Why did the markets miss it?
By Scott Sumner
On February 5th I wrote:
I suspect that the stock market disagrees with experts who predict a global pandemic:
The Wuhan coronavirus spreading from China is now likely to become a pandemic that circles the globe, according to many of the world’s leading infectious disease experts.
It will be interesting to see who turns out to be right. I don’t have a strong opinion either way.
The fact that I didn’t sell my stocks, however, suggests that I leaned toward the “market” view. I was wrong.
Craig Fratrik directed me to a discussion in the “rationalist” community, where a number of individuals did believe the coronavirus would become a big problem in the West. This February 17 Eliezer Yudkowsky tweet is interesting:
And here’s the S&P500 after his tweet:
Eliezer Yudkowsky has been a longstanding believer in the Efficient Markets Hypothesis, and by mid-March he had begun to wonder whether there were certain types of unusual events where markets would not respond in an efficient manner. (Rationalists like Yudkowsky update their beliefs about the world as new information comes in, whereas many non-rationalists try to make new information fit their preconceived ideas.) Indeed Yudkowsky even made some money by investing at the very low point of the stock market, on March 23.
Yudkowsky also pointed out that (rationalist?) Wei Dai made a lot of money shorting the market, in anticipation of the coronavirus crash.
Craig Fratrik also directed me to a post in another rationalist blog, which described selling stocks in the belief that the markets were wrong about coronavirus. It seems like the rationalist community was ahead of most of the rest of us.
[I don’t follow this group closely, so someone let me know if I’ve misrepresented the rationalist community in any way.]
Should all of this make us less likely to believe in the EMH? I’d say yes, but only a little bit.
This is not the first time something has happened that seemed inconsistent with the EMH. Consider the October 19, 1987 stock market crash, where the Dow fell 22% on a light news day. Nonetheless, I’ll argue that the EMH remains more useful than it appears, despite the poor performance of the markets in this case, or in October 1987.
Let’s start with the tweet at the top, where Yudkowsky retweets a Robin Hanson tweet, which summarizes a Rod Dreher article from February 15th. A very pessimistic article.
Most of the Dreher article consists of quotes from an anonymous American living in China. [Yes, we are now 4 layers deep in this process.] This American gets the big picture right (a global pandemic on the way) but gets wrong some of the details. For instance:
With respect to the disease itself, I don’t think this disease can be stopped anything short of supernatural means. Infections continue to soar, even under military-enforced quarantines that have been in place for almost a month. You have to see the Army response here to believe it, and yet nothing has worked. You mercifully haven’t had many cases there, yet, but I fear that you’re just six or seven weeks behind where we are in China, and four to five weeks behind Japan. Only a miracle can stop it, and that’s what we need to be praying for. If you’re a man or woman of faith, get some more. If at some point you left it or lost it, go back to where you saw it last, and pick it up again.
In fact, the epidemic in China was halted very quickly after that tweet, without “supernatural means”. I don’t want to sound like I’m nitpicking, as this anonymous American was right on the big issue–Americans weren’t taking this anywhere near as seriously as they should. But being right about the public policy implications is not the same as being right about the implications for the EMH.
I recall thinking in late February that since China had quickly gotten this under control, then more developed countries that had all the advantages of being able to watch what the Chinese had done would be able do the same. That was clearly wrong, but it’s still not obvious to me that it was an irrational belief, given what we knew at the time. After all, previous diseases such as SARS didn’t have a dramatic impact after they left China. Yes, the coronavirus had a much higher “R0” (reproduction rate) than SARS, but again, China was quickly controlling the coronavirus epidemic, even after it had already infected tens of thousands in Wuhan and elsewhere. The US had only 15 known cases on February 20.
In a sense, this is similar to the US housing bubble and crash. In retrospect, it looks obvious that the housing market was unsustainable in 2005-06. But recall that other countries with similar “bubbles”, such as Australia, New Zealand, Canada and the UK, never had the sort of crash that the US experienced. It’s only in retrospect that the US housing crash seems obvious.
I predict that community transmission of coronavirus in Australia and New Zealand will be down close to or at zero by mid-May. (Someone remind me of this prediction in mid-May.) Unfortunately for those two countries, the world as a whole will still have a big problem in May, and thus the economies in those two lucky countries are still likely to be severely depressed. But as of mid-February, it was not obvious (to me or the markets) that a virus the US and Europe would be unable to control would be relatively quickly controlled in Australia.
For me, the claim that the EMH is “wrong” is equivalent to the claim that it is no longer useful. But is that true? I very much doubt that markets will under-react the next time the world is faced with a coronavirus-type threat. Indeed I suspect if there is irrationality, it’s equally likely to be in the direction of overreaction. So I don’t see how this particular market error will help me going forward. How do I trade in the future on the knowledge that the market blew it in the case of the coronavirus?
Undoubtedly, there will be future events where a select few well-informed people will see the truth more clearly than the market consensus. But how will I know when that situation is occurring, as compared to a situation where well-informed people wrongly believe they are smarter than the market? Does this example tell us how to know when to trust the experts over the markets? I don’t see how.