EMH and Bubbles
By Arnold Kling
John Cassidy interviews John Cochrane. Cochrane says,
I think most people mean by a “bubble” just, “Prices were high and I wish I sold yesterday.” The efficient markets (hypothesis) never told you that wasn’t going to happen. What efficient markets says is that prices today contain the available information about the future. Why? Because there’s competition. If you think it’s going to go up tomorrow, you can put your money where your mouth is, and your doing it sends (the price) up today. Efficient markets are not clairvoyant markets. People say, “nobody foresaw saw the market crash.” Well, that’s exactly what an efficient market is–it’s one in which nobody can tell you where it’s going to go. Efficient markets doesn’t say markets will never crash. It certainly doesn’t say markets are clairvoyant. It just says that, at that moment, there are just as many people saying its undervalued as overvalued. That certainly seems to be the case.
Thanks to Mark Thoma for the pointer. Read the whole thing. I agree with much of what Cochrane has to say (Cassidy clearly does not).
It is tempting to say, “So-and-so called it a bubble in 2003, and it crashed in 2007. That proves that markets are not efficient.” But the conclusion does not follow. I would point out that ex post markets almost never appear to be efficient. Yet, ex ante they are.
Recently, we discussed on this blog various people who were quoted as arguing that there was not a housing bubble. The efficient markets hypothesis would predict that you could find such quotes. If nobody believed that high house prices made sense, then they would have not have gotten so high. For a bubble to form, there has to be some plausible evidence that would persuade many reasonable people that there is a high probability that we are not in a bubble.
I quoted myself doubting the bubble hypothesis in 2004, and a commenter found a more recent post, in 2006, where I said that I thought that there was a 20 percent chance that we were in a bubble. Actually, 20 percent is extremely high. That is my version of a strong sell signal.
I would not trust anyone who would say “With probability 1, we are in a bubble.” That person has way too much confidence in their own analysis. Markets can go wrong. But nobody can be 100 percent certain that they are smarter than the market. Nobody acts as if they are 100 percent certain that they are smarter than the market. Did your favorite prognisticator make a billion dollars betting on the Case-Shiller index? Why not? Because he was not as sure then as he is sure now that he was right.
Cochrane goes on to describe examples of what he sees as market inefficiencies. They tend to be relatively small. I also think there are market inefficiencies. Most recently, I have suggested that gold investors are betting in high inflation and bond investors are betting on low inflation. To me, that suggests that there is a profit to be made by some combination of going short gold, going short Treasuries, and going long indexed Treasuries. Will it work with probability 1? No. If it works, would that completely discredit the efficient markets hypothesis? No. It’s a notion I have about some market prices that I think are out of alignment. If that notion turns out to be right, then good for me (although I am not doing that trade myself–there is too high a probability that I am wrong). If that notion turns out to be wrong, then once again the markets are smarter than I am. They don’t always have to be smarter than I am to efficient. Just enough to keep me from getting infinitely rich.