For me the predictive ability of these markets is secondary to their usefulness in hedging risks. If price does not represent probability due to a supply/demand imbalance, longshot effect, etc, this simply represents an opportunity for speculators to profit.

Lastly, it shouldn’t be a surprise that these markets may tend to fail especially in cases where the candidate list is semi-open.

(time to stop blog commenting, back to bond trading)

In particular, there are lead-lag effects between large and small-cap stocks and a measurable Granger-causation relationship between them. You can make, over most time periods, a consistent return by using the returns on large-cap stocks as an element in forecasting the returns on small-cap stocks. Note that this is not a risk-free profit (although it is a more or less zero-beta profit in the sense of the standard CAPM) because what you are doing is providing liquidity to the small-cap stock market; your profit is the reward to this service, and you run the standard risks of a liquidity provider.

I think Lo’s smallcap/largecap result is the most solidly grounded violation of weak EMH, but there are others.

Your summary is pretty much correct, though a big problem for weak form EMH comes with speculative bubbles like that of the dotcom boom, and even more the associated boom in the S&P 500.

Most of the sceptics (including me) said that the markets were wildly overvalued. In relation to the dotcoms, we could argue on fundamentals: most of these companies had no prospect of making any money, so were worth zero.

But as regards the S&P 500 we said that P/E ratios were way out of line with past experience, which is pretty close to saying weak EMH was violated, especially as you can replace E with a long-term trend assuming constant profits share.

Having said all that, I still think technical analysis is voodoo.

that depends on which EMH you’re talking about. ‘Strong-form’ EMH claims that, yes, market prices have already factored in all material information including inside information. But SFAICT strong EMH is a decidedly minority opinion even among EMH adherents (though I suppose that Daniel Fischel would need to believe in it, as he has written that insider trading is a good way to get information to the market).

Semi-strong EMH, which is what most EMH adherents seem to be talking about (and is the version of EMH underpinning the ‘fraud on the markets’ theory developed in the Texas Gulf Sulphur and Basic v. Levinson decisions) claims that prices reflect all publicly available information. Weak EMH claims only that you can’t extrapolate from past to future prices (in other words, technical analysis is voodoo). This last form of EMH would seem pretty uncontroversial, though I believe dsquared has said he has a mate who does in fact use technical analysis with a fair degree of success.

• SCOTUS nomination futures markets (note that the SCOTUS confirmation futures markets will certainly work finely);
• 2012 Olympic city futures markets (the markets saw Paris as the winner);
• papacy futures markets (the Pope would come from Europe, said the markets, but they failed to divine Ratzinger and Germany as country of origin);
• Michael Jackson futures markets (like the commentariat, the markets had him behind bars);
• Purcell resignation futures market (the market said he would not resign);
• George Tenet resignation futures market (idem).

If they’re like a stockmarket, then insider trading (dishonestly buying or selling something) should be not allowed, but this obviously conflicts with making the best prediction. If they work like a bookmaker, then insider trading isn’t a problem, but the person setting them up stands to lose money if things go wrong. Is this a sensible distinction to make?

Posted by mkl · July 20th, 2005 at 12:23 pm

Is there an actual cost to pundits being wrong? I haven’t noticed the absence of too many pro-Iraq war pundits, for example. Shame, of course, it beyond even laughing about, by now.

Now, potentially markets are quite useful if they would reveal insider information reliably. The problem is that there is no good way to discriminate false rumors (about the Ediths) from credible ones until the reports are confirmed. Thus, people could pretend to be insiders and benefit from this.

Markets can have two structural advantages over pundits.

First, there are two sides to every trade. For the market to print a 70 trade on Edith Clement, you need both a buyer thinking she has at least those odds of selection, and a seller who likes the 30% she wouldn’t be tapped. A pundit does not need a counterparty. So a trading price contains more information than a recommendation.

Second, markets are typically anonymous and give participants no exposure but financial gain or loss. This can attract insiders in some circumstances —I recall recently market disruptions in Harry Potter plot bets coming from bettors in towns near the printers—where the anonymity and financial gain are uniquely attractive. On the other hand, pundits have less cost to a wrong projection (or to change their position right up to the bell) and can in fact benefit from publishing wrong guesses, just to stay in the discussion rather than withdraw and be silent.

Further, as broadly noted, markets can quickly aggregate many opinions and weight their strength, which is not easy to do with pundits.

Orin Kerr’s correct that the markets generally trailed and tracked the pundits in this case. I would guess that this has to do primarily with the relative relationships of the insiders, pundits and bettors in the case. The insiders (say, WH staff) might well be better rewarded by leaking to pundits than betting on Tradesports (or leaking to bettors).

Well, come to think of it, it’s just like in real life: they collect your money and distribute it to their cronies.