Monday, May 25, 2015

The Market is Efficient Enough: Robert Shiller's "Irrational Exuberance".

I read this not long after I had read Malkiel’s “A Random Walk Down Wall Street”. Both books came out in new editions this year, and both had been on my long list of books to read in the back of my head.

Oddly enough, both books were compelling and believable. The reasons that this is odd is mostly because one would think that they are diametrically opposed. The entire argument of Malkiel is that you can’t beat the markets consistently, so the best bet is to get into index. This is an acceptance of part of the efficient market hypothesis, where there is no free lunch and arbitrage opportunities disappear and are not predictable.

I can be into Shiller too because there is another part of the EMF that says that market prices are the right prices, so the value of the market is the true value of the market. If this is true there should never be any bubbles. You should also never be able to short sell anything unless you had inside information. But alas, the market can stay irrational longer than you can stay liquid. Bubbles do happen, in all markets and everywhere. Shiller got a bit lucky by having the first edition of this book come out at the point where the dot com bubble was right at the top. Those who had gone all in on technology were not as lucky. As Shiller examines. bubbles can and do happen.

So how can I reconcile the fact that the EMF is the tool I rely on for investing even though I have full knowledge that bubbles happen and massive dollar amounts are lost in them? I answer by saying that the markets are rational enough. Bubble happen, but it is hard to know when you’re in them and you can’t time them. The prominent economist who called the housing bubble beforehand are small in number. If they were calling it, they were dismissed as bearish or too heterodox. Too many people had failed to read their Kindleberger. This time wasn’t different and the bubble popped. Harder to know is when it will pop and at what level. That’s where the EMF works. When it pops, you’re going down with it, but so will everyone else. It makes me think of a couple of quotes. First, Keynes: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally,” and then Citi’s Chuck Prince approps the last bubble: “As long as the music is playing, you've got to get up and dance”. Sure, if you were in the main indices you lost half the value of your investments. Of course if you stayed in them you made them all back. Now imagine if you had put all your money into junior tranches of residential mortgage backed securities -- it seemed like a sure thing, but you would have ended up with nothing. It’s not perfect, but the market is efficient -- enough.