Archive for the Category Efficient markets hypothesis


Bubblemongers don’t get a second chance

Tyler Cowen recently made this statement:

I used to think Bitcoin was a bubble, but I no longer hold this view.

Yes, but at the risk of being a pedant I wish he had said the following:

I used to think Bitcoin was a bubble, but we now know that this is not the case.

There is literally nothing that could happen between now and the end of time that would in any sense confirm the view that bitcoin is a bubble.  It isn’t.

But let’s say I’m wrong.  What would that imply about bubble claims?  If we gave bubblemongers a second chance, then they could do the following:

1.  Predict that Bitcoin was a bubble when the price was $10.

2.  After they were shown to be wrong they could make a new prediction that bitcoin is a bubble, this time when the price hits $100.

3.  After that prediction was shown to be wrong, make a new bubble prediction when the price hits $1000

4.  After that prediction was shown to be wrong, make a new bubble prediction when the price hits $10,000.

I hope you see the problem here.  In any 100% efficient, bubble-free market, where prices are highly volatile, eventually there will come a time when predictions that prices are too high will come true.  But that’s virtually a tautology, a market cannot be both highly volatile and efficient, unless there are occasional steep plunges in the price.  There will be some price which, in retrospect, will have been the peak price—even in an efficient market.  I don’t understand why so many people have difficulty grasping this point.

So what would tend to confirm bubble theories?  I can think of lots of evidence.  For instance, a meta-study of mutual funds that shows the superiority of funds taking advantage of bubble theories did better than funds that assumed the EMH is true (i.e. contrarian funds vs. index funds).

But again, we know for certain that bitcoin bubble theories are useless.  It’s far to late for any new information to change that fact.

Perhaps part of the problem is that people don’t spend enough time reading Richard Rorty.  They think that truth is some sort of objective reality out in the world, which we can grasp.  Perhaps (they think) the bubble theory can still be shown to be true, but for a price of $10,000, not $10.  Sorry, things don’t work that way.  In fact, there is no objective reality.  True ideas are simply useful ideas.  Since bitcoin bubble theories have already been shown to be useless, and would continue to be useless even if prices plunged by 99% tomorrow, bitcoin bubble theories can never become true.  They are already falsified for all time.  There are no second chances–so if you are going to call a bubble, don’t do so at a time when the asset price is about to rise far higher.

Here’s an analogy.  If you claim that a certain coin is unfair, biased towards heads, you don’t get to keep flipping it until you happen to get 20 heads in a row.  You get 20 coin flips.  And those first 20 flips are your test.  Sorry bubblemongers; you lost.

Last laughs, etc.

In a recent post I criticized a headline on cryptocurrency bubbles.  Ryan Avent (who wrote the piece) told me to read the entire article, which is indeed much more nuanced in its discussion of whether Bitcoin is a bubble.  I should have pointed that out.

I’m not sure when I first predicted that (misdiagnosed) bubbles would be the new norm of the 21st century.  This is from January 2014:

I’ve also argued that low rates will create more “bubbles” in the 21st century.

And here’s what I said in July 2011:

My most important argument is that low real interest rates might be the “new normal.”  . . .

But (seriously) are stocks now overvalued?  Because I’m an efficient markets-type, the only answer I can give is no.   So why does Robert Shiller say yes?  Apparently because the P/E ratio is relatively high by historical standards.  And he showed that for much of American history investors did better buying stocks when P/Es were low than when P/E ratios were high.  Of course hindsight is 20-20.

[I feel so sorry for people who make their investment decisions based on Robert Shiller’s public statements.]

So how has my prediction held up?  Are so-called “bubbles” the new normal of the 21st century?

Here’s the real NASDAQ index:

And real house prices:

(Both indices deflated by the PCE price index.)

And Bitcoin:

All three major “bubbles” occurred after my predictions.

Bubbles, bubbles, as far as the eye can see.


I don’t buy the Economist for investment tips

I view The Economist as the best magazine in the world, which is why I like to pick on them so much.  I recently came across a couple examples of faith-based reasoning at the Economist.  Here’s a piece on the recent recovery in Japan:

JAPAN’S economy has been so sickly for so long that many have stopped looking for signs of recovery. And yet, on close examination, they are there. Years of massive fiscal and monetary stimulus seem to be having some effect. Unemployment is below 3%—the lowest rate in 23 years—and wages are rising, at least for casual workers. Prices are creeping up, too, albeit by much less than the Bank of Japan’s 2% inflation target.

Yikes!  Massive fiscal stimulus?  In fact, Abenomics has involved a sharp contraction in fiscal policy, mostly due to a large increase in their national sales tax.  Budget deficits are shrinking dramatically.  Yes, fiscal policy was expansionary in the 1990s and early 2000s, but that corresponded to perhaps the worst 19 year performance in aggregate demand ever seen in a developed economy, with NGDP actually falling between 1993 and 2012.  It’s only since the beginning of 2013 that Japanese NGDP has shown signs of life:

Then I came across this headline on Bitcoin:

Manias, panics and Initial Coin Offerings

Crypto-coin mania illustrates the crazy and not-so-crazy sides of bubbles

In fact, it would be hard to find a more perfect refutation of the bubble hypothesis than Bitcoin. And yet somehow The Economist sees Bitcoin as a good example of a bubble.

Recall that back in 2012 when Bitcoin was trading at $12, the Economist was already calling it a bubble:

These curious capabilities make Bitcoins a combination of a commodity and a fiat currency (creating the coins is referred to as “mining” and they have value only because people accept them). But boosters inflated a Bitcoin bubble. Shortly after the currency launched, articles spread around the internet arguing that Bitcoins would protect wealth from hyperinflation and that early adopters would make a fortune. The dollar price of a Bitcoin currency unit climbed from a few cents in 2010 to a peak of nearly $30 in June 2011 (see chart), according to data compiled by Mt Gox, a popular online Bitcoin exchange. Inevitably, the currency then crashed back down, bottoming out at $2 in November 2011.

Inevitably?  Do the writers at The Economist have no sense of shame?  It’s bad enough that they prevented me from becoming filthy rich by purchasing bitcoin back in 2012, but after being spectacularly wrong about it being a bubble in 2012, they continue to make the same predictions over an over again, year after year.  Bitcoin could fall 99% tomorrow and the Economist would still be completely wrong about it being a bubble.  Please, I beg you, just stop trying to predict asset prices.  I don’t buy the Economist for investment tips.

As each day goes by the four anti-EMH arguments from 2009 (when I started blogging) look weaker and weaker.  NASDAQ 5000?  It just soared past 6700.  (Roughly 5000 in real terms)  Housing prices?  They’re soaring again.  Hedge funds and college endowments outperform?  Not any more.  Bitcoin is a bubble at $30?  Where can I buy some at that price.

But of course none of this will matter.  People don’t believe in fiscal stimulus and bubbles because of the facts, as the evidence strongly refutes these theories.  Rather it seems like soaring prices are a bubble, and it seems like big government spending programs should boost the economy.  Thus people will continue to believe these myths no matter how much evidence piles up against.

PS.  And it’s even worse.  When Bitcoin prices finally plunge (and they will at some point, as all highly volatile asset prices do) then the bubbleheads will think they were right all along, even as they’ve been wrong all along.

It’s hopeless.

One by one, the anti-EMH arguments collapse

When I started blogging in early 2009, the anti-EMH forces were riding high.  The previous decade had seen tech and housing “bubbles”, there were studies showing that hedge founds and elite college endowments outperformed the broader markets, there was the absurdly high price of Bitcoins, and there were academic studies finding market “anomalies”.  In the eight years since, all of these arguments have either mostly or entirely collapsed.

1. Remember those people who told you not to buy Bitcoin at $30 because it was a wildly inflated bubble?  They stopped you from becoming filthy rich, as it’s now at over $2400.  Yes, it could collapse by 90%, but it would still be 8 times higher than when anti-EMH pundits were calling it a bubble.  Alternatively, if 98% of Bitcoin-type investments fell in value to zero, it would still be a good idea to invest in all of them as long as one in 50 went from $30 to $2400.  Yes, the anti-EMH argument is that weak—even if they were right 98% of the time on bubbles bursting, they’d be wrong in their broader argument that markets are not efficient.

2.  Hedge funds have done poorly since I started blogging (Buffett won his bet that they would not continue outperforming the S&P500.)  College endowments haven’t even been able to beat index funds.

3.  House prices are back up to the peak, and NASDAQ is almost 24% above the 2000 peak.  In fairness, in both cases the real price remains below peak levels.  But there is no longer a serious argument that these markets were “obviously” ridiculously overvalued, especially given that so many other foreign housing markets are now far above 2006 levels. Back in 2002, when NASDAQ was at roughly 1100, people were claiming that 5000, and even 4000, had been an absurdly overvalued level.  Now it’s over 6200.  And yet most of these pundits seemed to have no problem with a NASDAQ of 1120 in October 2002.  Don’t let anti-EMH people tell you how to invest.

4.  Alex Tabarrok linked to a recent academic study by Kewei Hou, Chen Xue and Lu Zhang, which looked at a large number of market “anomaly” studies, and found that the results were heavily influenced by data mining (aka p-hacking):

The anomalies literature is infested with widespread p-hacking. We replicate the entire anomalies literature in finance and accounting by compiling a largest-to-date data library that contains 447 anomaly variables. With microcaps alleviated via New York Stock Exchange breakpoints and value-weighted returns, 286 anomalies (64%) including 95 out of 102 liquidity variables (93%) are insignificant at the conventional 5% level. Imposing the cutoff t-value of three raises the number of insignificance to 380 (85%). Even for the 161 significant anomalies, their magnitudes are often much lower than originally reported. Out of the 161, the q-factor model leaves 115 alphas insignificant (150 with t < 3). In all, capital markets are more efficient than previously recognized.

In retrospect, 2009 was “peak anti-EMH”, and it’s been all downhill from there.

PS.  Just when you think the GOP and its fake news co-conspirators can’t get any further down into the gutter, they hit a new low.  Remember the saying; “The fish rots from the head down”?  A pro-Trump Republican assaulted a reporter in Montana, while running for Congress.  There was a Fox News reporter standing three feet away.  But during the next few hours, Fox News reported the candidate’s pathetic lie (notice how these bullies don’t even have the courage to stand up for their beliefs?), but failed to report its own reporter’s eyewitness account–which contradicted the candidate.  Perhaps Fox is spending too much time trying to find the real killer of Seth Rich.

And of course GOP politicians just run and hide when asked to comment.

Update:  The editors of Bloomberg want the Bank of Canada to stop trying to stabilize the economy and shift over to trying to control asset prices:

Canada Must Deflate Its Housing Bubble

Asset prices are always wrong, in retrospect

One argument against market efficiency is that asset prices are subject to speculative bubbles, where prices rise (or perhaps fall) more than can just justified by fundamentals. Today I’ll discuss why this theory is so hard to evaluate.

During my lifetime, I’ve seen three major asset price movements that looked, in retrospect, rather irrational:

1. The 1987 stock market boom and crash.

2. The late 1990s NASDAQ boom and crash

3. The housing “bubble” of 2006.

During the first 8 months of 1987, the Dow soared by about 40%, and then fell by a roughly equal amount late in the year, with a notable 22% decline on a single day (a record, by far).

After the crash, the pre-crash prices were widely viewed as a bubble, and not justified by fundamentals. Today those prices seem quite reasonable, and if anything it’s the post-crash levels that seem too low. On the other hand, the size of the price change, particularly the 22% decline in a single day, is hard to square with fundamental theories of asset prices, where stocks move only on new information. Nothing occurred on October 19, 1987, that would justify such a large price move. So in one of two respects, 1987 still looks bad for the efficient markets theory.

2. In the late 1990s, the tech-dominated NASDAQ soared from below 1000 to a peak of 5048 in March 2000. Then it fell 1114 in October 2002. During the 21st century, the March 2000 levels have been almost universally viewed as an insane bubble, whereas the October 2002 levels have received little comment. And yet a good case can be made that it is the October 2002 levels that are far out of line with fundamentals, at least based on today’s NASDAQ (over 5800 as I write this post.)

In fairness, the (PCE) price level is up 35% since March 2000, so the real NASDAQ is still considerably lower than at the 2000 peak. Still, even in real terms the NASDAQ is higher than it was just a couple months before or after the March 2000 peak. It should also be noted that the dividend yield on NASDAQ was lower than the real interest rate back then, so investors considerably over-estimated the returns they could expect from buying tech stocks at those lofty levels. I’m not claiming that the March 2000 prices look correct, in retrospect. But then if you go back in time and cherry pick the day when valuations were at their absolute peak, then of course it’s not going to look like the optimal time to buy that asset.

I’d also point to the 1114 low in October 2002, which looks, in retrospect, even more “wrong”. Obviously if I wrote this post in 2002, I would have reached very different conclusions about the 2000 “bubble”. The point here is that in retrospect, previous asset prices will almost always look “wrong”. And since we never reach the end of time, we don’t ever get a definitive reading on what asset price level would have been correct, at any given point in time.

3. As far as the 2006 housing bubble, two subsequent events have cast doubt on whether the prices actually were irrationally high in 2006. First, housing prices in many other countries with similar price run-ups, such as Canada, Australia, Britain and New Zealand, did not crash, and indeed are as high as in 2006, or even higher, even in real terms. (Ireland did crash like the US, to round out the English speaking countries.) Second, home prices in many coastal cities like New York, Boston and coastal California have soared back up to “bubble levels”, and even higher. Many central US regions like Texas never saw a price bubble. Yes, some cities never did recover, but Kevin Erdmann has many posts that provide further evidence that the so-called bubble was not as irrational as it now seems, given what people knew at the time.

This post is also very provisional. In two years, asset prices might be much higher than today and the idea of a 2000 NASDAQ bubble and a 2006 housing bubble may be almost completely discredited. (Just as the 1987 stock bubble was later discredited.) Or asset prices may fall sharply and this post may seem mistaken. That’s why I always try to take a pragmatic approach to bubble theory. What’s in it for me? How do bubble theories help me to live my life more effectively as an investor, as an academic, and as a voter? So far I don’t see much use for bubble theories, but I’ll keep an open mind.

Off topic:  I watched part of Trump’s press conference this afternoon, which reminded me the the “strawberries” scene in The Caine Mutiny.  I’ve got news for Trump—this is your honeymoon period.  It will get far worse.  If Trump’s already showing signs of being mentally unstable after a few minor flare-ups, what’s it going to be like when his administration gets into serious trouble?  Anyone who watched the press conference and still doesn’t understand why I think Trump is a spoiled, immature brat, then, well then I have nothing to say to you.

(Not that I could care less, but the rest of the world is laughing at us.  We elected a right-wing version of Chavez, or if you prefer a Duterte or a Berlusconi.  I feel bad for the reporters who had to sit through that clown show.  And thank God that there are a few GOP senators who are willing to tell the truth.)

PS.  I also recommend this FT article on bubbles:

The background history to these booms confirmed what historians of bubbles had already shown: that they always have at least some backing from the fundamentals. Bubbles may end up being irrationally expensive, but they are not stupid. They arrive when an exciting new development — canals, railways, the internet — creates confusion over the future value they will create. As he puts it, “there was at least some method to the madness of investors”.

He found 72 cases of a market doubling in a year. In the following year, six doubled again, and three halved, giving back all their gains: Argentina in 1977, Austria in 1924 and Poland in 1994.

For doubling in three years, he found 460 examples. In the following five years, 10.4 per cent of them halved. The possibility of halving in any three-year period, regardless of what had come before, was lower than this but not dramatically so: 6 per cent.

On this basis, arguments made by many (including me) that central banks should concentrate more on pricking bubbles before they get too big begin to look threadbare.