prices was large enough overcome transactions costs in the housing market. I think many people believe housing prices are much more predictable than they really are. Thus in 2006 there were people saying we were in a bubble and housing prices would fall significantly. I am claiming they just got lucky.

    Alternatively, I am saying the price of housing related paper assets do follow roughly a random walk. If the housing bubble was predictable, people should have shorted MBSs and banks. One guy did, and became very, very rich. But one guy isn’t enough to prove inefficiency.

    The Window Washer. You said;

    “I was looking for products to short housing in 06 but you couldn’t get one unless you were a hedge fund. So yes there were working class people that saw the same thing, it was just the hedge boys that got to make 20x on a short.”

    Let me explain why you are still a window washer and not living on a big yacht. You should have shorted the big banks if you saw the crash coming!

    BTW, I am just joking, but I couldn’t resist.

    Filip, No I shouldn’t include the entire sample, as my hypothesis is that we have only recently become bigoted against Protestants. I’m not crazy enough to think America was bigoted against Protestants in 1910. That’s the way people test for market anomalies. First data mine–then develop your hypothesis to fit the data.

    RobbL, Sorry, I’ll try to remember to do that in the future.

    You said;

    “2. It is not discrimination against protestants on the supreme court. It is right wing abortion politics.”

    Just as I thought, all those Catholics are trying to impose the agenda of the Vatican. Seriously, that might play a small role in this, if Catholic judges are more likely to be anti-abortion. But I thought polls showed there wasn’t much difference between Catholics and Protestants on abortion.

    Jim Caserta, You said:

    “There also developed two different types of housing markets: the normal one where most houses were for people to live in, and the other where you had 85% of Miami condo sales going to investors not occupants. You shouldn’t finance those two markets the same as default behaviors are wildly different, and you shouldn’t expect prices for both markets to work the same.”

    This is a good point, and really underlines the problem with our deposit insurance system. Because of deposit insurance banks are able to borrow money at roughly T-bill rates (zero default risk) and invest in these highly speculative business ventures. It’s an insane system, and I believe the financial reforms don’t even touch deposit insurance. At a minimum it should be cut from $250,000 to $25,000 (obviously once we are out of the woods). This would protect the little guy, but bigger savers could supplement their bank accounts with MMMFs or Treasury securities. Another idea is to allow banks to offer some big deposits that are fully insured, at slightly lower rates, but then require that these bigger deposits be backed with some sort of Treasury debt on the asset side of the banks balance sheet. Then the taxpayers wouldn’t be hurt when the bank fails.

  13. Gravatar of q q
    4. June 2010 at 06:55

    very appropriate — you juxtaposed the EMH and religion.

  14. Gravatar of Brendan Brendan
    4. June 2010 at 06:58

    Window Washer-

    In 30 minutes you could’ve opened an etrade account and shorted banks, homebuilders, REIT’s, whatever you wanted. Or if you wanted leverage you could’ve bought puts.

  15. Gravatar of Brendan Brendan
    4. June 2010 at 07:38

    Scott, I think the best evidence against the EMH is that most major persistent long-term anomalies appear to be caused by the same factor- the tendency for people to overweight recent experience and underweight mean reversion (or longer-term historical experience). And given human nature, this makes sense.

    I think it is pretty clear that market prices usually fluctuate around fair value and sometimes detach from FV pretty signficantly given unusual conditions (18 years from 1982 to 2000 with only 9 months of recession and a good internet story, for example.)

    But I still think you’re completely right that there are no interesting policy implications to the anti-EMH position because as imperfect as markets are, individuals are worse. The best example that you constantly give is when in September 2008 TIPS spreads were plunging and the Fed was worried about inflation. I guess I just think the argument should be more against pols and less in favor of a strong EMH.

  16. Gravatar of Jim Caserta Jim Caserta
    4. June 2010 at 08:05

    There were definitely things pols could have done. SEC not increasing leverage at i-banks. Restoring mortgage underwriting standards. Tighten credit rating on structured finance products. Pursued and limited accounting fraud. Not allow people to get the same loan on an investment property as one they planned to live in full-time.

    The EMH says that prices reflect known information. What if conventional wisdom (known information) is wrong? Lots of people assumed home prices would keep increasing – see the quote from Fitch above. How is that factored in?

  17. Gravatar of Jlonsdale Jlonsdale
    4. June 2010 at 11:41

    “the only natural experiment that tests the EMH is whether measured excess returns of sophisticated investors are serially correlated. That’s a sort of meta-test.”

    Scott, if you are looking at hedge-fund data for this you should be very careful. Autocorrelation for large multi-strat funds may exist because they are slowly recognizing their gains on illiquid trades by “marking to model” rather than marking to market.

  18. Gravatar of The Window Washer The Window Washer
    4. June 2010 at 20:58

    Let me explain why you are still a window washer and not living on a big yacht. You should have shorted the big banks if you saw the crash coming!

    Well Scott there is something to be said of being the BEST window washer in the country.

    Also the reason I didn’t play the banks was
    1) I couldn’t figuire out the balance sheets that ran into hundreds of pages. Think SIV’s
    2) I knew the Fed would give them free money so they wouldn’t go to Zero.
    3) I have one rule of investing “NEVER FIGHT THE MACRO!”, see point 2 I wasn’t going to go against the Fed.

    Being on the right side of the CDS’s was a better play than shorting banks in late 06. You would have your puts run out before the real bottom hit. CDS’s are 3+ years mostly

    Thanks for the blog.
    I’ll be lurking but won’t be commenting I don’t want to stink the place up with my ham-fisted prose.

  19. Gravatar of The Window Washer The Window Washer
    4. June 2010 at 21:08

    Brendan,
    Do you really think I don’t know what a put is?
    If we’re preaching stocks, I did nicely on FRE FNM after buying a property from them. Boy were they clueless at what was coming.
    I closed out my stock positions in the 3rd week of July 08. How did the EMH people do?

    By the way I went long FNM & FRE and came out great,best trade I’ve ever done. Figuire that one out.

  20. Gravatar of Mike Sandifer Mike Sandifer
    5. June 2010 at 06:47

    Scott,

    Sorry to be late on this, but I thought EMH didn’t apply as much to real estate markets, given their relative inefficiency. And I do suspect there is such a thing as momentum in those markets, given that we’re talking about whole markets and upward price movements really, really seem to encourage more people to invest.

    Perhaps this is also true of stock markets, but to a lesser degree. The better the overall markets do, the more people who get involved, at least anecdotally. This is much more the case than people wanting to invest in individual stocks due to momentum, although there are technical traders who regularly do just that.

    Then there is table 1.1 I came across in Value Investing in Real Estate, by Gary Eldred(page 5, if anyone has it). It shows that GDP grew 281% from 1980-2001, but the Dow by 1070%. S&P by 916%, and NASDAQ by 1400%.

    Now, my perspectives are far less well considered than yours, and of course, far less informed. However, this strikes me as a possible problem for strong EMH.

  21. Gravatar of Mike Sandifer Mike Sandifer
    5. June 2010 at 06:50

    Update: Apparently Shiller agrees with me about momentum in housing markets.

    http://www.nytimes.com/2010/04/11/business/economy/11view.html

    So, if wrong, at least I may be in good company/

  22. Gravatar of Doc Merlin Doc Merlin
    5. June 2010 at 07:35

    @The Window Washer
    “I closed out my stock positions in the 3rd week of July 08. How did the EMH people do?”

    You cannot use EMH when trying to actually make trades in the market. If enough of the market does, then the market will become inefficient! The market gains its efficiency because each trader is trying to beat the market and by doing so making it more efficient and making it harder to beat the market.

    This is something that I and Nick Rowe have talked about.

  23. Gravatar of scott sumner scott sumner
    5. June 2010 at 09:26

    q, Nice observation.

    Brendan. Good point.

    Brendan, You may be right. Don’t tell anyone, but I occasionally try to invest on that basis. I’m not just an intellectual contrarian. :)

    Jim Caserta, You said:

    “There were definitely things pols could have done. SEC not increasing leverage at i-banks. Restoring mortgage underwriting standards. Tighten credit rating on structured finance products. Pursued and limited accounting fraud. Not allow people to get the same loan on an investment property as one they planned to live in full-time.

    The EMH says that prices reflect known information. What if conventional wisdom (known information) is wrong? Lots of people assumed home prices would keep increasing – see the quote from Fitch above. How is that factored in?”

    I agree. But would you agree that “there were definitely things banks could have done–not make so many sub-prime loans and then buy the bonds back and carry them on their books?”

    On point 2, the EMH allows for most people to be wrong. And in 2006 most people were wrong about housing.

    Jlonsdale, I am thinking of a Fama and French study of mutual funds. I promise a post on this soon.

    The Window Washer. Thanks, I’m glad you took that as a joke, some of my commenters get sensitive. I would point to how many big players were fooled. I’m not saying the market didn’t screw up, or that a few people didn’t notice, I’m saying that there is no outside referee that can reliably tell us that it is screwing up, ex ante.

    Mike, the value of stocks was low in 1980 because inflation was double digits, and expected to stay high. Lower inflation was new information.

    I may be wrong, but I thought the idea was that if the transactions costs for real estate was say 5%, then real estate prices shouldn’t get more than 5% away from their EMH value. But people claim they got much further away. But I may have misinterpreted the EMH here.

    I think the EMH allows for a bit of momentum in housing, but not too much.

  24. Gravatar of scott sumner scott sumner
    5. June 2010 at 09:30

    Indy, The counterargument is that land prices went very high in those markets–but there was plenty of land. Others say the government was restricting the flow of buildable land. I have an open mind on the issue.

    The EMH says prices shouldn’t even temporarily deviate from the efficient price.

  25. Gravatar of Mike Sandifer Mike Sandifer
    5. June 2010 at 12:28

    Scott, you said:

    “Mike, the value of stocks was low in 1980 because inflation was double digits, and expected to stay high. Lower inflation was new information.”

    However, the stock indexes roughly quadrupled from 1990 until 2001, while GDP was up about 41% over that period. And this is an appreciably greater gap in growth than from 1980 to 1990.

  26. Gravatar of The Window Washer The Window Washer
    5. June 2010 at 18:47

    Scott,
    Thanks for getting back to the original point; I didn’t want to comment on EMH really. Just needed to call you out on your belief that people that got it right were just lucky.
    Seems like you just think there isn’t a regulatory framework that could be put in place to call all bubbles ex ante, which I agree with.
    Just because a few people got famous for making money on the last mess doesn’t mean people will listen to the right specialist the next time.
    “It is difficult to get a man to understand something, when his salary depends upon his not understanding it!”
    Upton Sinclair, 1935, “I, Candidate for Governor: And How I Got Licked”
    R

  27. Gravatar of ssumner ssumner
    6. June 2010 at 11:50

    Mike, Are those real or nominal variables?

    The Window Washer, The only way to prove it isn’t luck, is to show that some people can consistently beat the market. But studies have failed to find that to be true.

  28. Gravatar of Mike Sandifer Mike Sandifer
    6. June 2010 at 15:15

    Scott,

    These numbers are in real terms. Links:

    http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=6&ViewSeries=NO&Java=no&Request3Place=N&3Place=N&FromView=YES&Freq=Year&FirstYear=1990&LastYear=2001&3Place=N&Update=Update&JavaBox=no

    and

    http://www.econ.yale.edu/~shiller/data.htm (click on the excel link and then “index plot” at the bottom of the excel sheet.) Or, you can see the same chart here:

    http://dshort.com/charts/SP500-real-price-and-earnings.gif

    Notice also, of course, that the S&P index levels are growing much more quickly than earnings. That is, if I’m interpreting all of this right, which is far from guaranteed.

    I’m sorry to waste some of your time. I should have provided these links in the first place.

  29. Gravatar of scott sumner scott sumner
    7. June 2010 at 08:24

    Mike, Thanks, I agree the increase in the 1990s was unusual, but I don’t think it refutes the EMH unless the post-2000 crash was predictable. And it obviously wasn’t (or at least it’s obvious to me.) People thought we had entered a new era.

    Shiller thought stocks would fall after 1996, which just shows how hard prediction is.

  30. Gravatar of Mike Sandifer Mike Sandifer
    7. June 2010 at 09:29

    Scott,

    Well, I’m not sophisticated enough to draw any firm conclusions, but in my mind that differential between index price growth and earnings growth and GDP growth makes me think stock investing has become more speculative Of course, part of this might be due to higher dividend taxes.

  31. Gravatar of Mike Sandifer Mike Sandifer
    7. June 2010 at 09:35

    I should sum up by saying that looking at these numbers and considering the S&L crisis, tech bust, and the recent financial crisis, maybe the markets aren’t dealing with risk very well. Just look at the extreme highs and lows.

  32. Gravatar of ssumner ssumner
    8. June 2010 at 14:13

    Mike, I think there is an enormous amount of uncertainty about what stocks are actually worth. That’s why they fluctuate so much. In recent decades corporate profits have done well and real interest rates are far lower than the 1980s. So future returns discount back to high values. But will this continue? Hard to say.

    Even the 1929 values weren’t that absurd if you bought and held for 70 years. But I agree that the tech bubble looks very fishy in retrospect.

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