I think the same thing is going on with the commentary on economy currently. Whenever I browse around Reddit for example the comments that get upvoted are the cynical ones, "markets are irrational", "feds are pumping up the stocks" etc, but they do not put any real thought into what is happening with the markets and why.
I don't think starting from the EMH is correct either, I suspect nobody really knows why the US stock market doesn't reflect the deepest recession since the 1930s, though of course everyone has opinions. The market may simply be wrong in its assessment of risk at this time (it tends to swing wildly around the true future returns), or the recession might be very short (as mr market currently believes).
How long do you think market is predicting the recession to last?
There's predictions expecting 30% unemployment since March for Q2, and also predictions expecting 50% GDP drop for Q2.
So current market should have these predictions priced in.
I think one major thing that people fail to consider is that this recession is not like other recessions - namely, it's not failing of economics, or a bubble popping, it's a temporary natural disaster and economy is deliberately shut down. So it shouldn't be compared to other recessions which were issues with how economy worked. Right now there's no evidence that economy or system is failing by itself. Of course it might, but there's no evidence.
I think current market price stems from rational strategy by investors. This is why I think markets are rational. Current recession doesn't have implications 5 years into the future. We might lose some potential developments we could've had right now, but it just gets delayed few years, so it's not a big deal.
Maybe it is hindsight to me, but to me it seems clear why stock market has the current price it is. Maybe I'm "overfitting" somehow my theory, but it seems to make sense to me and I'm not seeing a clear logic error with my theory. I've argued a lot on this topic on this forum and reddit, and I haven't seen good retorts yet, it's just that I'm not getting any responses or somebody says "I just disagree and that's it".
If it lasts long enough, a temporary natural disaster becomes an economic disaster.
I think the rough market consensus at the moment is as you state it - this is a natural disaster which will be over soon. That is a possible outcome at this point, but a second wave in the US for example would have significant impacts and cause entire industries to fall into bankruptcy - wiping out shareholders and leading to significant second-order effects on other industries and supply chains, plus causing a consumer-led recession. It seems increasingly unlikely to me that this will be over as soon as you expect. Just to pick one example - that 20-30% unemployment will not go away quickly if this is not over in the next month or two for the US and those people rehired. Companies will not rehire unless they are certain it is over.
Current recession doesn't have implications 5 years into the future
Remind me in 5 years! I don't think it will impact behaviour massively in 5 years, but I do think there is a danger this recession could trigger significant other events which have impact for more than a few years - for example unrest in the middle east after 2008 led to regime change in many countries, and ongoing war in Libya. Economic depression, unrest and wars are a common occurrence after smaller crises than this one.
When people say the market is irrational it is more to point out that the market valuation swings about the future expected returns quite wildly - for example if what you say is true, the market should not have crashed quite so strongly when coronavirus first spread then bounced back quickly again, but it did, because people panic. It does the same in the opposite direction based on incomplete or incorrect information about drugs/vaccines. There's a nice graph in the above book of the expected return from stocks (pretty much a straight line up and to the right, with small bumps on the way), and stock market valuations (massive swings around the expected return based on sentiment in that moment).
How do you determine whether it was panic or just uncertainty?
It could be a rational reason for markets to swing wildly because of uncertainty about future. It might take time to gather enough data to assess the risks properly, and while risks are as unknown it is rational that market will be valued lower.
Each bit of knowledge makes uncertain a little bit less uncertain.
This lecture contains a similar graph on asset prices - he uses returns from the S&P for the period 1871-2013. The book really is worth a read too, it's more accessible than the lecture or slides might indicate.
> The comparison is between the actual stock prices against the constant discount rate of subsequent real dividends.
The EMH states that the market incorporates all currently available information, but future dividends are known only in hindsight. Prices that fluctuate around future earnings therefore are not in conflict with efficient markets at all.
I'd recommend the book if you haven't read it, I don't think my poor summaries do it justice, and it does address some of your objections from memory, and also doesn't attempt to throw out EMH, just questions whether it fully explains market behaviour.
Yes the chart compares measured return (divs) against projected return (prices) so it is not a prediction machine but I think it does illustrate well that market prices are usually far from true value.
If you think there's a significant chance the market is wrong in its assessment of risk, you can make a significant amount of money by betting against it. For example, as of the time of this writing, put options at $310 for December 31 on the S&P 500 (current price $293.94) cost $33.09. That means that if there is at least a 50% chance of a 17%[1] drop in value of the S&P 500 at any time between now and December 31, you can make money on average by buying those puts and selling them as soon as prices are down by 17%. The possibility of making this bet means that the market as a whole is 50% confident that stock prices of the S&P 500 will not drop by at least 17% before December 31.
Likewise, option prices imply:
- A 75% chance[2] prices won't drop by 26%+ (which would be back around the low from late March 2020) by the end of the year
- A 90% chance[3] prices won't drop by 48% or more (around the movement from when it became clear that something was deeply wrong in 2008 to the bottom)
- A 95% chance[4] the price won't drop by 58% or more (which is around the peak-to-trough movement from the 2008 financial crisis)
- A 99.5% chance[5] that the price won't drop by 90% or more (like the great depression).
While it's _possible_ that the market is wrong about its assessment of risk, that would also mean that it's wrong about its assessment of its assessment of risk, and people who are better at risk assessment could clean up.
-----
[1] Ok, technically a 50% chance of a drop of 17.05%. ($310 - ($293.5 * 0.8295)) / $41.75 == 1.9999 i.e. if you buy now and sell as soon as the price drops by $17.05, you make a 2x return on investment.
[2] $20.77 for $280 puts expiring Dec 31
[3] $4.62 for $200 puts expiring Dec 31
[4] $1.83 for $160 puts expiring Jan 15. I actually have a small position here, because "95% chance this isn't at least as bad as the 2008 financial crisis" seems a bit overly optimistic to me.
[5] $0.16 for $75 puts expiring Jan 15. Note that there is extremely low volume this far out on the tail.
The market is usually wrong, but it's very hard to know when it will stop being wrong in one direction and start being wrong in the other (as in the great depression say).
"The market is wrong but not in any way that's possible to make concrete predictions about ahead of time" and "the market is correct relative to available information" seem like functionally identical statements to me.
Unless you mean something stronger than "today's price usually isn't the same as next year's price after taking into account the discount rate" by "the market is usually wrong".
Just because you can't predict it in the short term doesn't make it correct or efficient in the short term, it is only correct in some sense in the very long term.
What does 'irrational in important ways' even mean?
What Shiller has shown is simply that the idea of a perfectly effecient market is self-contradictory.
Efficiency is just a very good approximation in practice.
I believe he shows in that book it's not a very good approximation - the market oscillates from overshooting to undershooting actual returns, and I don't think he believes market movements are always based on rational decisions, hence the title of the book.
> I believe he shows in that book it's not a very good approximation
But what does that mean? What is a good predictor of future returns and what is not? If markets are not, what is?
> the market wildly overshoots and undershoots actual returns
Well, the actual returns are only known retrospectively, but the current prices have to reflect all future returns. So, of course, current prices will always be wrong, that's not surprising at all.
It's simply easier to dismiss the potential legitimacy of actions which challenge one's existing notions than to reconsider those notions.
What's interesting is that "markets are irrational" cannot be a failure of the market but a failure of the rational theory being used to interpret markets. That is, current economic theory is squalid by its attempts to explain market phenomenon; and that is to the extent the market is irrational, the degree it disagrees with the theory. It was for this reason Von Neumann readily decided to eschew economic theory.
Quite contrary to common belief, "rationality" has nothing to do with knowledge nor degree of skill in achieving some objective measure. For instance, one with perfect pitch has an ability which is irrational but one could hardly call it invalid.
Rationality is merely the quality of propounding some intellectual framework of which others can subscribe to in sharing of that understanding based on the framework of symbols and their operations embedded in our global culture.
A thing is said to be rational when it can be interpreted completely into one of these pre-existing frameworks which claim to circumscribe the phenomenal sphere of that thing.
It's simultaneously not that complicated and more complicated.
The idea that "markets are rational" is an extension of the idea that "economic self-interest is rational." That's a political and moral position - essentially equivalent to "greed is good" - and not an empirical argument. You can certainly argue strongly against it, and many people have.
The second-order question is whether markets are genuinely rational in the sense of fulfilling the contract implied by ideas like rational price discovery, accurate predictions of future prospect ("pricing in", etc), and so on.
You can agree with the first position and still argue strongly against the second.
For markets to be "rational" in the sense that's usually meant, both positions have to be true. IMO this is simply nonsense. There's no empirical evidence that markets behave any more rationally or are any better at predicting the future than a herd of animals or a school of fish is, and plenty of evidence - not least regular crashes - that markets are actually very bad at fortune-telling.
The third order question is whether markets are "rational" in the sense that they create a political and economic reality distortion field which benefits their own interests at the expense of the wider economy. This is another political position, but it implies agency - almost a form of sentience - which predicts national and international policy because it influences it - rather than being influenced by it.
IMO this third position is closest to truth. Markets are politics by other means, and the successes come from having access to political and economic leverage that other classes don't have. The idea that markets are "wise" or even good at price discovery is questionable at best. But market morality is clearly a very influential thing, and it's easier to look like a winner when you have your fingers on the scales.
I think the current market rally is an example of this effect. "Markets" are hoping they have enough influence with the Fed and Trump's government to keep a privileged position above the carnage that's going to spread through the rest of the economy. And this is what has really been "priced in."
That's a bit off-topic, but what do you think is happening? I'm considering buying some s&p500 based stock, but I'm a bit afraid. What do you, anonymous stranger on the interweb think?
I have many thoughts on this topic, I'm not an expert and many of these are theories up with so the may also be flat out wrong, but I just disagree with the sentiment that markets are irrational or it's just feds pumping up the stock. I think saying those things is dismissive and anti-intellectual.
When I'm trying to think about the subject and whether I should invest myself, I'm trying to figure out what are the actual consequences of coronavirus long term and what in general are investor's motivations.
Here are few assumptions I make:
1. Stock price is determined by an umbrella of possible consequences and chances for each consequence. These are just examples, but for example there might be 30% chance that we can manage coronavirus while reopening the economy, +50% chances that we will have a vaccine in 1 year period that we can mass-produce etc. For each of those consequences we can think of an appropriate SP500 price (I'm taking SP500 here as an example, but it could be any other index as well). If economy goes back to normal, the SP500 price could go to 3400 again. Investors will try to predict what are the odds and in total stock price should reflect what investors on average think the odds of something to happen are.
2. The way investors react to these possible consequences comes from that specific investor's expectations and long term strategy. It's important to know what is average investors expectations and risk tolerance. If SP500 is 2200 (which it was when people were expecting it to go to 1700) and you expect 90% of chances of SP500 going back to 3400 within 3 years you can determine that you have 90% chances of making 54% returns within 3 years which is crazy good. So at this point it makes sense for most investors to buy in, because even if it goes lower, you will still be making very good returns. Now that SP is at 2800-2900 I think it's still better to buy in than not, but you can't obviously expect as fantastic returns. I bought in and even with a little bit margin, but I have enough margin left to buy in more if stock should fall. I'm investing and looking at least 5-10 years ahead. So it makes sense for investors to buy in now that they are not crippled by fears of what coronavirus might do - it's already quite clear it's not the end of the world even if it might shake up economy further throughout this year.
3. There are possibly some positive long term effects of coronavirus. Increased productivity, tech and automation from having been forced to experiment with WFH etc. I think all of these might increase productivity. I'm speaking of those not to just sound optimistic, but these are something a lot of people don't mention.
These are just rough thoughts I have right now, but in conclusion I have decided to buy in since I have determined that in 3-7 years there are very high chances of making very decent returns. I doubt corona can affect us for that long timeframe.
Of course it's more risky than usual to buy in right now so if you have low risk tolerance it's up to you. If you possibly need that cash within 1-3 years, then maybe not buy in, but whether you should buy in right now should be determined with when you want to use that money and how much you are willing to risk. Usually more risk means more reward since only people who can handle that risk will be buying (so stocks will be more underpriced when there's more risk and uncertainty). And since I don't want to use that money before 5 years anyway, for me it definitely makes sense to take that risk. Also even if stocks fall just after you bought in you must be able to handle that and not think you did the wrong thing and sell. You likely wouldn't be able to sell in time anyway.
Many people are fearful right now which means a lot of people are holding cash or shorting. Once fear subsides, stock will start to climb faster again so you should want to be in before general fear subsides..
Thank you very much for that lengthy explanation.
I experienced the fear of loss before and I was surprised how bad I handled it.
It's shortcircuting all rational decisions.
