I told you so! . . . Um, no you didn’t.

Talk about burying the lede!  Last night I did a post discussing how the people who say “I told you so” after bubbles are often suffering from cognitive illusion.  Only right before bed did I realize that a link in a quotation provided a perfect illustration of the phenomenon.

One of the most famous pro-bubble publications is The Economist, which likes to brag about how they predicted the housing bubble.  Here is Free Exchange:

This is truly remarkable. A bubble is an unsustainable increase in prices relative to underlying fundamentals. These fundamentals are more or less observable; those who called the housing bubble did so based on historically anomalous increases in the ratio of home prices to rents and incomes. And many people did correctly identify the bubble years before it imploded, including writers at The Economist who were worrying about rapid home price increases while the American economy was still limping out of the 2001 recession. This is the reality that Mr Fama seems unwilling to confront. How unwilling?

Only when I had finished the post did I realize it provided a link to an ad for subscriptions to The EconomistFree Exchange must have thought that was a big joke, as they had just quoted Fama as follows:

I never said that. I want people to use the term in a consistent way. For example, I didn’t renew my subscription to The Economist because they use the world bubble three times on every page. Any time prices went up and down””I guess that is what they call a bubble.

Then Free Exchange made this snarky joke (something I never do):

Obviously, we are disappointed to have lost Mr Fama’s business. But I can’t say we regret the cause.

UPDATE: An Economist correspondent notes that as a die-hard believer in the Efficient Markets Hypothesis, Mr Fama is actually being quite rational in cancelling his subscription. As all publicly available information is already reflected in market prices, there’s not much point in trying to learn anything from our paper.

But the joke is on Free Exchange.  The magazine ad he linked to says this:

Sep 11th 2003
From The Economist print edition

A SURVEY in The Economist in May predicted that house prices would fall by 10% in America over the next four years, and by 20-30% in Australia, Britain, Ireland, the Netherlands and Spain. Prices have since continued to rise, so have we changed our mind? . . .

Register now and receive a 14-day premium pass.

The irony here (and ironies just don’t get any richer) is that this prediction was wrong.  And not just slightly off, but  monumentally wrong.  Biblically wrong.  Or perhaps I should say Malthusianly wrong.  Recall that Thomas Malthus and Paul Ehrlich are often (falsely) credited as predicting a “population bomb.”  Actually they (wrongly) predicted the opposite, that the “limits of growth” would prevent Earth’s population from rising to 6 .8 billion.  The Economist was not predicting that a housing bubble would occur between 2003-07, they were predicting that a housing bubble would not occur.

Think about it.  In May 2003 The Economist told us that house prices were going to fall 10% over the next four years.  Time to short Toll Brothers!  Predictions just don’t get much more specific than that.  And yet housing prices actually rose nearly 30%.  How much wronger could they have been?  And for this we are supposed to believe in bubbles?  The housing bubble was “obvious” because The Economist predicted it?

From past experience with commenters who have a near religious faith in bubbles, I am expecting letters like the following:

“But, it’s like when Bush said ‘mission accomplished’ [another great May 2003 prediction.]  He was right in the long run.  Once Petraeus got the surge going in 2008 we achieved a pro-American democratic Iraq.  So he was right!”

Please read my previous post before making this sort of absurd argument.  Predicting prices will eventually fall is equivalent to making no prediction at all.

BTW, I notice one commenter dismissed my Economist mutual fund idea by pointing out that it is hard to short certain stocks.  Actually, there are plenty that can be shorted.  But even if he was right, it wouldn’t matter.  If you really know the fundamentals, then there is always some stock, bond, commodity, or currency in some part of the world that is undervalued.  So they could just invest in those “negative bubbles,” those areas of “irrational pessimism.”  Unless you seriously think an Economist mutual fund would reliably outperform an index fund (which I think is absurd) then you don’t have a leg to stand on.

Life is good.

Update:  It gets even worse.  A commenter named Michael from downunder just gave me this:

The Economist definitely seems to have gotten it badly wrong for Australia, as far as I can tell. Just had a quick look at the Australian Bureau of Statistics’ housing price stats for capital cities (couldn’t find more general prices in the minute or so I spent looking).

Within the period that The Economist forecast prices would fall 20-30%, there is a single year where prices fell…and they fell 0.1%.

The largest decrease in any year from June 2003 to the present was -1.4% from June 08 to June 09, which is outside the period The Economist forecast. And prices increased 4.2% from June 09 to Sept 09…

So prices since June 2003 are currently roughly 30-40% higher here.

Wow, The Economist track record is beginning to resemble Sports Illustrated cover stories.  When they say “bubble,” you should get leveraged and buy.

Update#2:  I just noticed that Robin Hanson already discussed many of the points that I made in my previous post.


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34 Responses to “I told you so! . . . Um, no you didn’t.”

  1. Gravatar of Michael Michael
    15. January 2010 at 06:55

    The Economist definitely seems to have gotten it badly wrong for Australia, as far as I can tell. Just had a quick look at the Australian Bureau of Statistics’ housing price stats for capital cities (couldn’t find more general prices in the minute or so I spent looking).

    Within the period that The Economist forecast prices would fall 20-30%, there is a single year where prices fell…and they fell 0.1%.

    The largest decrease in any year from June 2003 to the present was -1.4% from June 08 to June 09, which is outside the period The Economist forecast. And prices increased 4.2% from June 09 to Sept 09…

    So prices since June 2003 are currently roughly 30-40% higher here.

  2. Gravatar of ssumner ssumner
    15. January 2010 at 07:01

    Michael, Thanks, This has to be the most embarrassing mistake I have seen in a long time. How did we all miss the fact that The Economist was so far off?

  3. Gravatar of Michael Michael
    15. January 2010 at 07:28

    I subscribed to The Economist when I started my econ undergrad degree a bit under three years ago, but I became disenchanted with their economics/finance coverage pretty quickly, so I never paid much attention to their predictions. Their analysis of financial markets and economics matters was very descriptive, so good for keeping you updated on developments, but weak on reasoning – not so good for understanding why things developed a certain way.

    Or at least it seemed that way to me, but I haven’t even finished my undergrad degree so maybe I’m just missing something.

    I still subscribe to The Economist, but just to keep updated on news from around the world. There aren’t that many sources that conveniently cover news from the range of countries that The Economist does.

  4. Gravatar of libfree libfree
    15. January 2010 at 07:31

    Personally I don’t spend a lot of time looking back at who was right and wrong because I don’t believe that gives me any information about the future. If The Economist is wrong this time, it makes them no more likely to be right or wrong in the future. Like you (I guess), I only look back at someone’s record when they start boasting about it. More often than not, I find they get things write with no obvious patterns.

  5. Gravatar of Giles Giles
    15. January 2010 at 08:14

    I have considerable sympathy with the criticisms of people calling a housing bubble far too early – in the UK, we had economists – notably Roger Bootle of Capital Economics – crying ‘bubble’ about UK housing since 2003, at least. Although they may have had a very good point about the relative economic merits of renting and buying – rental yields surely could not cover interest costs and likely repair costs – their timing meant they would have lost money if they had tried to trade house price movements. In fact, I took a lot of bets from people gambling that way and did very nicely.

    But this still makes me think there is a valid distinction between the two senses of efficient markets 1. being able to beat the price movements and 2. providing always correct price signals. By 2005-6 in the UK, there was little conceivable way one could make a long term profit from buying and holding a house and taking rents. Therefore you could only hope to profit if you expected a greater fool to come round and buy the house. Given how slowly financial fads spread through the public, this could go on for a long while. It would surely not be hard to model a market that worked this way, with short-term incentives.

    (In the UK part of the problem was artificially constrained supply – we have dreadful planning laws – which meant that one natural reaction to high housing – booming construction – could not take place. This is why we have bounced. Prices are still wrong from a rental yield point of view. I still can’t think of how to exploit this.)

    I still see nothing in these anecdotes suggesting that strong EMH works – that where house prices stood in the US in 2006 were a full and rational reflection of all information relative to their future earnings. The difficulty of timing shorts seems to be a slightly different question.

  6. Gravatar of Giles Giles
    15. January 2010 at 08:18

    PS if you want similar logic on a stock, in 2001 I thought ARM was overvalued:

    http://boards.fool.co.uk/Message.asp?mid=6374644&sort=recommendations

    and sure enough, it was. On really basic valuation terms.

    http://quote.fool.co.uk/chart.aspx?s=ARM

    But then, and now, I had no confidence in shorting it. Maybe I am a bad trader, but I could see the stock moving 50% against me and me losing my nerve. This sort of consideration affects a lot of traders.

  7. Gravatar of Doc Merlin Doc Merlin
    15. January 2010 at 08:30

    I think Soros said, “people have a way of staying irrational until just after you run out of money shorting them…” or something to that effect.

  8. Gravatar of ryan ryan
    15. January 2010 at 09:01

    Really, Scott? Predicting in 2003 that home prices would fall was a huge error? It’s not just that The Economist was right “in the long run”. They were right about the bubble during the bubble about which they were declaiming for the right reasons. And within that 4-year window, from 2006 to 2007, prices did fall, significantly in some places. I think you’re being pretty silly about this.

    And it’s not an ad. It’s an article that can only be accessed by subscribers.

  9. Gravatar of matt matt
    15. January 2010 at 09:03

    …To be fair, those predictions were from “a survey”. Would you be happier if instead of using the word bubble we said that “prices are becoming detached from fundamentals as parties are making leveraged, momentum trades on a upswing”? The challenge becomes predicting when those momentum based trades would come to an end.

    I think there is a case to be made for prices to result from a variety of factors, including people’s awful predictions of what things are going to be worth when they sell them.

  10. Gravatar of rob rob
    15. January 2010 at 09:31

    FOR IMMEDIATE RELEASE: After only two days in business, I am sad to announce the closure of The Ecomomist Fund. We have had a good run, with a 1% return to investors so far and now feel that we shouldn’t push our luck.

    I actually agree with you and Fama. Great posts.

  11. Gravatar of Dilip Dilip
    15. January 2010 at 09:47

    How about Update #3:
    http://www.economist.com/blogs/freeexchange/2010/01/more_bubble_spotting

  12. Gravatar of Simon K Simon K
    15. January 2010 at 11:06

    ryan – The problem with having called “bubble” in 2003 for house prices is that many prices have not fallen back to 2003 levels. I’d have to check the local data, but I suspect that the places where prices were already rising very fast at that time are still high – its the places that rose later that fell back furthest and fastest.

  13. Gravatar of Mike Sandifer Mike Sandifer
    15. January 2010 at 11:07

    One of the first rules of value investing is to place no weight on the opinions of others when making investment decisions. This is especially true when a source has financial incentives that may undermine its objectivity. They want to sell their product. I haven’t read the Economist in years.

  14. Gravatar of Lord Lord
    15. January 2010 at 11:34

    A Survey said, not the Economist, they were just quoting it. I agree with the Economist, fundamentals did show extreme aberration. Part of this was justified by the decline in interest rates, part of it was not. How much of the decline was short term and how much long term? Difficult to estimate. That there was a bubble, I have no doubt. For debt to be supported, income must exist to repay it. Where was income all these years? Flat to falling. That does not support growing debt, and that is why we were in the ponzi finance stage. You are also mistaken that something that is overvalued should be shorted. The big money is jumping on the bubble while it is inflating and only jumping off and shorting when it is about to decline. That is what makes bubbles unpredictable, not that they don’t exist, but that they require market timing. And there are winners, but fewer than losers or a bubble wouldn’t have inflated in the first place. Bubbles start in uncertainty, grow to absurdity, and burst unpredictably. The survey was incorrect because it underestimated Bush’s craving for reelection, not because they missed the bubble.

  15. Gravatar of Simon K Simon K
    15. January 2010 at 12:13

    Giles – It is sort of possible to exploit mismatched rental yields by renting. Very glad I didn’t do this when I thought about it in the UK in 2003, since I’d be nearly $100k out of pocket now.

    I’m out of touch with UK house prices now, but here in the Bay Area (which has similar land/planning restrictions) the market seems to have partitioned itself into segments. For multi-family homes and single family in less desirable areas rental yields now match. For single family homes in desirable areas they’re still totally out of whack, but I don’t think they’ll ever match up again – there’s plenty of demand from potential owner-occupiers and no-one in their right mind would buy a house there to rent it out, so there’s just no downward pressure forcing prices to adjust to yields. Probably the same applies in the UK since if anything Brits are even more house-crazy than Californians.

  16. Gravatar of Edel Edel
    15. January 2010 at 12:18

    I still subscribed to the Economist. Maybe because I take it as it is, a compilation of well written articles on Economy and parts of technology and science (I miss not focusing a bit more on other beyond NA and EU). What I don’t take the Economist, (or any other publication, expert or organization) is on any predictions beyond pinpointing trends, and Ryan mention, The Economist did that fine! Their mistake was the 4 years claim. I am afraid that our knowledge on measuring the economy still cannot provide us with that precision.
    Seriously, when the IMF says the crises will end at the second half of 2010 is it based on extrapolation of trends, on historical records, on experts´ perception… I would like to understand the math they use behind it to come with those claims.

  17. Gravatar of Marcus Nunes Marcus Nunes
    15. January 2010 at 12:34

    In “Why such a deep recession”, Arnold Kling has this to say:
    …”The Keynesian story at least has some microfoundations. Scott Sumner’s Y = expected MV/P story is just hand-waving. Does he want to default to the sticky-wage story?

    Some pundits say “credit crunch,” but it appears to me that since the beginning of this year the signs point to lower credit demand rather than lack of credit supply–unless you want to blame the banks for their reduced willingness to make stupid, risky loans. In any case, “credit crunch” is not in the macroeconometric models or in the textbooks. If the main story of this recession is going to be “credit crunch,” then it is going to require at least as much theoretical and empirical back-filling as Recalculation.

    I think where we are is this: every economist can tell a story of a sectoral recession in housing. No economist, from any school of macroeconomics, has a really convincing story of how that recession spread so widely”…
    http://econlog.econlib.org/archives/2010/01/why_such_a_deep.html

  18. Gravatar of Doc Merlin Doc Merlin
    15. January 2010 at 12:48

    @Marcus:

    I agree about the lower credit demand. Its textbook ABCT, everyone is too full of debt and busy trying to dig themselves out of it.

  19. Gravatar of Marcus Nunes Marcus Nunes
    15. January 2010 at 12:55

    Doc Merlin
    My main “beef” is with the last paragraph: Nobody knows why the recession spread so widely?!!! I´ll bet Scott gets peeved with that assertion!

  20. Gravatar of Giles Giles
    15. January 2010 at 13:09

    Simon K, I think you are right to mention ‘house crazy’ in that last sentence, and in a way it explains your first point: why we don’t rent (and therefore help equalise the out of whack prices) instead of buy. The obsession with owning a house in the UK – a relatively (<50 year) thing, makes people attach an irrational premium to that mode of consuming housing goods.

    Of course, in an unrigged market, entrepreneurs would step in and build enough of them to deal with this. I still think that should be one of the major policy priorities in the UK next few years.

    I have only been to SF once, in 2001; it was the only time i have ever been in a place where I thought the prices might rival London's for lunacy.

  21. Gravatar of StatsGuy StatsGuy
    15. January 2010 at 13:22

    ssumner:

    “People think they have made accurate predictions because an upswing is always EVENTUALLY followed by a downturn.”

    Well, technically certain individuals did make an accurate prediction. They predicted something, it came true. Let’s accept this first.

    You’re argument (I think) is that the a priori probability of that prediction being true was 50/50 (more or less, where votes are weighted by wealth). This may be true in an aggregate sense, but certainly not in an individual sense.

    Clearly there are some individuals who have private information (e.g. someone in the industry with a brain).

    But where does one draw the line between private information and superior anaylsis? Let’s say someone has built a model that accurately predicts deviations between market predictions and true predictions in a particular market… Is this private information? The result is typically that the new model will be incorporated into future market planning (so that it will become obsolete).

    In this regard, comments by EMH defenders that a rule to beat the markets should be consistent and simple enough that a government agency can use it are silly.

    Any predictive model is incorrect; complete reliance on any single model makes decisions vulnerable to any other model that can spot the residuals of the first model. Thus, ANY model will be subsumed by the market given time (if enough value is at stake).

    But… let’s turn this on its head. Going back to 1999 and 2005, let’s consider – what was THE dominant model of behavior?

    The answer – which was very clearly stated by Alan Greenspan in multiple interviews, and which was echoed by all sorts of Vanguard-low-cost-fund and ETF-promoting investment advisors and anti-Peter-Lynch B-school professors – was that you can’t beat the market. Ergo, don’t try. Ergo, it doesn’t really matter much where you put your money, it’s just a pure risk/return tradeoff.

    I would argue that PRECISELY because we became attached to EMH, the EMH became less valid. The period of the EMH’s absolute intellectual dominance coincided with the period of two huge (with the benefit of hindsight) “bubbles”. One could argue that 1929 was similar (tremendous faith in the absolute perfection of American capitalism), though I’m not necessarily arguing 1929 was a bubble.

    So here is my definition of a “bubble” – when too many people instinctively feel something is heavily overpriced but ignore their own beliefs because of an overriding belief that the market is better at predicting than they are.

    In such circumstances, a narrative or paradigm can persist indefinitely until a body of evidence (or a sufficiently vocal authority) becomes so inconsistent with the paradigm that people begin to question the value of the EMH in the particular market.

    One can call this unpredictable, but irrational? In a game theoretic context with feedback (e.g. markets signal information, and participants believe that other participants may have private information) and sufficiently short time horizons and a high prior belief in the EMH, lots of things that seem irrational can be rational. And this doesn’t even take into account behavioral claims (e.g. “herding” instincts).

    To boil everything down: excessive belief in EMH is the EMH’s own worst enemy.

  22. Gravatar of David Pearson David Pearson
    15. January 2010 at 13:52

    Scott,

    So a few economics editors serially pronounce on bubbles, only to be proven repeatedly wrong? I would say, don’t stop the presses for that news.

    Seriously, Scott, I think you would do readers a service by picking the most robust, useful bubble definition and then arguing how it doesn’t refute EMH. Enough straw men.

    The robust one I propose is “asset prices driven primarily by a self-reinforcing dynamic between those prices and their impact on the real economy (whether on a sectoral or macro basis)”. Bubbles begin with the onset of the dynamic, not with the onset of overvaluation. They end when the dynamic fails to its own inherent flaws (such as scores of borrowers obtaining loans that they cannot service from income).

    That said, Fama is probably right that a bubble is not a useful investment concept for most investors, most of the time. I can tell you from first hand experience that even if you time them right in their real-economy impact, timing the market’s reaction to that is very difficult. That doesn’t mean it can’t be done, although to expect to do it twice in one’s lifetime is probably being too optimistic. I think having done it once I would have a better chance at it than most, which is to say, a very small chance indeed.

  23. Gravatar of Simon K Simon K
    15. January 2010 at 14:49

    Giles – San Francisco has some of the same planning problems as London, but a bit more of a geographical excuse, what with all the water and mountains. Ultimately densities in some of the San Francisco suburbs will have to increase, but of course they’re seperate legal entities and don’t want to p*** off their tax base, so don’t hold your breath.

  24. Gravatar of scott sumner scott sumner
    15. January 2010 at 18:45

    Michael, I added your info at the end of my post in an update. That is a huge problem for The Economist. Everything was in place for a bubble, and it never happened. Why the hell not? I’d like an answer from The Economist. On the other hand I focus on monetary policy. Australia is the one big country where the central bank didn’t let NGDP fall. And no housing crash, despite all those factors the Economist says should cause one. Interesting.

    libfree, I agree.

    Giles, You said;

    “By 2005-6 in the UK, there was little conceivable way one could make a long term profit from buying and holding a house and taking rents. Therefore you could only hope to profit if you expected a greater fool to come round and buy the house.”

    You probably know more than me, but the same thing happened to the very house I live in. It’s a “2 family.” My interpretation is that this means the apartments are viewed as a condo waiting to happen, waiting to be converted. So yes, the market is sort of out of (long run) equilibrium. But it is a signal to convert. Does London allow apartments to be converted into condos (or freeholds, or whatever you call them.) Does this make sense?

    Giles#2, OK, say you don’t like shorting. What about when you see stocks undervalued. You can go long. Could you run a managed fund that way and beat an indexed fund?

    Doc Merlin, The Soros quotation is an excuse. If you are a long term investor, and don’t get too leveraged, and look for lots of different inefficiences, then this should not prevent someone from beating the market if the EMH is truly wrong.

    ryan, You don’t understand the problem I raised. If prices had been level for 4 years then collapsed, I’d give them a break. But they first rose 30%. But the Economist said they wouldn’t rise. That is pretty bad. It’s like when Galbraith bragged about predicting the 1987 stock market crash at the beginning of 1987. Who cares? The Dow was at 1700 at the beginning of the year, and AFTER the crash. So an investor would not have been helped at all by that prediction.

    To this day I don’t think housing was overvalued in 2003. But 2005-2006? Sure in retrospect. But not 2003. I think housing overshot too low in 2009 because of the big fall in NGDP.

    Matt, You said;

    “To be fair, those predictions were from “a survey”.”

    Hey, come on. If they are going to go around bragging about these predictions, then I can certainly question them.

    rob, Thanks.

    Dilip, Thanks, I already saw it and have the reply.

    Simon, It’s funny how often when I get to your replies I find we think alike. I said something similar. You should start a blog.

    Mike, good idea. Although I do respect the integrity of The Economist.

    Lord, See my answer to Matt. I still think 2003 prices were fine.

    Simon#2, Again we agree. Are you my long lost twin brother?

    Edel, I do too, and think it is the best magazine in the world.

    Marcus, Thanks, as if I’m not busy enough.

    Statsguy, You said;

    “But where does one draw the line between private information and superior analysis? Let’s say someone has built a model that accurately predicts deviations between market predictions and true predictions in a particular market… Is this private information?”

    I don’t think people really “build models,” they go with their gut. Everyone basically knew all the crazy stuff going on. At some point you just need to ask yourself whether it can last. Through experience I learned it can last in tight coastal markets. When I heard about Vegas and Phoenix I thought “maybe there is some land constraint there I don’t know about.” Turns out there wasn’t, so I missed it.

    I view the smaller price drops in places like Boston and Dallas as entirely rational, merely reflecting the weak economy.

    You said;

    “The period of the EMH’s absolute intellectual dominance coincided with the period of two huge (with the benefit of hindsight) “bubbles”.”

    Most finance professors I know never believed in the EMH. Does anyone know if surveys have been done? Of course on Wall Street it has never been popular, so you can hardly blame the EMH for bubbles. It’s a cute theory, but a bit too cute for my taste.

    Sorry David, but I’m going to do posts on what is published in the blogosphere. If Free Exchange trashes Fama, I will respond.

    If you can get the Shillers of the world to accept your definition, I’ll respond with a post. But to me it’s all about prediction. No predictions, no useful bubble models.

  25. Gravatar of DanC DanC
    15. January 2010 at 18:48

    to Stats guy

    Marginal investors decide the price. So a majority of investors can be crazy and a market can still be efficient.

    Do you assume that if a majority of investors invest in index funds that means that the entire market stops looking for profitable investments.

    Nothing in EMH assumes that the entire market is following a single investment strategy. For example, risk preferences can vary etc. What one group of investors thinks is too risky another group will think is an opportunity. Both investors can be rational, but they have very different views of risk. Until the market agrees on the correct risk discount, opportunities exist.

    Of course if you just bet the market you don’t have to make such choices. But we see people every day trying to exploit what they think is an opportunity.

    Perhaps housing is less liquid then other markets and less efficient. High demand marginal buyers can inflate a market (with some of the demand fueled by government programs) where the majority of holders of the investment rarely trade. These marginal buyers were rational. Low interest rates, government assistance, and escalating values made housing look like a great investment because it was, for a period.

    If banks incorrectly judge the risk of a downturn in housing markets, or assume government bailouts, they may take on more risks then they should. Why so many bet on one side of the outcome is an interesting question. But marginal buyers, enough to cause damage, kept pushing the limits.

  26. Gravatar of Giles Giles
    15. January 2010 at 23:06

    “So here is my definition of a “bubble” – when too many people instinctively feel something is heavily overpriced but ignore their own beliefs because of an overriding belief that the market is better at predicting than they are.”

    I think that is very clever. It was what put me off investing money in shorting stocks in 2000-01 – a belief in EMH – and massive exposure to the views of the believers. Very hard to go against the grain sometimes. As I said, I’m a bad trader

    Scott, I suspect that ultimately what popped the 2000-01 bubble was people doing just what you describe in answer #2- gradually shifting their investments out of funds that held crazy stocks. But it can be very gradual, and the resulting mispricing very persistent.

    UK TIPS seems to have even more persistent mispricing issues right now – they ‘predict’ changes in inflation 30 years out that seem rather odd

  27. Gravatar of StatsGuy StatsGuy
    16. January 2010 at 06:12

    DanC – “too many people” is often more than a majority, even a majority of active market participants.

    We should also divide market participants into demand-based participants and arbitrage participants. Much of the EMH is based on the following notion – if “normal” market participants don’t get the price “right”, then arbitrage participants will get it right. This depends on arbitrage participants commanding enough liquidity to make that happen.

    So, the intellectual dominance of EMH would have to extend to arbitrage participants as well. (Although in housing, arbitrage participants would only participate heavily on one side of the equation, so that’s a strange argument – but anecdotally speculators and ‘flippers’ did play a role.)

    ssumner: It strikes me that the primary response to individuals who cried “bubbles” was to ask “Who are you to second-guess the market?” If too many people think this, the market price becomes its own justification.

  28. Gravatar of DanC DanC
    16. January 2010 at 07:40

    To StatsGuy

    This is the Fama view.

    “If misinformed and uninformed active investors (who make prices less efficient) turn passive, the efficiency of prices improves. If some informed active investors turn passive, prices tend to become less efficient. But the effect can be small if there is sufficient competition among remaining informed active investors. The answer also depends on the costs of uncovering and evaluating relevant knowable information. If the costs are low, then not much active investing is needed to get efficient prices.”

    So in some outlier you could be correct, but it has not occurred.

    In housing you saw more uninformed buyers enter the market, often with government help, taking increasing risks until the markets collapsed. Some people became very rich shorting the market but they were no match for all the people entering the market.

    I don’t understand the “too many people” reference.

    Going forward increasing government interventions in the markets may make markets less efficient has people try to game political markets and information about the future is clouded by political battles.

  29. Gravatar of StatsGuy StatsGuy
    16. January 2010 at 11:33

    That Fama quote does not (by itself) sufficiently define passive/active.

    Presumably, Active means actively trading (transacting), rather than merely holding an asset. So the question is what proportion of active trading is “dumb” money, recognizing that there are limits to liquidity among smart investors (“the market has a habit of staying irrational longer than you can stay solvent”). I would categorize “dumb” as including money/active participants who believe (based on the EMH alone rather than independent review of fundamentals/evidence) that the price truly reflects true long term value.

    If the latter view becomes dominant, the liquidity commanded by dumb money can swamp the liquidity commanded by smart money, and a bubble can ensue.

    But shouldn’t arbitrage fix this? In a perfect world, yes, but the world is imperfect.

    Betting against the bubble can be dangerous (since it’s termination is unpredictable). Even active money managers that strongly believe in a bubble are hesitant to massively short (given they have lower time horizons). Shorting can leave one vulnerable to short squeezes, which is a miniature liquidity crisis (I may still believe in my position, but I can’t borrow more money to back it up), and FORCE me to cover at an inflated price which spikes the price even more. (And it’s a truth that short squeezes DO exist, even though they can be rapidly deflated – but, AFTER shorters lose their shirts.)

    Here’s a terrific example – in October 29, 2008 (when the sky was falling), perhaps the greatest short squeeze ever.

    http://www.istockanalyst.com/article/viewarticle/articleid/2749422

    Even if you are right in the long run, you can get killed in the short run – and never get the chance to reap long term wins due to insolvency.

    And, as it turns out, the Volkswagon shorters WERE right in the long run (at least so far)…

    http://finance.yahoo.com/q/ta?s=VW.SW&t=2y

    But they didn’t live to fight another day.

    Now here’s an example of a beautiful, long term short –

    http://www.bloomberg.com/apps/news?pid=20601109&sid=akryRHYHS0Sg

    Here’s a quote:

    “The first year the trade was in effect was a nervous time. “From early 2005 to early 2006, it wasn’t clear the trade was going to work,” Pellegrini says. “People thought we were throwing money down the drain. We asked, Are we missing something?” Pellegrini says he would wake up in the night pondering the trade. Before he increased his bet, Paulson wanted proof of a housing bubble, and he thought Pellegrini could produce it. “The mortgage market lends itself to deep quantitative analysis and modeling,” Paulson says. “Paolo excelled in this area.” ”

    Note the logic here – first, the data WAS present and publicly available. The analysis was not, or at least it was ignored. Second, the primary reason Pellegrini cites for his sleepless nights was the fact that everyone else thought they were throwing money away. Third, this was a massive bet with a 2 year payoff, and it STILL didn’t move the market prices at all, because the sheer quantity of liquidity on the other side of that trade was massive. Maybe the money was managed by “professionals”, but the money was “dumb” in many many ways.

    The key thing above was that they found a way to make a long term trade with limited liquidity risk (unlike shorting, where the loss is theoretically infinite), and they had the guts to go through. These options are not widely available to retail investors.

    —-

    Regarding govt. intervention – this can make markets more or less efficient, depending on the quality of the regulation and the current severity of market failures. It may be true that the average intervention makes markets less efficient, but that isn’t an argument against ALL interventions. It’s simply an argument to create a high bar for justifying intervention.

    But if you believe that all intervention MUST by definition be detrimental, that’s an ideological view. There is no amount of evidence that can cause you to change your mind.

  30. Gravatar of StatsGuy StatsGuy
    16. January 2010 at 12:01

    [long comment hit the filters again… hopefully ssumner gets to it sometime today]

    Giles… I think I am a pretty lousy trader too (thank goodness I have a day job), mostly because I’m constantly second guessing myself. Also, I’ve discovered that my psychological time horizon is not as constant as I’d want it to be. :)

    I should also note that I took a passive, ETF/vanguard approach to investing (with age appropriate allocation to stocks, which means high exposure to equities, due to research by folks like Jeremy Siegel) until 2008. I did so because I firmly believed I couldn’t beat the markets, and had read many studies to that effect. I also believed Bernanke would run monetary policy the way he’d stated he would. I only became an active investor in 2008.

    I remember in late 2007 suggesting to my wife that we sell her largest holding (she ordered me not to touch it). I left it alone, figuring “who am I to question the market?” It subsequently lost 70% of its value and has only recovered marginally. (Besides, it was an asymmetric risk – if I was right I wouldn’t have gotten the credit, and if I was wrong I’d have been blamed for eternity.)

    I also recall that my wife wanted to buy a house twice (in 2003, and again in 2005, both times after a move). In both cases we rented, after significant arguments. We bought as late as possible, right before our daughter entered kindergarten – which was in November 2007 (that was based on an ultimatum). Why the delay? We could afford the house in 2005, but I believed prices were inflated. Technically, our house has actually increased in value (based on our refi appraisal) – this is dumb luck, since if I had my way we’d still be renting.

    I did perform better than average in 2008/2009, but not nearly as well as I might have if I’d held certain positions just a little bit longer (I’m about where I was at Oct 2007.) I readily concede that I might just have gotten lucky.

    I read an article that peak investing skill is achieved at ~ age 50, primarily because it takes that long to build up self-awareness that comes with historical and emotional experience. After 50, decay in intellectual faculties outweights improvements from experience. Apparently, this is a statistically robust finding (which, it would seem, counters the EMH).

    But sooner or later, someone will build an index of what people are investing in based on age (dumb youngsters, smart middle agers, and failing elders), and arbitrage away this fact as well.

  31. Gravatar of ssumner ssumner
    17. January 2010 at 10:50

    Giles, Your last point reminds me of “on the run” and “off the run” pricing anomalies between 29 and 30 year bond yields in the US. Have you heard of this issue, and is related to the British TIPSs?

    Statsguy, You said;

    “ssumner: It strikes me that the primary response to individuals who cried “bubbles” was to ask “Who are you to second-guess the market?” If too many people think this, the market price becomes its own justification.”

    Good point. I would distinguish between pundits and policymakers. Pundits should make predictions, that is their job. I want to know what Cramer thinks will happen (well not really, but you get the idea.) My only objection is people who say “I see a real estate bubble, so tighten monetary policy.” That’s not a good enough reason unless there is supproting evidence from NGDP (which arguably there was after 2004.)

    Statsguy; You said;

    “Note the logic here – first, the data WAS present and publicly available. The analysis was not, or at least it was ignored. Second, the primary reason Pellegrini cites for his sleepless nights was the fact that everyone else thought they were throwing money away. Third, this was a massive bet with a 2 year payoff, and it STILL didn’t move the market prices at all, because the sheer quantity of liquidity on the other side of that trade was massive. Maybe the money was managed by “professionals”, but the money was “dumb” in many many ways.”

    This is what my newer 8 questions post is about. It raises all sorts of issues. You are basically saying that almost the whole world is dumb. But then dumb is normal. And the anti-EMH position has no utility because their aren’t enough investors and policymakers to take advantage of it. And if you say “well let’s publicize this perspective” I’d say fine, then the EMH would still hold, but the market would work even more efficiently.

    All the EMH says is people do the best they can, it doesn’t imply people are any smarter than monkeys. But it does imply there is no animal on Earth smarter than people that can tell people (collectively) when they are wrong. Maybe the individual you cited was smarter, but all an EMH person like me can then say is “good for him.”

    As i have said many times, I pay no attention to the “it’s hard to short” argument, as the anti-EMH position also implies many assets are undervalued.

    I am a little bit active, because life’s to short and boring if you don’t take any chances. Recently I’ve done well, which should make me more anti-EMH. But it doesn’t, as I think it was mostly luck. My only “skill” if you could call it that, was about 30 years ago recognizing China’s economy would do very well. But even that forecast has only helped my modestly, the Latin America funds (which I don’t own) have done better recently.

  32. Gravatar of DanC DanC
    18. January 2010 at 08:45

    To statsguy

    I agree with government interventions and regulations that encourage free open markets, that is rarely the case

  33. Gravatar of ssumner ssumner
    18. January 2010 at 13:18

    Statsguy, You said;

    “I remember in late 2007 suggesting to my wife that we sell her largest holding (she ordered me not to touch it). I left it alone, figuring “who am I to question the market?””

    My guess is that your wife would remember cases where she was right and you were wrong. Is that right?

  34. Gravatar of TheMoneyIllusion » Another bubble? When was the first one? TheMoneyIllusion » Another bubble? When was the first one?
    14. September 2013 at 05:21

    […] So back in 2006 pundits in 5 English speaking countries cried “Bubble!!!”  In 4 out of 5 of the countries they were wrong.  But in 5 out of 5 cases they insist they were right, as we see from self-congratulatory advertisements in The Economist. […]

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