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Sunday, October 20, 2013

How do bubbles exist in efficient markets?

Thought for the day, from Robert Shiller

“…we have always to reflect that if you swim with the current, you will be thinking the same things as everyone else. You have to recognize that your own thoughts are not your own thoughts. They kind of filtered and percolated in from other people. It all seems like my own common sense, but it's just what everybody is saying now."

There’s more here: http://www.fool.com/investing/general/2013/10/14/10-fascinating-insights-from-nobel-prize-winner-ro.aspx 

Which brings me to the efficient market hypothesis.

Shiller and Fama shared the Nobel award in economics this year (with a third economist).  But they were on opposite sites of the efficient market hypothesis.

Fama is known as the "father of the efficient markets hypothesis (EMH)," which asserts that all information is efficiently priced into the markets making it incredibly difficult to profit off of trading in the short run. 

Strictly speaking, if all information is efficiently priced into the markets, bubbles would be unlikely/impossible. Shiller was famous for showing the obvious fact that bubbles do exist, most famously illustrating that housing was a bubble in the 2000s before the bubble burst – after a bubble bursts, all is obvious.

My own view of this is this:

1. There is insider information. Those with insider information can clearly profit from it.  Congressmen, for example, seem to be unusually good at stock picking. http://www.huffingtonpost.com/2011/05/24/members-of-congress-get-a_n_866387.html 

2. Markets are generally efficient, at least from the standpoint of an individual investor without inside information.  From where I sit, I don’t know anything special, and index funds make good sense.

3. A lot of the “information” which is efficiently priced into the markets is just wrong or overapplied.  This makes it easy to see how bubbles occur. The information that you can’t have a bubble in housing, or that housing had never had a decline on a national basis, was just wrong. The risk models used to determine the risk of bundles of mortgages were wrong/overapplied – a fact known at the time but buried in the excessive exuberance surrounding Wall Street making lots of money from these bundles.

4. Those who believe in the common wisdom of the bubble invest in it. Those who don’t are more likely not to invest in it than they are to invest against it. 

Sure, you can short a stock, but that’s a strategy for certain speculators – and a riskier strategy if your timing is wrong. 

Certain investments are also hard to short; stocks are straightforward, but betting against the housing market is something John Paulsen could so, but an ordinary investor would not be able to.  Similarly, even those who were pretty sure Bernie Madoff was a fraud may have (ineffectively) reported their concerns to the SEC, or just invested their money somewhere else. They couldn’t “short” him – and, if they had, they likely would have lost patience as his Ponzi scheme went on for decades.

So, most of those who think an investment is overpriced just don’t invest in it. They don’t invest against it. This means those who are skeptical don’t contribute to the bubble, but don’t exert much push against it, either.