Scott Sumner Defends EMH

Last week I wrote about the sudden increase in stock market volatility as an illustration of why the efficient market hypothesis (EMH) is not entirely accurate. I focused on the empirical argument made by Robert Shiller that the observed volatility of stock prices is greater than the volatility implied by the proposition that stock prices reflect rational expectations of future dividends paid out by the listed corporations. I made two further points about EMH: a) empirical evidence cited in favor of EMH like the absence of simple trading rules that would generate excess profits and the lack of serial correlation in the returns earned by asset managers is also consistent with theories of asset pricing other than EMH such as Keynes’s casino (beauty contest) model, and b) the distinction between fundamentals and expectations that underlies the EMH model is not valid because expectations are themselves fundamental owing to the potential for expectations to be self-fulfilling.

Scott responded to my criticism by referencing two of his earlier posts — one criticizing the Keynesian beauty contest model, and another criticizing the Keynesian argument that the market can stay irrational longer than any trader seeking to exploit such irrationality can stay solvent – and by writing a new post describing what he called the self-awareness of markets.

Let me begin with Scott’s criticism of the beauty-contest model. I do so by registering my agreement with Scott that the beauty contest model is not a good description of how stocks are typically priced. As I have said, I don’t view EMH as being radically wrong, and in much applied work (including some of my own) it is an extremely useful assumption to make. But EMH describes a kind of equilibrium condition, and not all economic processes can be characterized or approximated by equilibrium conditions.

Perhaps the chief contribution of recent Austrian economics has been to explain how all entrepreneurial activity aims at exploiting latent disequilibrium relationships in the price system. We have no theoretical or empirical basis for assuming that deviations of prices whether for assets for services and whether prices are determined in auction markets or in imperfectly competitive markets that prices cannot deviate substantially from their equilibrium values. We have no theoretical or empirical basis for assuming that substantial deviations of prices — whether for assets or for services, and whether prices are determined in auction markets or in imperfectly competitive markets — from their equilibrium values are immediately or even quickly eliminated. (Let me note parenthetically that vulgar Austrians who deny that prices voluntarily agreed upon are ever different from equilibrium values thereby undermine the Austrian theory of entrepreneurship based on the equilibrating activity of entrepreneurs which is the source of the profits they earn. The profits earned are ipso facto evidence of disequilibrium pricing. Austrians can’t have it both ways.)

So my disagreement with Scott about the beauty-contest theory of stock prices as an alternative to EMH is relatively small. My main reason for mentioning the beauty-contest theory was not to advocate it but to point out that the sort of empirical evidence that Scott cites in support of EMH is also consistent with the beauty-contest theory. As Scott emphasizes himself, it’s not easy to predict who judges will choose as the winner of the beauty contest. And Keynes also used a casino metaphor to describe stock pricing in same chapter (12) of the General Theory in which he developed the beauty-contest analogy. However, there do seem to be times when prices are rising or falling for extended periods of time, and enough people, observing the trends and guessing that the trends will continue long enough so that they can rely on continuation of the trend in making investment decisions, keep the trend going despite underlying forces that eventually cause a price collapse.

Let’s turn to Scott’s post about the ability of the market to stay irrational longer than any individual trader can stay solvent.

The markets can stay irrational for longer than you can stay solvent. Thus people who felt that tech stocks were overvalued in 1996, or American real estate was overvalued in 2003, and who shorted tech stocks or MBSs, might go bankrupt before their accurate predictions were finally vindicated. There are lots of problems with this argument. First of all, it’s not clear that stocks were overvalued in 1996, or that real estate was overvalued in 2003. Lots of people who made those claims later claimed that subsequent events had proven them correct, but it’s not obvious why they were justified in making this claim. If you claim X is overvalued at time t, is it vindication if X later rises much higher, and then falls back to the levels of time t?

I agree with Scott that the argument is problematic; it is almost impossible to specify when a suspected bubble is really a bubble. However, I don’t think that Scott fully comes to terms with the argument. The argument doesn’t depend on the time lag between the beginning of the run-up and the peak; it depends on the unwillingness of most speculators to buck a trend when there is no clear terminal point to the run-up. Scott continues:

The first thing to note is that the term ‘bubble’ implies asset mis-pricing that is easily observable. A positive bubble is when asset prices are clearly irrationally high, and a negative bubble is when asset price are clearly irrationally low. If these bubbles existed, then investors could earn excess returns in a highly diversified contra-bubble fund. At any given time there are many assets that pundits think are overpriced, and many others that are seen as underpriced. These asset classes include stocks, bonds, foreign exchange, REITs, commodities, etc. And even within stocks there are many different sectors, biotech might be booming while oil is plunging. And then you have dozens of markets around the world that respond to local factors. So if you think QE has led Japanese equity prices to be overvalued, and tight money has led Swiss stocks to be undervalued, the fund could take appropriate short positions in Japanese stocks and long positions in Swiss stocks. A highly diversified mutual fund that takes advantage of bubble mis-pricing should clearly outperform other investments, such as index funds. Or at least it should if the EMH is not true. I happen to think the EMH is true, or at least roughly true, and hence I don’t actually expect to see the average contra-bubble fund do well. (Of course individual funds may do better or worse than average.)

I think that Scott is conflating a couple of questions here: a) is EMH a valid theory of asset prices? b) are asset prices frequently characterized by bubble-like behavior? Even if the answer to b) is no, the answer to a) need not be yes. Investors may be able, by identifying mis-priced assets, to earn excess returns even if the mis-pricing doesn’t meet a threshold level required for identifying a bubble. But the main point that Scott is making is that if there are a lot of examples of mis-pricing out there, it should be possible for astute investors capable of identifying mis-priced assets to diversify their portfolios sufficiently to avoid the problem of staying solvent longer than the market is irrational.

That is a very good point, worth taking into account. But it’s not dispositive and certainly doesn’t dispose of the objection that investors are unlikely to try to bet against a bubble, at least not in sufficient numbers to keep it from expanding. The reason is that the absence of proof is not proof of absence. That of course is a legal, not a scientific, principle, but it expresses a valid common-sense notion, you can’t make an evidentiary inference that something is not the case simply because you have not found evidence that it is the case. So you can’t infer from the non-implementatio of the plausible investment strategies listed by Scott that such strategies would not have generated excess returns if they were implemented. We simply don’t know whether they would be profitable or not.

In his new post Scott makes the following observation about what I had written in my post on excess volatility.

David Glasner seems to feel that it’s not rational for consumers to change their views on the economy after a stock crash. I will argue the reverse, that rationality requires them to do so. First, here’s David:

This seems an odd interpretation of what I had written because in the passage quoted by Scott I wrote the following:

I may hold a very optimistic view about the state of the economy today. But suppose that I wake up tomorrow and hear that the Shanghai stock market crashes, going down by 30% in one day. Will my expectations be completely independent of my observation of falling asset prices in China? Maybe, but what if I hear that S&P futures are down by 10%? If other people start revising their expectations, will it not become rational for me to change my own expectations at some point? How can it not be rational for me to change my expectations if I see that everyone else is changing theirs?

So, like Scott, I am saying that it is rational for people to revise their expectations based on new information that there has been a stock crash. I guess what Scott meant to say is that my argument, while valid, is not an argument against EMH, because the scenario I am describing is consistent with EMH. But that is not the case. Scott goes on to provide his own example.

All citizens are told there’s a jar with lots of jellybeans locked away in a room. That’s all they know. The average citizen guesstimates there are 453 jellybeans in this mysterious jar. Now 10,000 citizens are allowed in to look at the jar. They each guess the contents, and their average guess is 761 jellybeans. This information is reported to the other citizens. They revise their estimate accordingly.

But there’s a difference between my example and Scott’s. In my example, the future course of the economy depends on whether people are optimistic or pessimistic. In Scott’s example, the number of jellybeans in the jar is what it is regardless of what people expect it to be. The problem with EMH is that it presumes that there is some criterion of efficiency that is independent of expectations, just as in Scott’s example there is objective knowledge out there of the number of jellybeans in the jar. I claim that there is no criterion of market efficiency that is independent of expectations, even though some expectations may produce better outcomes than those produced by other expectations.