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and when they are wrong, are more powerful than is commonly understood.
Indeed the world is ruled by little else. Practical men, who believe themselves to
be quite exempt from any intellectual influence, are usually the slaves of some
defunct economist.
Chapter 5
Quite possibly, the efficient market hypothesis is the topic most discussed and
debated in financial economics in both popular and academic literature. And no
wonder: it incorporates the gamut of theories including rational expectations;
elements of the portfolio theory; and the predictability of prices in asset markets,
an issue at the heart of modern finance capitalism.
We discuss below some elements of the structure of todays market, the reality
on the ground, and what other academics have argued on various issues.
5.2 Structure of he Market
The investor who buys assets for the long term, looking to make a profit
from return from the investment including both dividends and price
changes: such investors would invest in the so-called value (i.e.
undervalued) stocks based on their estimates of fair values;
The participant who has no clear strategy or time horizon but buys rising
stocks and sells falling ones, driven by a fear of missing an opportunity.
Other asset markets also have participants with similarly diverse time horizons
and strategies. Take, for example, currency markets which were born to facilitate
exchange of one currency into another, without which cross-border trade would
not be possible: importers and exporters are the end-users of the market. So are
businesses who borrow foreign currencies for the medium/long term in
expectation of reducing costs compared to domestic currency loans or for other
reasons or make long term investments in other countries creating assets in
currencies other than their home currency. Other participants include currency
traders/speculators. In fact, the transactions of this latter category of
participants are far larger than those of end-users.
Commodity markets also have participation not only from producers and end-
users, but also speculators.
Market prices of various assets are the result of an interaction between all these
classes of participants: given the differing time horizons and strategies, can asset
prices generally, let alone always, reflect fundamentals?
The reality in todays financial markets was well articulated by Andrew Haldane,
Executive Director Financial Stability, Bank of England, in an address to a
conference in Beijing in September 2010. Some quotes:
an untested investor, who can mimic either the speculator or the long-term
investor, but whose performance either way is assessed at frequent
intervals by end-investors who withdraw or maintain funds accordingly.
(One example of this is mutual or hedge funds.)
Excess volatility puzzle: There is strong evidence that asset prices, both
real and financial, are both considerably more volatile than fundamentals
and can deviate for persistent periods.
Serial correlation puzzle: There is strong evidence that asset prices do not
follow a random walk, but instead exhibit short-term positive correlation
(for example, due to momentum traders) and medium-term negative
correlation. (EMH argues that price changes should be random.)
Equity premium puzzle: The required yield on equity over safe assets is
greater than can be explained by conventional asset pricing theory - a
puzzle which some have explained using hyperbolic discounting.
HFTs operate in size as well at speed. HFT firms are believed to account for
more than 70% of all trading volume in US equities, 40% of volumes in US
futures and 20% of volumes in US options. In Europe, HFTs account for
around 30-40% of volumes in equities and futures. These fractions have
risen from single figures as recently as a few years ago. And they look set to
continue to rise . Another way of gauging short-termism is to look
at investors implied preferences for income today (dividends) over income
tomorrow (retained earnings). In theory, investors should be indifferent
between these options, as the dividend payout ratio ought not to affect the
value of a firm. Empirical evidence suggests, however, strong evidence of
high and sticky dividend payout ratios, almost irrespective of profits.
. Between 1980 and 2010, the worlds largest 200 companies reduced
dividends only 8% of the time. This was despite dividends being greater than
earnings in over 10% of cases and, indeed, dividends being positive despite
negative earnings in 5% of cases. people dislike goods price inflation, but
like asset price inflation.
The following extracts from the Report (July 2012) are worth quoting:
The Reviews principal concern has been to ask how well equity markets are
achieving their core purposes: to enhance the performance of UK
companies and to enable savers to benefit from the activity of these
companies though returns to direct and indirect ownership of shares in UK
companies short-termism is a problem in UK equity markets. We
question the exaggerated faith which market commentators place in the
efficient market hypothesis, arguing that the theory represents a poor
basis for either regulation or investment. Regulatory philosophy influenced by
the efficient market hypothesis has placed undue reliance on information
disclosure as a response to divergences in knowledge and incentives across the
equity investment chain. This approach has led to the provision of large
quantities of data, much of which is of little value to users. Such copious data
provision may drive damaging short-term decisions by investors, aggravated by
well-documented cognitive biases such as excessive optimism, loss aversion
and anchoring. We focus on the important, though not clear-cut,
distinction among asset managers between those who invest on the
basis of their understanding of the fundamental value of the company and
those who trade based on their expectations of likely short term
movements in share price. While some trading is necessary to assist the
provision of liquidity to investors, current levels of trading activity exceed
those necessary to support the core purposes of equity markets.
Apart from the wide divergence between the objectives and time horizons of
market participants, the psychology of market participants contributes to prices
moving significantly away from intrinsic values. The principal elements which
often contribute to the phenomenon, include the following:
As we have argued earlier (Chapter 4), demand: supply curves in financial and
real economies are quite different. In the real economy, the rise in the price of a
commodity reduces demand for it, even as the supply is incentivised. On the
other hand, in the financial market, the rise in the price of an asset (equity,
currency, etc.) often attracts more speculative buyers thus accentuating the price
trend, carrying the price of the asset further away from intrinsic value.
Michael Lewis has argued in Liars Poker that Most investors are scared of
looking foolish. Investors do not fear losing money as much as they fear solitude,
by which I mean taking risks that others avoid. When they are caught losing
money alone, they have no excuse for their mistake; and most investors, like
most people, need excuses. They are, strangely enough, happy to stand on the
edge of a precipice as long as they are joined by a few thousand others. But
when a market is widely regarded to be in a bad way, even if the problems are
illusory, many investors get out. The fear of losing money when others are
earning too often outweighs the hope of making money by taking a contrarian
position, a point Keynes made a long time back. Even earlier, in his Theory of
Moral Sentiment, Adam Smith had argued that emulating others is a
pervasive and powerful human trait today we call it the herd instinct. And,
the herd instinct produces ever stronger feedback loops in market movements.
The reason why the 2008 crisis was not predicted is that the economic world,
far more than the physical world, is influenced by our beliefs about it. Such
reflexivity leads to the efficient market hypothesis, which claims that
available knowledge is already incorporated in the price of securities. (Ingenuity
and Stupidity Endure, John Kay, Financial Times, September 9, 2011)
One basic precaution (or risk management principle) most traders follow is
adherence to predetermined stop loss levels: reversing the position when the
trend starts going against the position. While this is essential for the trader, the
stop loss level adherence further accentuates the trend.
To elaborate, consider that the price of a currency (or stock) starts rising, for
whatever reasons. This can lead to a series of trades, which feedback into the
trend, accentuating it:
The stop loss levels of those with short positions would be hit forcing
them to reverse the position by buying the currency;
Deltas (or hedge ratios) of those who have sold call options on the
currency will go up, even as deltas of sold put options will fall.
Rebalancing of the deltas would require purchase of the strengthening
currency; etc.
To give another example, this time from the debt market, consider what
happened during the height of the sovereign debt crisis in the euro zone. As
yields in the secondary market went up, speculators/investors bought credit
default swaps, either because their expectations of the probability of default was
more than what was embedded in the price of the CDSs; or to hedge the credit
risk in existing exposures to such bonds. The CDS premium went up and,
chasing it, so did the yields in the secondary market; in turn, this increased the
cost of borrowing for the government, further increasing the possibility of default!
In short, the very structure of the market creates powerful feedback loops,
accentuating a trend, carrying the price further away from intrinsic value: in fact,
this is the reason why the correlation between changes in fundamentals and
changes in prices is often poor.
The second is that any gains from the strategy will be dissipated in higher trading
costs.
The third is that higher returns simply reflect the higher risks of the
strategy.
If markets are rational, as the efficient-market hypothesis assumed, then
they will allocate capital to its most productive uses. But the momentum
effect suggests that an irrationality might be at work; investors could be
buying shares (and commodities) just because they have risen in price.
The EMH contends that no simple rule based on published information can
generate above average returns: the consistent success of momentum
trading is a clear evidence of market inefficiency.
In short, markets can be reflexive where simple cause and effect relationships
do not work, where effects become causes in feedback loops. Markets
create their own reality independent of the fundamentals! The fact is that
greed and fear; the herd instinct; the confirmation and other biases; etc.
(rather than rational analysis) seem to be far stronger motivators of market
participants and their decisions. In todays financial markets, are rational
expectations too often rationalized expectations, based on imperfect
knowledge, on swings between euphoria, fear and greed?
5.2.5.3 Derivatives
Perhaps the most spectacular example of feedback loops generated by the use
of derivatives, or derivative-like strategies, was the sharp fall of equities in the
now famous stock market crash in October 1987. The then popular portfolio
insurance strategies required the investor, worried about a general fall in prices
of stocks, to create the purchase of a synthetic put option on the index by selling
index futures (delta hedging). In the week previous to the crash, equity prices
had fallen. On Monday, October 19, 1987, as cash market prices started falling,
investors sold index futures on a large scale as a hedge. A gap developed
between the price of the index futures contract and the underlying stocks.
Arbitragers bought the index and sold the stocks, depressing prices further,
generating further sales of the index..! The cycle continued resulting into
the largest ever fall on Wall Street, in a classic example of the feedback
loop. Only prompt regulatory intervention stopped the crash escalating into
a crisis.
Prof. Burton Malkiel, in his article The Efficient Market Hypothesis and its Critics
(Journal of Economic Perspectives Volume 17, Number I Winter 2003
Pages 59-82) (from Chapter 4) has argued that A number of factors could
rationally have changed investors views about the proper value of the stock
market in October 1987; that it is not unreasonable to ascribe the sharp decline
in mid-October to the cumulative effect of a number of unfavourable
fundamental events. The fundamental events he has listed occurred over the
previous few months; implicitly, he acknowledges that prices do not absorb
all fundamentals immediately, which is one of the tenets of EMH.
5.2.5.4 Complexity
Consider one example from the equity market, the so-called VIX index and its
derivatives, supposed to be used by active investors as a measure of future price
volatility (NSE also publishes an India VIX index). The index itself is calculated
from the volatility implied by the prices of traded equity index options. Futures
and options based on the VIX index are actively traded in the global market,
ostensibly to manage the price volatility of equity portfolios.
Then the index of volatilities implied by option prices (the VIX index);
Another instance of contagion in equity prices, this time in the reverse direction,
occurred in the first decade of the 20 th century, after a major earthquake in San
Francisco. This was the experience also after the 1929 crash of equity prices on
Wall Street.
Bank runs, once again, are contagious across geographical boundaries. One
classic example of this comes from the 1930s when the run on Creditanstalt
Bank in Austria led to runs on many banks throughout Europe. Clearly, beliefs
(about bank solvency for example) and the animal spirits of the investors, the
risk on risk off sentiment matters to stock prices; can these ever be factored as
part of the rational expectations which are supposed to determine investor
decisions?
5.2.5.6 This Time is Different
In This Time is Different: Eight Centuries of Financial Folly, Carmen Reinhart and
Kenneth Rogoff argue that a major technological/geographical change creates
the perception that the old rules of valuation no longer apply Financial Crises
are things that happen to other people in other countries at other times; crises do
not happen to us, here and now. We are doing things better, we are smarter, we
have learned from past mistakes. In the 1890s, stories focused on the railroads;
a century later, it was the dotcom price bubble. The factor underlying the dotcom
boom was the invention of the internet which was supposed to revolutionalise the
way economies work. At the peak of the dotcom boom, stocks were trading
at very large multiples, not of profits because there were none but of
sales! When participants animal spirits are high, they too often rationalize
their optimism drawing comfort from the thought that this time is
different.
If prices can deviate from economic fundamentals for a long time, there is always
a plethora of pundits to rationalize and justify any price: retrospective
determinism, as Nassim Taleb terms it. The fact is that in financial markets
it is difficult to distinguish the cause of a price movement from a plausible
rationalization (Financial Times Editorial, April 13, 20020. If this is the reality,
much of the commentary in the electronic and print media plays a role in creating
an impression that there is some consistent and plausible cause and effect
relationship between market movements and economic events or developments.
Consider media predictions on stock prices. There is the story of CNBCs Jim
Cramer telling listeners to buy Bear Stearns stock days before it collapsed; of
Jon Stewart claiming that if he had followed CNBCs advice throughout the
previous year, he would be worth a million dollar now if he had started with a
hundred million! (CNBC is of course by no means unique.) More seriously,
financial media reporting is too often shallow, confident that the reader/listener
will not remember now what the commentator said a week back. But it does help
create a faade of plausible rationalization of what has happened and what
may.
As Nassim Nicholas Taleb argued in The Black Swan the Impact of the Highly
Improbable, the newspapers try to get impeccable facts, but weave them into a
narrative in such a way as to convey the impression of causality (and knowledge)
We are explanation seeking animals who tend to think that everything has an
identifiable cause and grab the most apparent one as the explanation.
The purpose of computer based AT is to analyse markets and place orders far
faster than human traders can.
Large orders, i.e. for quantities larger than what current market liquidity for the
asset can fulfill, often have impact costs; price moves against the seller or buyer,
as the case may be. To mitigate this, Big institutions often use execution
algorithms, which take large orders, break them up into smaller slices, and
choose the size of those slices and the times at which they send them to the
market in such a way as to minimise slippage. For example, volume
participation algorithms calculate the number of a companys shares bought and
sold in a given period the previous minute, say and then send in a slice of the
institutions overall order whose size is proportional to that number, the rationale
being that there will be less slippage when markets are busy than when they are
quiet....Electronic market-making algorithms replicate what human market
makers have always tried to do continuously post a price at which they will sell
a corporations shares and a lower price at which they will buy them, in the hope
of earning the spread between the two prices but they revise prices as market
conditions change far faster than any human being can (Donald Mackenzie,
How to Make Money in Microseconds, London Review of Books, 2011). These
points are equally relevant to AT in the forex market.
More complex AT systems are used in proprietary trading. For example, they can
use all the rule-based technical analysis models (filters, moving averages,
etc.) far faster than any human mind can. They also use more complicated
models, for example continuously analyzing correlations between the prices of
different assets. If the change in prices disturbs the pattern of established
correlations, AT uses this information to go long and/or short in the assets or
currencies in question.
The latest AT systems are adaptive in the sense that they are continuously
undertaking backtesting of the results from the rules they are using for trading
and adapting them to avoid the mistakes/losses made; and also to what other
players in the market are doing. The logic and strategy are similar to what
poker players use (John von Neumann and Oskar Morgenstern, Theory of
Games and Economic Behavior).
AT is rule-based;
Clearly AT leads to ever larger short term trading, facilitates so-called high
frequency trading (HFT), and has led to a few flash crashes. One has serious
doubts whether it improves pricing efficiency of markets.
This is a mathematical theory that seeks to explain how very minor, insignificant
factors can be the root cause of major events. The theory attempts to forecast
highly complex systems, weather for example; the often cited example is how a
butterfly flying in one part of the world can become the root cause of a major
storm thousands of miles, and a few months, away! There have been several
attempts to apply the mathematics of Chaos Theory to predicting what happens
in the financial market; so far, nobody has succeeded in doing so.
The reason is that since we can never know all the initial conditions of a complex
system in sufficient (i.e. perfect) detail, we cannot hope to predict the ultimate
fate. Even slight errors in measuring the state of a system will be amplified
dramatically, rendering any prediction useless. Systems often become
chaotic when there is feedback present. A good example is the behavior of the
stock market. As the value of a stock rises or falls, people are inclined to buy or
sell that stock. This in turn further affects the price of the stock, causing it to rise
or fall chaotically. The currency market is no different see paragraph 5.3 below.
To quote from Talebs book again, Poincare was the first known big-gun
mathematician to understand and explain that there are fundamental limits to our
equations. He introduced nonlinearities, small effects that can lead to severe
consequences, an idea that later became popular, perhaps a bit too popular, as
chaos theory Poincares reasoning was simple: as you project into the
future you may need an increasing amount of precision about the
dynamics of the process that you are modeling, since your error rate grows
very rapidly.
(To be sure, the theory is not applicable to complex physical or financial systems
alone, but perhaps even more to international politics. The start of the series of
events which led to the First World War, was the assassination of Franz
Ferdinand, the heir to the Austro-Hungarian Empire, by a Serbian nationalist. As
two recent histories document (The War That Ended Peace by Margaret
MacMillan, and The Sleepwalkers by Christopher Clark), the flight of the
butterfly set in motion a series of events culminating in perhaps the costliest war
in world history, in terms of lives lost directly (8.5 mn; another 8 mn permanently
disabled!).
There is only one theory of the fair value of a currency, namely that determined
by purchasing power parity (PPP), as propounded by Gustav Cassel, a Swedish
economist, back in 1921: the exchange rate between two currencies should be
such as to equate the domestic costs/prices of tradable goods and services in
the two countries. The corollary is that exchange rates should move to reflect the
relative inflation rates. The only modification I have come across is the so-called
Samuelson Balassa thesis that, apart from inflation differentials, changes in
productivity differentials also need to be reflected in the exchange rate.
Do floating exchange rates reflect prices based on PPP? I quote a few examples:
From the late 1970s to roughly 1984, the United States dollar doubled in
value against major currencies, and halved again over the next three
years. More recently, the movement in the USD: EUR exchange rate has
been equally erratic. When the euro was introduced on January 1, 1999,
the general expectation was that it would strengthen against the US
Dollar. It fell almost 30% over the next 22 months. Since its low of October
2000, the euro has been, broadly speaking, appreciating against the dollar
gradually at first, but spectacularly in 2007-08. It reached an all-time
high of $ 1.60 in July 2008, after a 21% rise in the previous 7 months.
Equally inexplicably in terms of fundamentals, the euro depreciated to $
1.39 by end December 2008, even as the US, not the euro zone, was in
the throes of a major financial crisis.
More recently the JPY: USD rate, the second most traded currency pair,
moved from JPY 79 in mid-November 2012 to around 100 in less than six
months, after mostly trading in the 70s for a year and a half.
There was no significant change of any kind between the inflation rates, or
productivity, in these countries, which can anywhere near account for the
changes. To quote from an interview by Nobel Laureate Robert Mundell (The
Wall Street Journal, October 18, 2010), The whole idea of having a free trade
area when you have gyrating exchange rates doesnt make sense at all.. All
this unnecessary noise, unnecessary uncertainty; it just confuses the ability to
evaluate market prices.What economic function did the exchange rate
changes among these islands of stability fulfil? Except for stuffing gift
socks of hedge funds, the answer is none": add to that the trading profits of
banks.
To quote from Kenneth Rogoff, Finance and Development, (June 2002), former
Economic Counsellor and Director of IMF's Research Department, there is
some tendency for a country's real exchange rate (the nominal exchange rate
adjusted for differences in relative national price levels) to return to its historical
value. But the adjustment is very slow indeed. All empirical evidence
suggests that one must think in terms of several years, not several
months, for the pull of purchasing power parity to kick in." And, purchasing
power parity in the tradeables sector is the economic fundamental that should
determine exchange rate.
Consider also the belief of too many commentators, analysts and market
participants that monetary easing depreciates a currency (one example:
Investors think that Federal Reserves monetary easing (will) weaken the
dollar. John Authers, Financial Times, April 7th 2013). This belief perhaps comes
from the pioneering attempt to offer an explanation for exchange rate volatility in
the floating rate era, made by Rudiger Dornbusch (1976). To quote once again
from Rogoff (ibid), Dornbusch's 1976 paper became an instant classic because
it seemed to make sense of the chaotic new world of flexible exchange rates,
which had only just replaced the serene 'Bretton Woods' system of fixed rates.
In Dornbusch's view, excessive exchange rate volatility was the inevitable result
of the chaotic monetary policies that had led to the break-up of fixed rates in the
first place. If domestic monetary policies are unpredictable, then so, too, will be
domestic inflation differentials. Ergo, the exchange rate must be volatile
because, in the very long run, there has to be a tight link between national
inflation differential and exchange ratesThe stroke of genius in his paper was
'overshooting'. According to Dornbusch's now famous logic, monetary policy
volatility is not only reflected in exchange rate volatility but is also amplified....
Dornbuch's theory, which he spiced up by incorporating the exciting new theory
of 'rational expectations' -- when private agents form exchange rate expectations
based on reasoned and intelligent examination of available economic data --
suggested that modest improvements in monetary stability would be rewarded
with large gains in exchange rate stability". Dornbusch's argument gave
reassurance that there might be some logic to the apparent randomness of
flexible exchange rates, and may be even a cure for volatility.
The fact is that the correlation between money supply and exchange rate is poor:
the Japanese central bank has been following an easy monetary policy for two
decades; during this period, the yen has reached new peaks against both the
dollar and the euro!
The underlying cause of such volatility is the domination of speculative trading in
market activity. The daily turnover in the global currency market now exceeds $
5.3 trillion, 100 times global exports involving exchange of currencies, to
serve which the market was born!
More evidence of pricing inefficiency comes from the inability of the forward rate
to predict the future spot rate: since the former is a function of interest
differentials between the two currencies (which would, in general, parallel
inflation differential), the forward margin should be strongly, and positively,
correlated with the changes in the spot rate. It is not.
The other tenet of efficient markets is that speculators step in when prices move
away from fundamentals to make arbitrage profit. In reality, speculators/traders
are trend followers and technical analysis and models often determine their
decisions. According to a study published in the Bank for International
Settlements Quarterly Review, December 2011, the two most popular and
successful trading strategies are momentum trading and carry trades:
momentum trading would not work if price changes were random. Its success
evidences that price changes are not random (as EMH postulates), but often
display auto-regression, one days price change influencing the next days.
Simple rules like technical analysis, based on published and available
information, can make money, as banks trading profits evidence.
Carry trades are in effect a play on the interest rate differential and changes in
the spot rate. Consider the structure:
Were the market efficient in terms of pricing, neither momentum trading nor carry
trade strategies should really work! But, the huge trading profits earned by banks
are enough evidence that they work. As The Economist argued in its Economic
Focus (December 12, 2009), If markets were truly efficient, carry trades
ought not to be profitable because the extra interest earned should be exactly
offset by a fall in the target currency. That is why high-interest currencies trade at
a discount to their current or spot rate in forward markets. Carry trades and
other speculative activities often drive exchange rates a long way from their
fair or equilibrium values.
The result of the highly speculative market is that exchange rates do overshoot
compared with the levels that are consistent with underlying
fundamentals..also because of the self-fulfilling nature of investors
expectations, and the herd behaviour that influences aggregate market
developments. Overshooting is the rule rather than the exception, and is
very difficult to mitigate. (Smaghi, Lorenzo Bini. 2013. Why the currency-war
deniers are wrong, A-List, Financial Times.) To put it differently, Economic
theory is that of the rational economic man. The reality on the ground is that a
herd mentality, impulse buying and insufficient research underlie decision making
more than rationalism. The result is that exchange rates deviate far from their
equilibrium values (quote from a letter by Saro Agnerian in The Economist,
March 9th 2013). As Heiner Flassbeck and Massimiliano La Marca argue in
Global Imbalances and Destabilizing Speculation (UNCTAD paper, 2007), if the
herd behaviour of speculators is sufficient to appreciate the target currency, the
appeal of large returns is sufficient to generate them. It goes on to argue that
(Capital) flows moving from low-yielding, low-inflation countries to high-
yielding, high-inflation countries would cause the currencies of the latter to
appreciate, and provoke the paradoxical and dangerous combination of
surplus economies experiencing pressures to depreciate, and deficit
countries facing a corresponding pressure to appreciate.
the examples also show how much real appreciation (loss of overall
competitiveness for a nation) can result from speculation that is driven by interest
rate differentialsfloating currencies under various monetary policy
regimes, rather than being immune to speculative operations actually
stimulate them.
As John Kay wrote in the Financial Times, July 17, 2013, The market is not the
best place to set a fair price for assetsThe greater the volume of trading (and it
is gigantic in the currency market), the greater the extent to which prices are
determined not by informed assessment of fundamental value but by speculation
In the past decade, the efficient market hypothesis has been mugged by
reality.
(iv) The case of Long Term Capital Management (LTCM), a hedge fund which
collapsed in 1998, is a good example of how mean reversion strategy
requires the speculator betting on it, to have huge liquidity; as Keynes
famously said, prices can remain irrational longer than an investor can
remain solvent!.
At the material time, based on its analysis of past data, it believed that, for
one thing, the yield difference between sovereign and corporate bonds
was much higher than mean levels; also, with the euro due to be formed in
a few months, it expected the yield difference between German and Italian
government bonds to narrow. Based on this expectation, it shorted the US
and German government bonds, and went long in corporate and Italian
government bonds (such highly leveraged long/short strategies was the
reason why hedge funds came to acquire their name: in the present case,
the strategy depended purely on mean reversion of the yield gap,
irrespective of whether yields as a whole went up or down).
What was not expected was that Russia would default on domestic
currency sovereign bonds; but it did. There was a flight to quality
amongst investors, who bought US and German government bonds,
selling other fixed income securities. The result was a wider yield gap,
resulting into margin calls from the banks which had provided leverage to
the positions. The leveraging was so high that LTCM could not meet
margin calls, and in a rescue led by the New York Federal Reserve, the
banks took over LTCM. The lesson is that the time when mean reversion
will take place and prices return to their intrinsic values, is always
extremely uncertain: as it happened, the banks which took over LTCM,
ultimately made money on the portfolio!
(v) The LTCM case also illustrates another reality in financial markets:
how market prices depend on the willingness of
lenders/counterparty banks to leverage the instrument used for
speculation. After the collapse of LTCM in 1998, most lenders cut credit
lines and leverage ratios for all hedge funds, many of whom were active in
carry trades shorting the low interest yen. As such trades were reversed
(with cuts in bank funding), the yen appreciated from JPY 146 to JPY
112 in a matter of seven weeks. Is the willingness to leverage carry
trades on the part of the banking system a fundamental for the yen:
dollar exchange rate?
(viii) Gordon Brown, the Prime Minister of U.K., and Nicolas Sarkozy, the
President of France, wrote in an article in the Wall Street Journal in mid-
July 2009, First (the oil price) rose by more than $ 80 a barrel, then fell
rapidly by more than $ 100, before doubling to its current level of around $
70. In that time, however, there has been no serious interruption of supply
. Such erratic price movement in one of the worlds most crucial
commodities is a growing cause for alarm. The surge in prices last
year gravely damaged the global economy and contributed to the
downturn Those who rely on oil and have no substitutes readily have
been the victims of extreme price fluctuations beyond their control and
apparently beyond reason. Importing countries, especially in the
developing world, find themselves committed to big subsidies to shield
domestic consumers from potentially devastating price shifts .. We
therefore call upon (regulators) to consider improving transparency and
supervision of futures markets to reduce damaging speculation. This
would serve the interests of orderly and adequate investment in future
supplies. Volatility and opacity are the enemies of growth.
Historically, the best known examples of mispricing of assets are the Tulip
Mania in Holland in the 1630s; the Mississippi Scheme which swept France in
1720; and the South Sea Bubble in England around the same year. The last
was described as an undertaking of vast importance . so secret that nothing
more can be revealed. In each case the prices first went to absurd levels, before
the inevitable crash. (All these cases have been described in detail in Charles
Mackays Extraordinary Popular Delusions and the Madness of Crowds (1841)).
During the internet stock IPOs (initial public offerings) a decade later, the cash
flows of startups, which had no hopes of making profits for the next several
years, were projected for, say, 15 years; and the IPO price justified using a
suitable discount rate. The weaknesses of the assumptions underlying the
models used were obvious once the crash occurred in early 2000. At the height
of the dot com bubble, the NASDAQ Composite Index, which included most
of the internet stocks, was trading at 5400; almost 14 years later the index
is still around 4000 and this even after a few of the internet based
companies have done spectacularly well (Amazon, Google, etc.) And, this
happened in a supposedly mature and efficient market in which information
was available practically without cost. Even otherwise very successful
speculators, George Soros and Julian Robertson for example, resisted the
temptation of internet stocks for a long time before joining the party and lost
heavily. One investor who never touched the dot com stocks was Warren Buffet,
the worlds most successful investor, who does not need anything more complex
than a calculator to make his investment decisions. His reason was that he could
not understand the business plan of the companies coming in the market and
would not invest in businesses which he did not understand. Schiller had
surmised that a bubble was forming; his book Irrational Exuberance came out in
the very year the bubble burst, 2000.
Too often, investment decisions are made on how much the asset price has gone
up in the recent past, extrapolating the past to the future, rather than making
decisions based on rational expectations of the returns in the future. When the
bubble is growing, greed overcomes fear; once it bursts the psychology is
reversed. (In India, there were several cases of well-educated professionals like
lawyers and doctors selling their businesses to invest in the booming stock
market during the securities scam of the early 1990s!) Evidence suggests that, at
such times, some participants are aware of the egregious mispricing; they still
buy the asset on what is referred to as the the greater fool theory: that they will
be able to sell the asset at an even higher price to a greater fool.
Investors do not seem to have become much more rational even in the 21 st
century, as the mortgage market collapse in 2008 witnesses. Just before the
market collapsed, the then Citibank Chairman memorably said that You have to
keep dancing till the music stops. For him, it stopped in a few days!
There is enough empirical evidence that speculation driven trading, the market
structure and feedback loops they lead to, often carry prices far away from
fundamentals. What about the allocative efficiency of capital markets, the belief
that markets allocate capital to businesses and areas that would produce the
maximum return? Several recent cases raise questions about this assumption as
well: the oil importers debt financing by banks in the 1970s on the belief that
companies can go bankrupt, countries cannot, a statement attributed to the
then Citibank Chairman; the junk bond financed takeovers of the 1980s; the
dotcom equity prices in the 1990s; the mortgage securities market in the first
decade of the 21st century; all are examples of misallocation of capital on a
gigantic scale, by the supposedly mature and efficient US financial market.
There are of course those who defend market efficiency but argue that efficiency
has nothing to do with socially desirable pricing (Robert Lucas). This of course
begs the question: in that case, how can markets be relied upon to allocate
capital where it will do the most good?
After studying financial markets for more than 50 years, one conclusion I have
come to is that markets are efficient in the sense that prices cannot be predicted
with any degree of certainty; they are not efficient in the sense that prices
always, or even generally, reflect fundamentals, or that price changes are
random. In fact, ruling prices are often significantly different from intrinsic
values.
I can do no better than conclude with some comments in John Kays The Map Is
Not the Territory: An Essay on the State of Economics (Institute for New
Economic Thinking, October 04, 2011), The economic world, far more than the
physical world, is influenced by our beliefs about it. .The efficient market
hypothesis is an illuminating idea, but it is not Reality As It Is In Itself.
Information is reflected in prices, but not necessarily accurately, or completely.
There is a trivial sense in which the deviations from efficient markets are too
small to matter and a more important sense in which these deviations are the
principal thing that matters. the belief that profit opportunities that
have not been arbitraged away still exist ,,, it explains why there is so much trade
in securities (or in other asset classes).
The preposterous claim that deviations from market efficiency were not only
irrelevant to the recent crisis but could never be relevant is the product of an
environment in which deduction has driven out induction and ideology has taken
over from observation. The belief that models are not just useful tools but also
are capable of yielding comprehensive and universal descriptions of the world
has blinded its proponents to realities that have been staring them in the face.
In many ways, John Maynard Keynes was not only the greatest macro-economist
of the 20th century (and relevant for the 21 st century democracies, who all
followed Keynesian prescriptions to stem the largest drop in global output since
the 1930s, after the financial crisis of 2008): his insights on financial economics,
some of which we have quoted, are equally relevant and realistic. One reason
could well be that he was not sitting in an ivory tower formulating theories and
models: he speculated in markets; was a civil servant, policy-maker and political
activist; an academic; a connoisseur of arts comfortable in the company of
writers, critics and artists; an author with an excellent turn of phrase; a pragmatic,
not an ideologue, willing to change his mind when new facts contradicted
his earlier beliefs. One wonders how many economists can boast such well-
rounded experience and personalities! I can do no better than end the Chapter
with a thought borrowed from him: in the long run market prices do reflect
fundamentals; but, in the long run, we are all dead! (To be sure, he wrote this in
a different context: inflation)