I recently finished reading The Myth of the Rational Market by Justin Fox. The book is a chronological history of modern economic and financial theory. It’s lighter reading than it sounds. The book is a good read for those of you with a deep interest in finance or economics.
I read the book on my iPad using Amazon’s Kindle app. This was the first book I read from cover to cover electronically. Reading for long periods of time on the iPad takes some getting used to, but it does have its advantages. One of benefits of the Kindle app is that all of the items you highlight and notes you make about a book are electronically uploaded for future reference to your Amazon Kindle page.
Below is a sample of some of the passages I highlighted in the book. Enjoy.
But the experiences of the previous decade had turned Fisher into enough of a realist that he immediately back-pedaled from his bold statement. Stock and bond price movements weren’t entirely random, he continued: Were it true that each individual speculator made up his mind independently of every other as to the future course of events, the errors of some would probably be offset by those of others. But, as a matter of fact, the mistakes of the common herd are usually in the same direction. Like sheep, they all follow a single leader.
The most wonderful thing about a bull market is that it creates its own hopes. If people buy because they think stocks will rise, their act of buying sends up the price of stocks. This causes them to buy still further, and sends the dizzy dance off on another round. And unlike a game of cards or dice, no one loses what the winners gain. Everybody gets a prize! Of course, the prizes are all on paper and would disappear if everyone tried to cash them in. But why should anyone wish to sell such lucrative securities?
The leap from observing that it is hard to predict stock price movements to concluding that those prices must therefore be right was, he [Shiller] declared at a conference in 1984, “one of the most remarkable errors in the history of economic thought.
They [Financial Economists] ignore what seems to many to be the more important question of what determines the overall level of asset prices. It would surely come as a surprise to a layman to learn that virtually no mainstream research in the field of finance in the last decade has attempted to account for the stock market boom of the 1960s or the spectacular decline in real stock prices during the mid-1970s.
“We are forced to conclude that [CAPM] does not describe the last 50 years of average stock returns,” they wrote. Fama and French argued that it was beta’s strong performance in just one decade, the 1940s, that had delivered positive results in the first round of CAPM tests in the early 1970s.
One of the most compelling pieces of evidence for the whole structure of efficient markets finance was, they seemed to be saying, just a data artifact. Coming as it did from Fama himself, this verdict had an impact that previous evidence of market patterns had not. “The Pope said God was dead,” efficient market critic Robert Haugen of the University of California at Irvine wrote a few years later. “At least the God of CAPM.”
A drop in the price of a security raised the value at risk of a portfolio containing that security. If a bank or hedge fund was trying to keep the VaR below a certain level, it might then have to sell off other securities to push the VaR back down.
Starting in the late 1970s, Chan and Lakonishok found, stocks that belonged to the S&P 500 index dramatically outperformed the rest of the market. Only 2 percent of the equity investments of the top two hundred pension funds were indexed to the S&P in 1980, they pointed out. By 1993 it was close to 20 percent.
The defining characteristic of the modern professional investor is that he manages someone else’s money. For such a professional, going against the sentiments of Mr. Market often means going against the sentiments of his clients. If he makes a contrarian bet, and it doesn’t pay off quickly, he might be in big trouble.
“It is the long-term investor, he who most promotes the public interest, who will in practice come in for the most criticism, wherever investment funds are managed by committees or boards or banks,” John Maynard Keynes had written in the 1930s. “For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion.” As a result, Keynes argued, believing that such long-term investors would set market prices rationally was a pipe dream.
That article was titled “The Limits of Arbitrage,” and it was published in the March 1997 issue of the Journal of Finance. It was precisely when the market was at its craziest, Shleifer and Vishny argued, that those who tried to end the craziness by placing bets against it would have the hardest time keeping their customers or borrowing money. “When arbitrage requires capital, arbitrageurs can become most constrained when they have the best opportunities, i.e., when the mispricing they have bet against gets even worse,” they wrote. “Moreover, the fear of this scenario would make them more cautious when they put on their initial trades, and hence less effective in bringing about market efficiency.”
Shleifer and Vishny proposed that the limits to arbitrage made value investing work. It wasn’t that there was anything especially risky about value stocks themselves, as Fama and French had argued, but that it was professionally risky for money managers to plunk down too much money on unpopular investments. Value stocks are, by definition, unpopular.
“Everybody knew there was a bubble,” says money manager Jeremy Grantham, who from 1998 through 2001 made a practice of asking investment professionals at every conference he attended if they thought the price-to-earnings ratio of the S&P 500—in the high 20s in 1999—would soon drop below 17.5. Of seventeen hundred money managers polled, all but seven said yes. Betting actual money on such a drop, however, could be a career-killing move.
There were, in real-world markets, limits to arbitrage that allowed hyperactive noise traders to drive prices to irrational levels and stay there for a while.
“Offsetting actions by informed investors do not typically suffice to cause the price effects of erroneous beliefs to disappear with the passage of time,” Fama and French concluded. “For prices to converge to rational values, the beliefs of misinformed investors must converge to those of the informed, so eventually there is complete agreement about old news.”
Economists in the Austrian tradition avoided equations not just because they were poor mathematicians, but because they thought equations failed to allow for the uncertainty and change inherent in economic life.
Stock prices contain lots of information. Markets, as Friedrich Hayek argued, are the best aggregators of information known to man. Yet mixed up amid the information in security prices is an awful lot of emotion, error, and noise.
Jeremy Jones, CFA
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