Justin Fox Is Attacking A Straw Man


Most non-economists find the ‘efficient markets hypothesis’ the most absurd belief that most economists believe. The latest broadside is Justin Fox’s book The Myth of the Rational Market. A lot of this gets into semantics. If you think efficient markets mean they are always correct, then clearly this is a stupid theory. But it only means that it is highly improbable to outperform the market, say by reading blogs about finance, listening to CNBC, and then buying or selling securities traded in liquid exchanges. The market price is an unbiased predictor of future prices, conditional on all the current information (there is a risk premium that complicates this, but I wrote about this in my upcoming book and will talk about that when released in a few weeks).

There are lots of straw men in this book. Efficient markets does not imply prices changes (‘errors’?) are normally distributed. LTCM’s failure, and its positions, were not predicated on the Black-Scholes-Merton option model. No one believes markets are perfect. It does not say no individual has alpha.

Think of the problem this way. Say one can buy a contract that Global Warming implies temperatures will be 3 degrees higher in 2100. If it were a traded contract, such that there was a way to generate some validation (say, that average temperatures in the troposphere done by NASA, paid to legal beneficiaries of current bettors). People strongly disagree on this, and most people think those who disagree aren’t merely making an honest mistake, but have biased or stupid beliefs, though unintentionally (tools of bigger forces, a malevolent Borg), and the key is you cannot prove this today via indisputable logic. The set of information is large, and it is not clear what is relevant to this forecast (climate models are very complicated). In 90 years, with hindsight, the losers will look like stupid ideologues, and that will pertain to a significant number of otherwise smart people. Is this market then ‘inefficient’, because those taking the other side of a losing bet will be not merely unlucky, but ‘wrong’?

I think not. Truth is not obvious. People do their best, and usually the phalanx of assumptions and theories that underly a belief are so comlex you can not fully articulate why you believe something. That does not mean your belief is irrational, just that in the real world, many things are very complicated, and you can’t work backward to isolate essential differences. Even if you could, there would be many assumptions that are also really unverifiable opinions, not that they don’t have data, just like saying the minimum wage causes unemployment, you don’t have enough data to prove it one way or the other to a suffficiently sceptical person. So it’s an infinite regress. Are these disagreements, manifested in markets where prices change all the time, sometimes violently, irrational? It would be nice if we all could agree on the facts and theories, and that they be correct, but that’s rather naive.

The bottom line is that most investing experts underperform passive benchmarks, and counter-examples like Warren Buffet are merely reused again and again. Sure, some may have alpha, but they are relatively few, and almost all of them follow the Peter Principle in finance and accept money until their alpha is gone (the dominant strategy, it appears). That fact has held up pretty well since first discovered by the Cowles commission back in the 1930s. I would like to see the final paragraph of every book touting the stupidity of rational markets to give specific advice, like “buy gold, GM, Sell the VIX and the dollar”. The fact that people don’t know the sign of the market’s incorrectness is the reason we call the market efficient .

A good example of what seeming market inefficiency looks like in practice is the appearance and disappearance of the ‘convexity bias’ between swap forwards and Eurodollar futures. The arbitrage worked like this. If future and forward rates were equivalent, one could go long swaps (forwards) with short Eurodollars (futures), and the daily mark-to-market of the Eurodollars vs. the future mark-to-market of the swap would allow one to lock in a sure thing. In equilibrium, precluding arbitrage, futures should be slightly higher than forward rates. The mechanism underlying this opportunity is subtle, but the effect added up to 15 basis points in present value if done with 5-year swaps, and it was truly risk free. Several banks made tens of millions of dollars on it in the early 1990s. It was written up in RISK magazine in 1990 (Rombach, 1990). It disappeared around 1994, after which academic economists wrote about it in the Journal of Finance (Grinblatt and Jegadeesh, 1996), and today you see the convexity adjustment right there in Bloomberg so traders don’t think forwards are futures.

That ‘inefficiency’ is history. True arbitrage profit opportunities such as these do exist, and they don’t disappear immediately, but they do go away eventually, usually well before academics have proven they are arbitrage. Market efficiency sceptics would see this as a fantastic embarrassment, I see it as disequilibrium phenomenon, a temporary aberration that is of interest only to those lucky few who identified it while it still conferred a profitable opportunity. Disequilibrium behaviour has always been difficult for economists to explain, as all such activities are idiosyncratic or ephemeral.

The problem for those who think the market is irrational is to generate a model that is better. To merely state, with hindsight, that people were over-extrapolating in one case, underextrapolating in another, leads to an unbiased market in real time, and it is unbiasedness, not zero price variance, that is the essence of the efficient markets hypothesis.

The behavioralists like to portray themselves as rebels, Davids versus the theoretical Goliath, but in reality the efficient markets folks deserve the true rebel status. Almost everyone outside this literature is sympathetic to behavioural theories over the rational markets assumption, regardless of one’s political bent. I used to work for a bank where our swap salesmen could always sell swaps to companies by telling their Treasurers how these instruments could make money given their personal view of the market.

To these Treasurer’s detriment very few of them had an efficient markets prejudice (“perhaps the forward prices and their implied volatilities are as good a forecast as mine, and so including commission this is a negative-sum speculation!”). It has been well documented by people like Odean and Barber that people trade too much, based on the mistaken idea that markets are not efficient. It would be harmless fun, but it’s a lot of money. Sure some are right, but most are burning money via transaction costs in zero-sum bets.

One doesn’t have to love Dilbert to know that there are lots of irrational business people, and that many business decisions are made by former B- students who are both boundedly rational and internally inconsistent. The real question is whether or not these irrational actions generate useful hypotheses about economic behaviour, and thus far most of these predictable actions relate to volume and volatility. The over and underreaction hypotheses seem about as promising as the adaptive expectations assumption that underlies it, and Keynesians worked with that for years without bearing fruit.

The efficient markets paradigm is a triumph of economics because it is so counterintuitive to the layman, so restrictive in what it allows, and so pervasive in its application. A healthy respect for the rationality of markets is a hugely advantageous mindset for the researcher and practitioner. This is the most useful base from which one identifies anomalies, and then explains them with specific frictions or cognitive biases. If you start out thinking all prices are wrong, odds are you are gambling, and the house wins.

(This post was originally published at Falkenblog)

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