Tuesday, 4 August 2009

Slow EMH and diversity

A perceptive article by Tony Jackson in the FT illustrates two theoretical points I'll be developing in more detail over the next few weeks.

First, he equivocates about the efficient markets hypothesis (EMH):
When we make a killing in a rising market, we dwell on our own smartness rather than the irrationality of prices having been too low.
This is a key point to understand in markets - especially illiquid ones such as property. Some commodities tend to exhibit long-term bear and bull markets. Residential property in the UK showed a consistent rising trend from the early 1990s until 2007. It's hard to argue, even having seen subsequent falls, that this obeyed the "random walk" theory of the pure EMH.

Instead, it's more convincing to posit that there was a "correct" efficient value - perhaps the 2004 or 2005 price? - and that most people from the mid-90s onwards could see that the correct value was higher than the current price. However, natural caution, slow turnover of properties and the structure of the mortgage market meant that the price could not jump directly to its correct market-clearing value. The mechanism for getting there involved millions of market participants gradually testing out higher and higher prices on each other to see if they would stick. When they did, the market price ratcheted up and the process continued.

Of course, the process can also overshoot, despite the tiptoeing built into it. That happened in 2000 with technology stocks and in 2007 with housing. The reason seems to be that after a time, people come to mistake experimental price-setting for permanent momentum.

This phenomenon is what I call the "slow EMH" and it does offer opportunities for profit if you have the capital and time to take advantage of it.

Jackson also points out that not everyone can do this. If you are not compensated by finding true market value but by beating your peers in a quarterly contest, you may know about trends in the market that you can't act on. Warren Buffett is the classic exception to this rule, but Jackson makes a more general point at the end of the article:
That is the fundamental failing in the efficient market hypothesis. You cannot beat the market today or next week. But you can beat it in the long run, provided you do not want what the average does - or not at the same time, anyway.
That point, insightful as it is, is much more important than a mere rule of investment. In fact, it's at the heart of all economics. We can't all want the same things at the same time - and if we do, we must be induced to change our minds. Otherwise, we will create for ourselves a completely unnecessary shortage - of food, energy, land, money or any other scarce resource.

Much more on this later.

No comments: