How Not to Spot a Bubble | Value Research In theory, effective market hypothesis sounds fine. But anyone who has bought & sold stocks on a serious basis knows this is not true
Generally Speaking

How Not to Spot a Bubble

In theory, effective market hypothesis sounds fine. But anyone who has bought & sold stocks on a serious basis knows this is not true

Eugene Fama, an economist at the University of Chicago, won the Nobel Prize in economics in 2013. His major contribution, the efficient market hypothesis (EMH), over the years became the bedrock on which most financial theories are based.

Benoit Mandelbrot, a mathematician who did some pioneering work in economics, had an influence on Fama's initial work. As Mandelbrot (along with Richard Hudson) writes in The (Mis)Behavior of Markets: A Fractal View of Risk, Ruin and Reward: "It [the EMH] became the intellectual bedrock on which orthodox financial theory sits."

So what is the EMH? As Mandelbrot and Hudson write: "At its heart: In an ideal market, security prices fully reflect all relevant information... Given that, the price at any particular moment must be the 'right' one." Or, as Fama put it in a 1965 journal article, "in an efficient market at any point in time the actual price of a security" is a good "estimate of its intrinsic value."

This means different assets, whether stocks, bonds, commodities or even real estate are at any point of time always correctly priced, and their prices reflect their underlying fundamentals. But how is that possible?

Mark Buchanan explains this through a small thought experiment in his book Forecast: "Let's do a thought experiment, which I'll call the 5 percent problem. Suppose that on Tuesday morning everyone knew for sure that the markets would recover, stocks gaining 5 percent (on average) in a big rally in the final half hour at the end of the day. Everyone in the market would expect this rise, and lots of people on that morning would be eager to pay up to 5 percent more than current values to buy stock, as they would profit by selling at the day's very end. Knowledge of the coming afternoon rise would make the market rise immediately in the morning, violating the assumption we made to start this thought experiment; the prediction of a late rally would be totally wrong."

Hence, information about the market rising by 5 per cent towards its close would be incorporated into the prices of the stocks immediately. Given this, financial markets are correctly priced all the time. Robert J. Shiller, who shared the Nobel Prize along with Fama, summarises this argument best in Irrational Exuberance: "The efficient market theory asserts that all financial prices accurately reflect all public information at all times. In other words, financial assets are always priced correctly, given what is publicly known, at all times." And if financial assets are correctly priced, there can be no question of any speculative bubbles.

Fama put forward the hypothesis in 1965, and by the late 1970s, there was a great belief in it. During the 1970s, a lot of research suggested that there were few systematic patterns in stock markets that could be exploited. This even led the economist Michael Jensen to quip: "[t]here is no other proposition in economics which has more solid empirical evidence supporting it than the efficient market hypothesis."

In theory, the EMH sounds perfectly fine. But anyone who has bought and sold stocks on the stock market on a serious basis knows this is not true. Buchanan talks about flash crashes to show that EMH doesn't hold. As he writes: "In November 2010, the New York Times reported on a dozen 'mini flash crashes' in which individual stocks plunged in value over a few seconds, recovering shortly thereafter. In one episode, for example, the stock of Progress Energy-a company with eleven thousand employees-dropped 90 percent in a few seconds. There was no news released about the business prospects of Progress Energy either before or after the event... On May 13 (2011), Enstar, an insurer, fell from roughly $100 a share to $0 a share, then zoomed back to $100 in just a few seconds."

Further, hundreds of studies carried out since the 1980s have shown that the EMH does not really hold. Ironically, some of the most influential of these studies were carried out by Fama himself. Nevertheless, economists continued to believe in the hypothesis as gospel truth.

In fact, this belief has continued even after the dot-com bubble burst in 2000 and the real estate bubbles burst all over the developed world from 2007 onwards. Interestingly, in a 2010 interview Fama said: "I don't even know what a bubble means. These words have become popular. I don't think they have any meaning."

Given this belief in the EMH and that bubbles don't exist, it is not surprising that economics remain horrible at predicting bubbles. As Shiller writes in Finance and the Good Society: "Recognizing a bubble is essential to preventing a financial crisis, but recognizing bubbles is as much a question of judging, from their actions, people's intentions and motives as it is of looking at the numbers themselves."

Hence, it is not surprising that central banks, which are run by economists, did not see the financial crisis coming. In fact, as an IMF working paper, titled 'How Do Central Banks Write on Financial Stability?', published in June 2006, pointed out with respect to central banks, "virtually all (96 percent) have started off with a positive overall assessment of soundness of the domestic system (characterizing the health of the financial system as being, e.g., 'in good shape,' 'solid,' or at least 'improving')." Similar positive statements were made by the Federal Open Market Committee, the European Central Bank and the IMF during the course of the year.

In a speech made in October 2005, current chairperson of the Federal Reserve of the United States, Janet Yellen, who was President of the Federal Reserve Bank of San Francisco at that point of time, asked three questions: "First, if the bubble were to deflate on its own, would the effect on the economy be exceedingly large? Second, is it unlikely that the Fed could mitigate the consequences? Third, is monetary policy the best tool to use to deflate a house-price bubble? My answers to these questions in the shortest possible form are 'no,' 'no,' and 'no'."

When the real estate bubble burst and the global financial system came on the brink of disaster, only then did the economists who run central banks started to realize that they have a problem.

To conclude, the first step towards solving any problem is acknowledging that it exists. This is something which economists who have total faith in EMH need to recognise, that bubbles do exist.

Further, people expect a trend that has started to continue for a while. As Neill writes: "It has been my observation that it takes us average humans a considerable interval to shift our viewpoints, once we have established a given mental outlook. That is, if we have (mentally) accepted a trend as moving in one direction, we are not inclined to change our outlook until well after the trend turns." This is precisely what did Greenspan in. And therein lies a lesson for all of us.

Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected]

This column appeared in the June 2015 Issue of Wealth Insight.

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