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<font face="Verdana" size="2"><font color="#002864"><strong><font size="5">Are Bubbles Efficient?</font></strong></font>
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<p class="MsoBodyText"><font size="4"><span class="574375713-03022004">B</span>y
Robert Blumen</font>
<p class="MsoBodyText">[<span class="574375713-03022004">Posted </span>February
3, 2004]
<p class="MsoBodyText"><img alt src="http://www.mises.org/images3/bubble.gif" align="right" border="0" width="276" height="157">any
investors purchased absurdly overvalued stocks during the late '90s and have
since suffered devastating losses. The explanation now given for this is that
the stock market was in a"bubble" which has burst, but those buying
stocks at the time were not able to identify the bubble.
<p class="MsoBodyText">What is clear in retrospect was a controversial
proposition at the time. Many individual investors justified their own
purchases of stocks at inflated values by the naĂŻve belief that stocks at
current prices are always a good investment. Their prices have been set in
a competitive market and returns from the ownership of stocks will always be
in line with historical averages, so the thinking goes.<a id="_ftnref1" title href="http://www.mises.org/fullstory.asp?control=1432#_ftn1" name="_ftnref1"><span class="MsoFootnoteReference">[1]</span></a>
<p class="MsoBodyText">Individual investors could find intellectual support
for their view in a 1999 speech by Fed governor Alan Greenspan. In this speech,
he argued that a stock market bubble could not be distinguished (until after
it had burst) from a rise in prices of stocks due to improvements in
fundamentals:<a id="_ftnref2" title href="http://www.mises.org/fullstory.asp?control=1432#_ftn2" name="_ftnref2"><span class="MsoFootnoteReference">[2]</span></a>
<blockquote dir="ltr" style="MARGIN-RIGHT: 0px">
<p class="MsoBodyText">To anticipate a bubble about to burst requires the
forecast of a plunge in the prices of assets previously set by the judgments
of millions of investors, many of whom are highly knowledgeable about the
prospects for the specific investments that make up our broad price indexes
of stocks and other assets.<a id="_ftnref3" title href="http://www.mises.org/fullstory.asp?control=1432#_ftn3" name="_ftnref3"><span class="MsoFootnoteReference">[3]</span></a>
[/i]
<p class="MsoBodyText">Greenspan was expressing a form of what economists call
the Efficient Markets Hypothesis (EMH) in rationalizing his inability
to determine whether there was indeed a stock market bubble.<a id="_ftnref4" title href="http://www.mises.org/fullstory.asp?control=1432#_ftn4" name="_ftnref4"><span class="MsoFootnoteReference">[4]</span></a>
<p class="MsoBodyText">The EMH has its roots in the development of academic
finance theory since the 1960s. It is an extension of a theoretical construct
from mainstream economics of a state in which no profit opportunities exist
(and hence no serious possibilities of errors or losses, either). The
extension of this model to securities pricing has created a widely accepted
but perverse understanding of financial markets.
<p class="MsoBodyText">The Efficient Markets Hypothesis is the proposition
that there are ultimately no profit opportunities in financial markets because
the prices of securities already take into account all relevant
information. This is equivalent to saying that no individual could
systematically improve upon the financial forecasts already embedded in
financial market prices.
<p class="MsoBodyText">The reasoning behind the EMH is that, should a security
become momentarily under- or over-valued, the most alert and well-informed
traders ("the smart money") will pounce on the opportunity and
eliminate the price discrepancies before an investor of a more average
situation could act. They will do this by a process known as arbitrage: either
purchasing the security in sufficient quantity until its price rises to
eliminate the discrepancy, or borrowing it and selling it short until the
price declines to its fair value.
<p class="MsoBodyText">A well-known joke illustrating the EMH concerns two
finance professors walking down the street. One spots a $100 bill lying on the
pavement. He brings this to the attention of his colleague, who says,"That
cannot be a $100 bill or someone would have already picked it up." And so
they continue walking.<a id="_ftnref5" title href="http://www.mises.org/fullstory.asp?control=1432#_ftn5" name="_ftnref5"><span class="MsoFootnoteReference">[5]</span></a>
<p class="MsoBodyText">According to the EMH, there is no point for the
investor in doing research on companies, whether that means evaluating their
financial statements, studying their business prospects, or examining the
competitive structure of the industry."The market" has already done
this analysis and it is already priced into the stocks.<a id="_ftnref6" title href="http://www.mises.org/fullstory.asp?control=1432#_ftn6" name="_ftnref6"><span class="MsoFootnoteReference">[6]</span></a>
<p class="MsoBodyText">Since the investor cannot beat the market, buying a
broad-based market index is likely to earn as good a return with a lot less
work. The EMH suggests that an investor picking stocks at random should
do as well as the more analytical investor. According to a famous example (from
before the days when most people got stock quotes from the internet), it is
said that a blindfolded monkey throwing darts at the stock listings page of
the newspaper could do as good a job picking stocks as a diligent analyst.<a id="_ftnref7" title href="http://www.mises.org/fullstory.asp?control=1432#_ftn7" name="_ftnref7"><span class="MsoFootnoteReference">[7]</span></a>
<p class="MsoBodyText">Because current prices take into account all known
information, price changes can only occur because new information becomes
available. For example, a new invention has been discovered, or a fire has
destroyed a factory. Such"information shocks" are assumed to arrive
randomly, distributed according to a bell curve distribution.
<p class="MsoBodyText">This assumption of this type of statistical randomness
allows stock prices to be modeled according to mathematical formulae devised
by physicists in the 19<sup>th</sup> century who were studying the physics of
gas particles. The physical description of the motion of a single particle in
a gas is said to describe the fluctuations of a single stock price, a type of
motion that is known as a"random walk."
<p class="MsoBodyText">Modern finance theory is founded on the proposition
that future events can be divided into those that are known and those that can
be described statistically. This classification omits a third category:
uncertainty."Uncertainty" describes our state of mind in relation
to the future, when trying to anticipate changes that cannot be characterized
by probability distributions. The distinction between risk and uncertainty
is central to Austrian price theory.
<p class="MsoBodyText">Although future events are unknown, some of these
events can be characterized by statistics. As Rothbard has written:
<blockquote dir="ltr" style="MARGIN-RIGHT: 0px">
<p class="MsoBodyText">"Risk" occurs when an event is a member of
a class of a large number of homogeneous events and there is fairly certain
knowledge of the frequency of occurrence of this class of events. Thus, a
firm may produce bolts and know from long experience that a certain almost
fixed proportion of these bolts will be defective, say one percent. It will
not know whether any given bolt will be defective, but it will know the
proportion of the total number defective.<a id="_ftnref8" title href="http://www.mises.org/fullstory.asp?control=1432#_ftn8" name="_ftnref8"><span class="MsoFootnoteReference">[8]</span></a>
[/i]
<p class="MsoBodyText">To properly characterize the statistics of a given risk,
one already must know quite a lot about the situation—enough to gather
statistics of similar classes. But in many situations that we face in the real
world, we cannot be sure even how much we know and how much remains that we do
not know. This is uncertainty.
<p class="MsoBodyText">As Rothbard wrote:
<blockquote dir="ltr" style="MARGIN-RIGHT: 0px">
<p class="MsoBodyText">Most uncertainties... are unique cases facing each
individual or business; they may bear resemblances to other cases, but are
not homogeneous with them. Individual entrepreneurs know something about the
outcome of the particular case, but not everything.<a id="_ftnref9" title href="http://www.mises.org/fullstory.asp?control=1432#_ftn9" name="_ftnref9"><span class="MsoFootnoteReference">[9]</span></a>
[/i]
<p class="MsoBodyText">In a market economy, entrepreneurs are people who
voluntarily take on uncertainty. They do this by forming forecasts of future
supply, demand, and prices, and then directing their capital to the particular
sectors of the economy, industries, individual firms, even different countries,
or new products that will be most profitable if their views about the future
are correct. Entrepreneurs thus earn profits or suffer losses depending
on how accurate their forecasts are: they get paid for correctly placing
capital resources where they are most needed.<a id="_ftnref10" title href="http://www.mises.org/fullstory.asp?control=1432#_ftn10" name="_ftnref10"><span class="MsoFootnoteReference">[10]</span></a>
<p class="MsoBodyText">So far the advocate of the EMH might agree with the
Austrian. But why, over time, would the more active and successful
entrepreneurs not drive stock and other asset or commodity prices toward their
intrinsic value, and then keep them there, until some change in data arrives?
<p class="MsoBodyText">Clearly there is a process behind the idea of the EMH
that Austrians can embrace—the most talented traders and investors are
indeed constantly seeking profit opportunities in markets and placing their
bets when they believe that they have found them. Indeed, many niches
are found and exploited by the nimblest trades and the most far-sighted
venture capitalists.
<p class="MsoBodyText">But the process does not converge in the way that the
EMH suggests. The EMH misrepresents the nature of financial markets. Financial
markets are a nexus for the exchange of claims on the future income of
business firms. The value of these claims is ultimately derived from the
income stream of the underlying business, and then by the assets of the
company itself.
<p class="MsoBodyText">In his seminal
paper on the economics of socialism, Mises argued that economically
meaningful prices are necessary for the allocation of goods within the economy,
and that such prices come about only as a result of multiple owners of
private property bidding for capital goods:
<blockquote dir="ltr" style="MARGIN-RIGHT: 0px">
<p class="MsoBodyText">Moreover, the mind of one man alone—be it ever so
cunning, is too weak to grasp the importance of any single one among the
countlessly many goods of a higher order. No single man can ever master all
the possibilities of production, innumerable as they are, as to be in a
position to make straightway evident judgments of value without the aid of
some system of computation. The distribution among a number of individuals
of administrative control over economic goods in a community of men who take
part in the labor of producing them, and who are economically interested in
them, entails a kind of intellectual division of labor, which would not be
possible without some system of calculating production and without economy.<a id="_ftnref11" title href="http://www.mises.org/fullstory.asp?control=1432#_ftn11" name="_ftnref11"><span class="MsoFootnoteReference">[11]</span></a>
[/i]
<p class="MsoBodyText">The multiplicity of capital owners bringing their own
knowledge, beliefs, and abilities that each potential buyer and seller brings
to their job is what creates the"intellectual division of labor"
that drives the formation of prices in financial markets. While it is true
that smart and well-informed traders will profit at the expense of the
uninformed and unsophisticated, this is not the whole story.
<p class="MsoBodyText">If the future values of each company’s income and
assets could be known with certainty, then the prices of securities could be
computed in a straightforward way. This unknown value is the"intrinsic
value" or"fair value" of the security. Because the future
values of the corporate accounting numbers are not known, the prices of
securities represent mere forecasts of the future values of these numbers.
<p class="MsoBodyText">Securities prices are in a constant state of flux not
only because of a changing world, but because the process by which
entrepreneurs digest this information and act on it depends on the
differential evaluations of many actors. Mises argues that the market economy
does not ever reach a resting place: it is a dynamic process of adjustment to
constant change that requires judgment and skill by participants. And, the
progress of this adjustment process depends on the differing opinions held by
the various players.
<p class="MsoBodyText">The search by entrepreneurs for profit is a search for
price differentials—the opportunity to"buy low" and"sell
high." This price-driven search process is what Mises called"economic
calculation."
<blockquote dir="ltr" style="MARGIN-RIGHT: 0px">
<p class="MsoBodyText">The problem of economic calculation is a problem
which arises in an economy which is perpetually subject to change, an
economy which every day is confronted with new problems which have to be
solved. Now in order to solve such problems it is above all necessary that
capital should be withdrawn from particular lines of production, from
particular undertakings and concerns. This is not a matter for the managers
of joint stock companies, it is essentially a matter for the capitalists—the
capitalists who buy and sell stocks and shares, who make loans and recover
them, who make deposits in the bank and draw them out of the banks again,
who speculate in all kinds of commodities. It is these operations of
speculative capitalists which create those conditions of the money market,
the stock exchanges and the wholesale markets which have been taken for
granted by the manager of the joint stock company…<a id="_ftnref12" title href="http://www.mises.org/fullstory.asp?control=1432#_ftn12" name="_ftnref12"><span class="MsoFootnoteReference">[12]</span></a>
[/i]
<p class="MsoBodyText">In an uncertain world, people have different views
about the future. Mises had the insight that prices are formed by these
differences of opinion, belief, and information between competing
entrepreneurs. To see the importance of difference of opinion, consider the
following example: a stock trade has two parties: the seller who thinks that
the stock is worth no more than the price at which it trades, and a buyer who
thinks that it is worth no less. If everyone held the same beliefs about the
future, there would be no trading at all.
<p class="MsoBodyText">Not only is it true that not everyone knows all
relevant information, but knowing what is relevant information is itself a
matter of judgment. People differ in how much they know, and in their
abilities to perceive connections between one thing and another thing. As
Mises wrote:
<blockquote dir="ltr" style="MARGIN-RIGHT: 0px">
<p class="MsoBodyText">In an economic system in which every actor is in a
position to recognize correctly the market situation with the same degree of
insight, the adjustment of prices to every change in the data would be
achieved at one stroke. It is impossible to imagine such uniformity in the
correct cognition and appraisals of changes in data except by the
intercession of superhuman agencies.... Certainly the market[ economy] is
filled with people who are to different degrees aware of the changes in data
and who, even if they have the same information, appraise it differently.<a id="_ftnref13" title href="http://www.mises.org/fullstory.asp?control=1432#_ftn13" name="_ftnref13"><span class="MsoFootnoteReference">[13]</span></a>
[/i]
<p class="MsoBodyText">The paradox of the EMH is that it assumes the existence
of entrepreneurs seizing profit opportunities to prove that there are no
profit opportunities for entrepreneurs. Economist Robert Shiller shows the
contradictory nature of this view by raising the following questions: When did
the smart money set the prices? Are they all done now? If they are all done,
then did they leave the market and retire with their earnings? If the smart
money is setting the prices who are they trading with? It cannot be other
smart people because a smart person would not enter into a losing trade.<a id="_ftnref14" title href="http://www.mises.org/fullstory.asp?control=1432#_ftn14" name="_ftnref14"><span class="MsoFootnoteReference">[14]</span></a>
Economists Lo and MacKinlay ask, if there were no profit opportunities, then
why would the smart money incur the expense of research and transaction costs?<a id="_ftnref15" title href="http://www.mises.org/fullstory.asp?control=1432#_ftn15" name="_ftnref15"><span class="MsoFootnoteReference">[15]</span></a>
<p class="MsoBodyText">Companies that are listed on the stock market have been
financed by entrepreneurs, been analyzed by financial analysts, and been
bought and sold in the market by traders to establish their prices. The
strategy of"buy and hold" of a market index works as well as it
does because of the work already done by financial entrepreneurs such as
analysts and traders.<a id="_ftnref16" title href="http://www.mises.org/fullstory.asp?control=1432#_ftn16" name="_ftnref16"><span class="MsoFootnoteReference">[16]</span></a>
As Austrian economist E.C. Pasour points out, putting the monkey in a position
to select stocks with darts assumes that some competitive selection process
has already taken place that reduces the selection of stocks to those that are
now publicly traded.<a id="_ftnref17" title href="http://www.mises.org/fullstory.asp?control=1432#_ftn17" name="_ftnref17"><span class="MsoFootnoteReference">[17]</span></a>
<p class="MsoBodyText">In financial markets, securities prices cannot be
assumed to be at all times equal to the value a perfect forecasting machine
would place on them. Opportunities for profit continually arise and some are
spotted sooner than others. Individual investors are financial entrepreneurs
as well, and as such are relieved neither of the burden of forecasting the
uncertain future nor of helping to create it.
<div class="MsoBodyText">
<hr align="left" width="33%" SIZE="1">
<p class="MsoBodyText">Robert Blumen is an independent enterprise software
consultant based in San Francisco. Send him mail at robert@RobertBlumen.com.
</div>
<p class="MsoBodyText">
<hr align="left" width="33%" SIZE="1">
<div class="MsoBodyText">
<div class="MsoBodyText" id="ftn1">
<p class="MsoBodyText"><a id="_ftn1" title href="http://www.mises.org/fullstory.asp?control=1432#_ftnref1" name="_ftn1"><span class="MsoFootnoteReference">[1]</span></a>
Like the children of Lake Wobegon, many investors believed that stock
market returns would always be above average.
</div>
<div class="MsoBodyText" id="ftn2">
<p class="MsoBodyText"><a id="_ftn2" title href="http://www.mises.org/fullstory.asp?control=1432#_ftnref2" name="_ftn2"><span class="MsoFootnoteReference">[2]</span></a>
Transcripts of FOMC meetings released some years later show Greenspan
discussing the existence of a stock market bubble, which in spite of his
protestations of innocence, he did know about.
</div>
<div class="MsoBodyText" id="ftn3">
<p class="MsoBodyText"><a id="_ftn3" title href="http://www.mises.org/fullstory.asp?control=1432#_ftnref3" name="_ftn3"><span class="MsoFootnoteReference">[3]</span></a>
http://www.federalreserve.gov/boarddocs/speeches/1999/19991014.htm.
</div>
<div class="MsoBodyText" id="ftn4">
<p class="MsoBodyText"><a id="_ftn4" title href="http://www.mises.org/fullstory.asp?control=1432#_ftnref4" name="_ftn4"><span class="MsoFootnoteReference">[4]</span></a>
It is impossible in a single article to deal with all of the problems in
Greenspan’s statement. For one, there was the Fed’s responsibility for
creating the bubble. In light of this, it should not be very reassuring
that Greenspan denies the possibility of a housing bubble at this point in
time. http://www.federalreserve.gov/boarddocs/testimony/2002/20020417/default.htm.
</div>
<div class="MsoBodyText" id="ftn5">
<p class="MsoBodyText"><a id="_ftn5" title href="http://www.mises.org/fullstory.asp?control=1432#_ftnref5" name="_ftn5"><span class="MsoFootnoteReference">[5]</span></a>
I first heard this joke some years ago with a $10 bill. It would seem that
fiat money inflation has eroded even the nominal value of jokes.
</div>
<div class="MsoBodyText" id="ftn6">
<p class="MsoBodyText"><a id="_ftn6" title href="http://www.mises.org/fullstory.asp?control=1432#_ftnref6" name="_ftn6"><span class="MsoFootnoteReference">[6]</span></a>
Another similar joke goes: Q: How many economists does it take to
change a lightbulb? A: None, the market will take care of it.
</div>
<div class="MsoBodyText" id="ftn7">
<p class="MsoBodyText"><a id="_ftn7" title href="http://www.mises.org/fullstory.asp?control=1432#_ftnref7" name="_ftn7"><span class="MsoFootnoteReference">[7]</span></a>
The"smart monkey"?
</div>
<div class="MsoBodyText" id="ftn8">
<p class="MsoBodyText"><a id="_ftn8" title href="http://www.mises.org/fullstory.asp?control=1432#_ftnref8" name="_ftn8"><span class="MsoFootnoteReference">[8]</span></a>
Rothbard, Man, Economy and State, p. 498.
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<div class="MsoBodyText" id="ftn9">
<p class="MsoBodyText"><a id="_ftn9" title href="http://www.mises.org/fullstory.asp?control=1432#_ftnref9" name="_ftn9"><span class="MsoFootnoteReference">[9]</span></a>
Rothbard, p. 499.
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<div class="MsoBodyText" id="ftn10">
<p class="MsoBodyText"><a id="_ftn10" title href="http://www.mises.org/fullstory.asp?control=1432#_ftnref10" name="_ftn10"><span class="MsoFootnoteReference">[10]</span></a>
The physicist Neils Bohr once said,"Prediction is very difficult,
especially about the future".
</div>
<div class="MsoBodyText" id="ftn11">
<p class="MsoBodyText"><a id="_ftn11" title href="http://www.mises.org/fullstory.asp?control=1432#_ftnref11" name="_ftn11"><span class="MsoFootnoteReference">[11]</span></a>
See section 2, http://www.mises.org/econcalc/Ch2.asp.
</div>
<div class="MsoBodyText" id="ftn12">
<p class="MsoBodyText"><a id="_ftn12" title href="http://www.mises.org/fullstory.asp?control=1432#_ftnref12" name="_ftn12"><span class="MsoFootnoteReference">[12]</span></a>
<em>Socialism</em>, p. 120.
</div>
<div class="MsoBodyText" id="ftn13">
<p class="MsoBodyText"><a id="_ftn13" title href="http://www.mises.org/fullstory.asp?control=1432#_ftnref13" name="_ftn13"><span class="MsoFootnoteReference">[13]</span></a>
Mises, Human Action, p. 328.
</div>
<div class="MsoBodyText" id="ftn14">
<p class="MsoBodyText"><a id="_ftn14" title href="http://www.mises.org/fullstory.asp?control=1432#_ftnref14" name="_ftn14"><span class="MsoFootnoteReference">[14]</span></a>
Schiller, p. 174.
</div>
<div class="MsoBodyText" id="ftn15">
<p class="MsoBodyText"><a id="_ftn15" title href="http://www.mises.org/fullstory.asp?control=1432#_ftnref15" name="_ftn15"><span class="MsoFootnoteReference">[15]</span></a>
Lo, Andrew and MacKinlay, Craig, A Non-Random Walk Down Wall Street.
Princeton University Press, 1999, p. 6.
</div>
<div class="MsoBodyText" id="ftn16">
<p class="MsoBodyText"><a id="_ftn16" title href="http://www.mises.org/fullstory.asp?control=1432#_ftnref16" name="_ftn16"><span class="MsoFootnoteReference">[16]</span></a>
Pasour,??.
</div>
<div class="MsoBodyText" id="ftn17">
<p class="MsoBodyText"><a id="_ftn17" title href="http://www.mises.org/fullstory.asp?control=1432#_ftnref17" name="_ftn17"><span class="MsoFootnoteReference">[17]</span></a>
<font face="Verdana, Helvetica">E. C. Pasour, The Efficient Markets
Hypothesis and Entrepreneurship, Review of Austrian Economics
vol 3, p. 102.
</font>
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