Asset Price Swings, Revisited
By Arnold Kling
Since writing on Frydman and Goldberg, I have had some email correspondence with one of the authors. I think I should do more to say where I agree with the authors.
1. I think that the rational expectations hypothesis in finance, much like the representative agent model in macroeconomics, incorrectly assumes that everyone has the same information set. It is tempting to presume, as do Cowen and Hanson, that rational individuals will converge to holding the same beliefs. However, I think that a more Hayekian view would allow for people to start out with and retain different models of the world. On this, I agree with Frydman and Goldberg.
2. I also agree that we observe asset price swings. There may be profit opportunities in these swings, although they are not arbitrage opportunities. One example seems to be the oil cycle. At the time that I wrote that post, it seemed highly predictable that the price of oil would rise. Eventually, I found an effective way to bet on that rise, via the fund PCRIX. Over the past month, I have sold out of that position, because I assume that at some point there will be another period where the price of oil overshoots on the down side. Of course, I could turn out to be wrong about that. Perhaps the price of oil will rise going forward, and I will never again have the opportunity to purchase shares in PCRIX at its current level. We will see.
3. Note, however, that there can be price swings when everyone has the same information. That is what Vernon Smith’s “bubble experiments” show (the link takes you to the web site of Mike Covel. As it happens, I interviewed him as a case study for my first book, Under the Radar, on entrepreneurship. Odd coincidence).
I conclude that people easily form models for asset price behavior that diverge from one another. An economist who has a view of what the fundamentals imply for an asset price is just one more individual with a unique model.