What we know about markets, and what we - PowerPoint Presentation

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What we know about markets, and what we think we know about markets

Prof. Dr. Oliver

Spalt

spalt@uni-mannheim.de

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Why are markets good?

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The Classical Answer

Classical economic position is that “markets are good”

They efficiently allocate risks and resources

Theory:

Adam Smith’s Invisible Hand (18th century)

Arrow-Debreu: Welfare Theorems (20th century)Does that settle the debate?

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Purpose of this Talk

Discuss some problems with thinking about how well markets function by looking at an important special case:

financial markets

Illuminate the difference between What we know, andWhat we think

we knowGet you started on thoughts like:What are the boundaries of science?What should my null hypothesis be?

How can we shape society in the absence of conclusive evidence?

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Eugene Fama, Nobel Prize 2013

The Efficient Market Hypothesis

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Fama (1970): An efficient market is one where prices always fully reflect available information

If markets are efficient, they provide informative signals for investors. Hence, efficient markets make sure funds are allocated to their best use

The power of “capitalism”

EMH has lead to several first-order academic break-throughs that changed the world (for better or worse)CAPMOption pricing

Passive investment industryThe Efficient Market Hypothesis

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EMH Theoretical Justifications (Shleifer (2000))

All investors are fully rational (Bayesian EU

Maximizers

)Some investors are less than fully rational, but their effect cancels out in the aggregateRandom mistakesNo price impact

Some investors are non-rational in similar, correlated ways. However, rational arbitrageurs eliminate their influences on prices

Decreasingly strict assumptionsCommon misconception: EMH requires everybody is fully rational!

Not true if arbitrage process works well

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Evidence consistent with EMH – Example 1

Annual returns US mutual funds 1963 – 1998

It is very hard to beat the market

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Source: Ross,

Westerfield

,

Jaffee

, and Jordan (2008) based on Pastor and

Stambough

(2002)

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Evidence consistent with EMH – Example 2

Abnormal returns around dividend omissions (event study)

Information is often incorporated into prices quickly

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Source: Ross,

Westerfield

,

Jaffee

, and Jordan (2008) based on

Szewczyk

, Tsetsekos

, and

Zantout

(1997)

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Challenges to market efficiency

Challenges to the theory of efficient markets have come mostly on two fronts:

Based on observed market “anomalies”…

…and sustained by a large literature on limits to arbitrageBased on systematic

deviations from rationality in individual decision makingIn particular: the

Kahneman and Tversky Nobel Prize winning research program

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Daniel Kahneman & Amos Tversky

Showed that standard ingredients used in economic models are often at odds with (or insufficient to describe) actual human choice behavior

Nobel Prize in Economics 2002

(Not bad for cognitive psychologists!)

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The “Market-Based Challenge”

Robert

Shiller

, Nobel Prize 2013

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Market anomalies (1) – tech stock bubble (?)

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Market anomalies (2) – housing bubble (?)

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Source: Robert

Shiller

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Shiller’s Interpretation

Markets are “excessively” volatile

Shiller (2013):

“

It is hardly plausible that speculative prices make effective use of all information about probabilities of future dividends. It is far more plausible that the aggregate stock market price changes reflect inconstant perceptions, changes which Keynes referred to with the term “animal spirits,” changes that infect the thinking even of the most of the so-called “smart money” in the market.”

Markets are governed by fads, fashions, collective illusions, and stories

Think: “new era stories” about tech stocks

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Alternative View

Start with Campbell-Shiller decomposition of D/P ratio.

D/P ratios are driven by:

Expected future returns (“discount rates”)Changes in future dividends“Rational bubbles”

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Alternative View

You can estimate how much each individual component contributes to explaining D/P

Fraction of variance explained (see e.g. Cochrane (2011)):

Expected Returns: 100%Expected Dividends: 0%“Rational” Bubbles: 0%Hence: “Prices are high because expected returns are low”

Cochrane (2011): “Prices being too high can only mean expected returns are too low relative to some theory”Discount rates may vary systematically due to some underlying rational theory. No need for “Animal Spirits”

For example: Campbell and Cochrane (1999) (rational model??)

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The Heart of the Debate

At the heart of the debate is what

Fama

(1970) calls the Joint Hypotheses Problem:If you want to claim that the price of an asset differs from its true fundamental value, you need a model to determine that price.Hence any test for mispricing is at the same time a test of the pricing model.

Since we can never be completely sure that our model is right, we can also never be sure that there is mispricing.In other words: observing something that looks like mispricing can simply mean that we need a better model

That new model may well be a “rational” one

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Example Tech Stocks

Many

believe the “Tech Bubble” is a prime example of an event due to investor irrationality

Shiller: “Irrational Exuberance”If you have seen it, it is hard to deny at least some irrationality…But even for that episode there is room for alternative models if you are smart and creative enough

For example: Pastor and Veronesi (2006)Key idea: uncertainty about future profitability growth was extremely high for tech stocksThey show higher uncertainty translates into higher valuationsThey calibrate a model to show uncertainty levels needed to match Nasdaq “bubble” are not excessively high

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Pastor and Veronesi (2006)

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Who Owns the Null Hypothesis?

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“Before we relegate a speculative event to the fundamentally inexplicable or bubble category driven by crowd psychology, however,

we should exhaust the reasonable economic explanations

... “bubble” characterizations should be a last resort because they are non-explanations of events, merely a name that we attach to a financial phenomenon that we have not invested sufficiently in understanding.”

Garber (2000, p.124)

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Who Owns the Null Hypothesis?

“Owning the null hypothesis” is a crucial issue in the debate

Many disagreements can be traced back to differences in the null

See Fox (2009) for fascinating account of how EMH became H0Summers (1986) makes this point as follows:H0: P(t) = P(t-1) + u(t), where u(t) is uncorrelated across timeH1: P(t) = P(t-1) + u(t), where u(t) is AR(1)

Even under unrealistically favorable assumptions for H1 being true, we lack the power in most empirical tests to reject H0With monthly data, need 5,000 years of data (even though everything is strongly rigged towards H1)

If we cannot reject H0, should we view it as “true”?

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Markets in Society

What do we really know about the efficiency of markets?

The Joint Hypothesis Problem

If markets are not efficient (i.e., prices do not correctly reflect all available information), then:How inefficient will the resulting allocation of resources and risks be?What follows for how much markets should matter in society more broadly?Role for regulation?

How would you regulate?What should be our null hypothesis?

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Questions for us in this Course

What is my implicit null hypothesis?

How do I know morals are important?

If you and I come from different priors, how can we productively move forward?If we feel we need to act now (instead of waiting 5,000 years until our t-stats are high enough)……How to decide on how to regulate markets?

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“Homework”

Watch and think about:

https://www.youtube.com/watch?v=faSa3r8WIU0

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