Burton Malkiel, a leading mind behind the efficient market hypothesis (EMH) and author of the finance classic A Random Walk Down Wall Street, recently reviewed Nate Silver’s new book The Signal And The Noise.
Over all, he was impressed.
“Mr. Silver’s breezy style makes even the most difficult statistical material accessible,” wrote Malkiel for the Wall Street Journal. “What is more, his arguments and examples are painstakingly researched—the book has 56 pages of densely printed footnotes.
“That is not to say that one must always agree with Mr. Silver’s conclusions, however.”
Of course, Malkiel takes issue with Silver’s discussion about the financial markets, particularly how financial models predicted the dotcom bubble.
As someone interested in financial markets, I found myself unconvinced by Mr. Silver’s view that it should not be “all that challenging” to identify financial bubbles “before they burst.” He suggests that the dot-com bubble that deflated in early 2000 was identifiable in advance. The price-earnings multiple for the market was enormously elevated at 44. Considerable empirical work, shown in the book, was adduced to point out that long-run (10- or 20-year) rates of return from stocks have generally been poor or negative when investors entered the market at such lofty valuation metrics.
The problem is that Mr. Silver has ignored all the false positives. Earnings multiples were elevated in the early 1990s, suggesting poor stock returns. But the 1990s produced extraordinarily generous equity returns. Earnings multiples were even higher in December 1996, suggesting negative long-run rates of return. This analysis influenced Alan Greenspan’s famous “irrational exuberance” speech that month. The stock market rallied sharply until March 2000. Yes, the valuation model gave an accurate bubble prediction in March 2000 but a devastatingly inaccurate one throughout much of the 1990s. Stock prices were wildly inflated in early 2000. But the efficient-market hypothesis doesn’t imply that prices are always correct, as Mr. Silver asserts. Prices are always wrong. What the hypothesis asserts is that one never knows for sure if they are too high or too low.
Read the whole review at WSJ.com.
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