Comments on: Rational manias

By: Nelson

Nelson — Wed, 21 Jul 2004 15:56:21 +0000

Keynes worried about the implications for our society when “the conventional valuation of stocks is established (by) the mass psychology of a large number of ignorant individuals.” The result, he suggested would lead to violent changes in prices, a trend that would be intensified as even expert professionals-who, one might have suppossed, would offset these vagaries by their perspective and judgement-follow the mass psychology, and try to foresee changes in the public valuation. As a result, he described the stock market as “a battle of wits to anticipate the basis of conventional values a few months hence rather than the prospective yield of an investment over a long term of years.”

By: Jason

Jason — Tue, 20 Jul 2004 17:50:03 +0000

Shai, as always the best comeback is to ask if you made your millions in predicting the crash? Yes, I had some VC friends at the time who thought things were massively overpriced (compared to historically), but they still had to invest at these prices. They did fine by managing their portfolio in a way that was bubble-burst resistant, while still managing to grab a lot of upside. However, even they still weren’t sure where all the tech was going to lead us, and weren’t so confident in their prediction that they bet the fund on the phenomena being a bubble. I didn’t lose a dime in the crash (nor make much either), so I’m not trying to justify my own stupidity here. I’m just saying that, even though there were pyramid scheme buyers like you, there were also plenty of smart investors who were thinking of the internet as a landgrab, and that it was important to grab as much territory as possible, and then figure out the money later. For a few companies this has worked. Look at Yahoo! or Google. In a different environment, neither of these companies would have been able to exist. If you really were so sure it was a bubble and going to burst, you really should have bet on it. You’d be a very rich person now. Of course, if you’d managed to get enough people along with you, there wouldn’t have been a bubble in the first place.

By: Shai

Shai — Tue, 20 Jul 2004 08:54:05 +0000

jason writes: “Sure, in 20/20 hindsight the valuations seem high, but if you’d had 20/20 foresight you’d now be a very rich man.” um, no. the tech bubble resembles powerball if it were a pyramid scheme. the information was out there that valuations were crazy. and i’m not just talking about the tail end of the bubble when everyone I talked to knew a 4 billion Akamai IPO was ridiculous, and the economics of VA linux was a sham (if you don’t believe me, go look at old threads on slashdot). sure, we do remember the fed, aka alan greenspan testifying to congress that IT productivity suspended the laws of economics, but there was also widespread talk about hundreds of ipo’s that were nothing more than some idiotic idea with e- tagged onto it. Here’s an example from pets.com, from a time period placing it inside the bubble: David Schehr, an analyst at the Gartner Group, based in Raleigh Durham, N.C., says he has some problems with the whole concept. “It’s possible there can be a price advantage, and it might be attractive if they build a good consumer experience online,” he says. “But shipping 50 pounds of dog food over UPS may become problematic over time. And if Fido runs out of food, you’re not going to be wanting to wait for it.” For those reasons and others, Scherhr says he thinks the online pet-supplies market will eventually be characterized by vicious price wars that over time will leave most of the competitors broke and howling at the moon. (it really wasn’t economic at all, they were just eating the shipping with hitherto unlimited cashflow, but still) Let me use myself as an example. In high school economics class my final presentation compared IPO’s and market valuations of several companies against future earnings potential derived from basic economic analysis of markets we learned earlier in the course (minimally mathematical super simple textbook). my conclusion was that this was possibly a sign of a bubble. (we had been discussing the recent asian bubble the previous week). this information didn’t come from nowhere. there was a lot of talk about ridiculous valuations in the media. but the point i wanted to get to is this: this information did nothing to prevent me from investing in qwest (internet backbone) or @home (cable internet, now bankrupt). I did happen to make money, but that’s luck: I was itching to spend money, thinking I could invest more and get rich later. the general idea was that everyone was irrational, so you may as well take advantage of them. but that’s obviously a self defeating idea. as james says here ( http://www.randomhouse.com/features/wisdomofcrowds/Q&A.html ): “… instead of worrying about how much a company is really worth, investors start worrying about how much other people will think the company is worth.”

By: LeftCoast

LeftCoast — Tue, 20 Jul 2004 08:27:01 +0000

The best argument I know of against the EMH applying to the stock exchange is closed-end mutual funds. Many of them have traded for years at either a premium or discount to the value of their underlying securities.

By: Jason

Jason — Tue, 20 Jul 2004 00:48:29 +0000

James, again I think it’s easy in hindsight to say we all should have shorted Cisco, but there were plenty of people who thought Cisco was going to own all the machinery that ran the internet, and they’d be able to price as much as they like. They bid the price up, and at the time Cisco was growing like crazy. I know plenty of people who bought them, and they weren’t all stupid (not me, thankfully, although looking at their share price now, if you’d bought in 99, you’d still be even now, which isn’t really that bad).

By: James Surowiecki

James Surowiecki — Tue, 20 Jul 2004 00:31:52 +0000

Daniel, absolutely right—I was going to add a caveat saying that shortselling limitations can’t explain why the price of, say, Cisco got completely out of whack. Again, as you know, I believe that the market was deeply irrational in the late 1990s.

By: dsquared

dsquared — Mon, 19 Jul 2004 23:41:25 +0000

I’d also note that regulatory explanations for the dot com boom have to cope with the fact that it also occurred in the UK, France, Germany and Italy under very much more lax regimes.

By: dsquared

dsquared — Mon, 19 Jul 2004 23:24:20 +0000

James: but the “dot com” boom wasn’t only in dot com stocks. It was perfectly possible to short America Online, the telco sector and large-cap software companies.

By: James Surowiecki

James Surowiecki — Mon, 19 Jul 2004 23:15:49 +0000

That’s an interesting argument about the price change in the 1987 crash. I’ll have to think more about it. It’s true that the dot-com boom tout court can’t be explained by institutional problems, but I do think that if shortselling Internet stocks had been easier (or, in some cases, even possible), and if Net-stock floats had been larger, the pricing of Internet stocks would have been significantly better. Even so, you would undoubtedly have been left with a significant deviation from intrinsic value, so that I’d say the structural problems magnified, but didn’t cause, the market’s collective irrationality in 1999 and early 2000.

By: John Quiggin

John Quiggin — Mon, 19 Jul 2004 22:11:14 +0000

James, I agree with you that these are empirical questions. Any model that shows either that the market uniformly outperforms the state or vice versa is inconsistent with our experience. On the 1987 crash, I didn’t regard it as definitive for a couple of reasons. First, although the change in market valuation was sudden, it wasn’t huge compared to changes that often occur over a year or two. So if you accept that these changes are consistent with EMH, a sudden adjustment is not much of a problem. Second, even if the crash was a violation of EMH it could be (and was) explained by fixable institutional problems, such as rules about program trading and so on. No such explanation is possible for the dotcom boom.

By: James Surowiecki

James Surowiecki — Mon, 19 Jul 2004 21:42:04 +0000

John, I agree that the use of strong EMH —often, as you said, implicitly—as an argument-stopper when it comes to the kinds of problems you mention is both common and dangerous. One place, at least in the US, where this is very much the case is corporate law, with pernicious effects. I think many of these questions—privatization, international flows of capital, etc.—are still open ones, and that market solutions may in some of these cases be the best ones possible (which is not to say they’re optimal). But the superiority of those solutions needs to be demonstrated empirically, rather than simply making recourse to a rational-expectations-based idealization of market efficiency.

By: still working it out

still working it out — Mon, 19 Jul 2004 21:41:40 +0000

If you’re going to talk about EMT then you should really mention George Soros’ principle of Reflexivity (which he explained, rather poorly, in Financial Alchemy, I think. Can’t remember the title exactly) as it provides a pretty good reason why EMT is bunk from someone who can claim to understand financial markets better than most. People keep seeming to assume is that if EMT fails, it is because humans are irrational and emotional creatures. This is not true. As George Soros explains, markets are inherently unstable, regardless how rational the market participants are. EMT assumes that the market has taken into account all information and processed it into a price. One of the fundamental problem’s with EMT is that one of the pieces of information that is used to calculate an asset’s price, is the previous price of the asset. If that price has been rising, then that will add to the value of the asset. Vice versa if it has been falling. This creates a self re-inforcing feedback loop that is not the result of irrational behaviour. If the price has been strongly trending, then it is entirely rational, whether you are a highly emotional manic-depressive or an ice cold supercomputer to assume that it will continue to trend for one simple reason. You know the market is smarter than you. Once you accept that a price is trending then the logical thing to do is buy or sell the asset based on that fact. Something any successful trader understands very well. Psycholoy probably plays a role, but trending markets are easily explained, even when it is assumed that all participants are completely rational as long as price history is part of the information used to determine the current price, which in practice it alway is.

By: John Quiggin

John Quiggin — Mon, 19 Jul 2004 21:32:16 +0000

To everyone, link is there now. Sorry about that. d2: I agree with your definition of “best”, in principle at least. It’s the standard Bayesian definition and the correct one to use in reading my post. Of course we don’t generally know which loss function to use – minimum-variance is a neutral choice. James: I agree that you can’t systematically otupick the stock market most of the time. But the strong EMH hypothesis is important in lots of contexts, such as arguments about unrestricted international movements of capital, use of markets rather than regulation in electricity and other infrastructure industries, privatisation and so on. It’s mostly implicit, but if you work through the argument you’ll find that it makes a big difference.

By: Matt Weiner

Matt Weiner — Mon, 19 Jul 2004 20:44:00 +0000

Having no expertise whatsoever, I'll try to be the link fairy: This looks to be the relevant Slate article. According to this, "Drawdown" represents the maximum percentage loss for a given period. This represents the greatest percentage difference between index highs and lows for a selected investment period. I might guess why equities traders care about it, but if Bill T or someone else wants to explain that would surely be more accurate.

By: Jim Harrison

Jim Harrison — Mon, 19 Jul 2004 18:23:16 +0000

About IT efficiency gains: the assumption seems to be that internet-related technologies produced the bulk of productivity gains. In my corner of the economy, though, it wasn’t the internet but older computer technology that drastically increased productivity. The outfits I work for finally figured out how to integrate homely applications like word processing and electronic databases into their workflow. The benefits promised in the 80s materialized in the 90s. For example, the turn-around time for the production of research reports shrunk drastically in that period, but most of the speedup resulted from organizational changes that used technology that had been around for quite a while. The effortless transmission of text materials over the internet certainly helped, but it wasn’t the main thing—technically with it people were already getting most of the benefits of that back in the late 80s through the use of email and modems. I think we generally underestimate how long it takes for business to figure out how to use technology efficiently. If I’m right, much of the benefit from the internet remains to be realized. One of the recurring problems of evaluating technology is to guess which lump in the snake corresponds to which pig.