Saturday, January 16, 2010

Efficient or not?

If prices are unpredictable, then rational behavior is an impossibility. If rational behavior is possible, they must be at least somewhat predictable. They may be more predictable in the long term than the short, but without predictability no coherent action is possible.

Equating price to value eschews any independent assessment of value. Without any fundamental value, prediction can only be extrapolation, and extrapolation leads more or less directly to bubbles. Extrapolation can take several forms, historical, momentum, or statistical, but they all rely on predicting future price from past price and change in price. Price is not always value. Often it becomes an assessment of the value of others, an assessment subject to wild speculation in the absence of any fundamentals. Stocks have earnings and real property has rents and while these are subject to change, they aren’t totally unpredictable, but once people focus on price and price change, they are no longer investing but speculating. Speculation may be self correcting eventually, but it is not necessarily in the short term. Speculation can feed on itself until the ponzi scheme runs low on new entrants or encounters a sufficient number of defectors. Prices then collapse to or below fundamentals.

It is precisely when people give up making their own prediction and rely instead on the predictions of others that trouble arises. They are no longer interested in the prediction, but what others believe and predict, what others perception of value is. They can then extrapolate that to absurdity.

For debt to be supported, income must exist to repay it. Where was income all these years? Flat to falling. That does not support growing debt. We were well into the ponzi finance stage. The big money is jumping on the bubble while it is inflating and only jumping off and shorting when it is about to decline. That is what makes bubbles unpredictable, not that they don’t exist, but that they require market timing. And there are winners, but fewer than losers or a bubble wouldn’t have inflated in the first place, and the interest of the most knowledgeable is not to counter the bubble but to feed it. Bubbles start in uncertainty, grow to absurdity, and burst unpredictably.

The flaw of efficient markets is to equate price to value, making price the fundamental value, forestalling the real search for value, and defining markets as efficient rather than ask the tough questions of how efficient it is and whether that efficiency is increasing or decreasing. Until we go beyond it, we will get nowhere.

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