Don't be afraid to catch a falling knife
By Scott Sumner
Here’s the Economist:
JOHN KENNETH GALBRAITH, a quotable economist, observed that one of the deeper mysteries is why, in a falling market, there is still a buyer for every seller. It is a conundrum that bond investors must now contemplate. Since January the yield on a ten-year Treasury bond has risen (and thus bond prices have fallen) with scarcely a backward step. It is above 3% for the first time in years.
At first glance that does seem like a puzzle; why would someone want to buy an asset whose price is falling? But on closer inspection Galbraith is wrong; there is no mystery. He overlooked the Efficient Market Hypothesis.
Here the English language is a bit ambiguous. When people talk about a “falling market”, do they mean a market that “has fallen” or one that “will fall”? In ordinary usage, the term ‘falling’ implies both, as falling physical objects in space have momentum, and hence are likely to keep falling for at least the next second or two.
But asset prices are not like physical objects. In the asset markets, it would be more accurate to say a price “has fallen” rather than “is falling”. Thus it’s not obvious why someone would not want to buy into a falling market. The same is true for rising prices. If Galbraith believed that it is hard to explain why people would buy into a falling market, shouldn’t he also have argued for the opposite in a rising market? Why would anyone not be a buyer in a rising market? Indeed why not buy into an asset price bubble, which is a “rising market”?
I don’t believe that this was Galbraith’s view of bubbles—indeed he occasionally predicted that asset prices were in a bubble that would soon burst. So his view of asset price movements seems confused, worrying about momentum on the downside and worrying about a lack of momentum in bull markets. Perhaps that reflects the fact that it is more intellectually fashionable for intellectuals to be pessimists.
PS. Please don’t cite academic studies of asset price movements, as those studies are not likely to be useful for current investments. They report on past patterns observed in asset markets.