Monday, June 29, 2009

Response to Fox's "Myth of the Rational Market"

My comment posted on The Economist.com Blog, Free exchange in response to Justin Fox's comment on irrational markets. Fox is the author of the book, "The Myth of the Rational Market."

Fox said in response to a question about efficient markets:
FE (Financial exchange): Burton Malkiel concluded a recent review of your book by saying, "With "The Myth of the Rational Market" Mr. Fox has produced a valuable and highly readable history of risk and reward. He has not, however, been able to bury the hypothesis that our securities markets are usually remarkably efficient." How do you build a regulatory system around this notion? (And do you accept Malkiel's assertion?)

Mr Fox: Depends what you mean by “efficient.” If you just mean securities markets are hard to outsmart, which is what Malkiel’s getting at, then he’s right. I haven't been able to bury that notion, and I wouldn't want to. If you mean that the prices prevailing in securities markets are always rational and reasonable, which really is what lots of finance professors used to believe, then that’s pretty well dead and buried by now. The upshot for regulation is that financial markets go crazy, but you can’t rely on regulators knowing when markets are wrong. Which seems to point toward doing roles that would both temper the market's moves and reduce the risk of collateral damage there's a crash. Restricting leverage seems to be the most straightforward way to do this—as we've learned over the past decade, a bubble based on equity (the dot.com insanity) causes a lot less trouble when it collapses than one based on debt (real estate).

My posted response:
Fox's last statement contradicts his entire thesis. If markets are irrational and unreasonable at times then an analysis of the markets should allow someone to outsmart the markets. However, while there are always a few who do better in the markets at these times, the number is never more than would occur by chance.

For Fox's thesis to be true, the majority of people must be irrational at times, and then they must become rational for prices to return to normality.

What Fox assumes is that events that affect prices must directly reveal themselves to investors before they change. However, investors make rational assumptions about the future based on signals in current events. These signals can change before future events happen and investors will modify their expectations of the future and the value of things.

To see this in a more obvious and shortened time example, let use a pharmaceutical company. If the company does research on a few individuals that shows that a new drug has the potential to be a blockbuster, the company's stock will increase. If later, small studies by that company or other researchers question that conclusion, the company's stock will decline. Sometimes, just allocating funds to do the research is enough to increase a company's stock price because it shows that the company believes there is a potential reward in this kind of drug. Just allocating funds for the research is a signal to investors. Sometimes, the publication of a scientific paper is enough of a signal to change a stock price.

All this occurs prior to actual clinical trials or production and sale of the drug. It is rational. It is about making a best guess on available information and signals.

The same logic is true for the recent home value rise and decline. Materials and labor costs for homes varies little across the country, increases generally by inflation and accounts for a small part of home price changes. However, land costs are a major determinate of house prices, but in different parts of the country account for a different share of the total home price.

In the San Francisco area, land can account for 80 percent of the value of a home, while in parts of the Mid-West it can be 20 percent of a home's value. A 50 percent increase in land values across the country will have different effects on home prices in different regions. In San Francisco, homes will increase by 40 percent (.5 x .8), but in the Mid-West by 10 percent (.5 x .20). A similar reverse effect also occurs when land prices decline. Of course, there would also be some local price changes due to local economic and demographic conditions.

No one has, however, studied land price changes in the US during the so-called "housing bubble" to see if there were logical reasons for this price change. For example, there could have been changes in expectations of the tightening of laws restricting home building, changes in immigration laws, changes in birth rates, changes in US mobility patterns, increased costs of residential development due to environmental laws, etc.

Until researchers verify that there were or were not rational reasons for land value changes, I will continue to believe markets are rational. It is like the example of guessing about the number of jellybeans in a large jar. Nobody need get it right or understand how to do it, but the average of all the guesses will be the best guess. The price of an object is the average best guess at the time and the one that is most likely correct until information about the future changes. Irrational market belief is like a belief in UFOs. Until someone actually produces a UFO or an alien, I will continue to believe that they do not exist on this planet. Others, however, do not need proof. Mr. Fox obviously needs much less proof than I do that markets are not rational.

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