As a few more minor points, it seems unfair to add the footnote that Madoff was involved in the founding of NASDAQ unless you want to allege that NASDAQ itself was actually a scam.

Also, aren’t Amazon and eBay two other companies founded during the dotcom boom that are making nice profits? (Of course, Amazon took many years to do it, but I thought they’ve generally been doing well, and eBay even better.) You might also count PayPal and a few others that were founded at that time and then absorbed by other companies.

All of the explanations for the equity premium puzzle I have seen in the literature are based on the demand side; trying to find utility functions for a representative investor and ex-ante probability distributions for returns that would explain investors demanding such high average returns for stocks relative to bonds, rather than bidding those returns down. But I suggest a supply based explanation: The long run supply curve for corporate stock may simply be extremely long and flat, and consistently about 5 ½ percentage points in return higher than the premium bonds supply curve, even at stock quantities as high as the entire national savings rate.

Why would this be? I posit that stock might simply allow a firm to create more wealth with an investment dollar than bonds, and this is because of the flexibility of stock. Firms are able to invest in high return long run projects when they raise money with stock that they sometimes cannot when money is raised from bonds due to the short run constraints of having to make interest payments and satisfy bond covenants.

With stock the firm has greater flexibility to take large projects which may make little or no money for years, which may even lose money for years, but which overall will be very high return due to long run profits. There are many areas where short run constraints (often undue ones) greatly decrease optimization. Such areas include business, politics, and academia.

Warren Buffet, arguably the most successful investor in history, constantly attributes his success to unusual efforts and willingness to avoid short term constraints so that he can choose the projects, within companies he controls and in buying stock, that offer the highest NPV. For example, in discussing his use of insurance company funds rather than debt to finance projects, he writes in his Berkshire Hathaway statement of business principles , “…they are liabilities without covenants or due dates attached to them. In effect, they give us the benefit of debt — an ability to have more assets working for us — but saddle us with none of its drawbacks.”

For more, see “Supply Based Explanation of the Equity Premium Puzzle”, by Richard Serlin.

In that case, sign me up for some negative economics. If enough people had been a little more dismal at the right times, we might not have this mess.

Great excerpt, very interesting reading (no mean feat for a passage about finance and economics!) I think other people have already pointed out the couple of apparent omissions/sentence fragments.

I think it’s interesting that LTCM’s business model was based on expecting the market to correct itself, given that any opportunity to profit by this presumes that (a) the market isn’t already correct and (b) you know where the market is going better than the market does.

I also found the mention of Robertson’s attempt to short the tech bubble particularly interesting – it seems like a concrete example of the saying that the market can remain irrational longer than you can remain solvent.

You have a point but I think you are missing a more important point. Friedman’s Methodology of Positive Economics is the inspiration for a two-step which is very popular with devotees of Panglossian models. Step 1: this model is totally unrealistic, that’s what’s so great about it; if you don’t understand that you don’t understand scientific method. Step 2: this model is the one we teach in all our courses; why would you allow policy to be shaped by old-fashioned models developed by defunct economists?

So you see, it’s not important that they don’t actually believe the strong-form EMH. They have found a way to exploit the policy implications of models they don’t believe in. Ideally John Quiggin’s book should deal with this philosophical dodge, but I suspect it’s more John Holbo’s kind of thing.

And you have yet to identify any economist who ever actually believed the strong form of the EMH. Fama himself said that he didn’t believe in it. To quote, again, the 1970 paper:

C. Strong Form Tests of the Efficient Markets Hypothesis. … We would not, of course, expect this model to be an exact description of reality, and indeed the preceding discussions have already indicated the existance of contradictory evidence. …

One would not expect such an extreme model to be an exact description of the world, and it is probably best viewed as a benchmark against which the importance of deviations from market efficiency can be judged.

You say that you want comments and corrections, but I’ve made this point before and it doesn’t appear to make any difference to what you write. Why do you want to give the impression that economists believed strong-form EMH when they didn’t?

I don’t think this is true. Here are two things that I suggest you consider for substantially beating the buy and hold market portfolio, a la CAPM, in risk-adjusted return:

1) Trading strategies based on P-E ratio – A good starting place to examine the research is Christopher Carroll’s recent Economists’ Voice article, “Recent Stock Declines: Panic or the Purge of “Irrational Exuberance”?”.

2) Trading strategies that favor value stocks and small stocks – Here I suggest starting with the short book, “The New Finance”, 4th Ed., 2009, by Robert Haugen, Emeritus Professor of Finance at the University of California, Irvine. The writing is very hyperbolic, but a lot of good research in top academic journals is pointed to and explained.

if converted into euros and spent in Europe 1

As with the closely related equity premium puzzle (see CH ..), it is easy enough to see that the standard theory underlying the EMH (and the closely associated capital asset pricing model).

along with more prosaic correction of errors

On the other hand, econometric studies given little support