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Source link: http://archive.mises.org/11671/bursting-eugene-famas-bubble/

Bursting Eugene Fama’s Bubble

February 15, 2010 by

Fama seems to think he has just defused the critics of the EMH, but I don’t see how. All Fama has demonstrated is that the people who bought overvalued assets didn’t realize they were buying overvalued assets at the time. No kidding. FULL ARTICLE by Robert P. Murphy


Steve February 15, 2010 at 8:07 am

Not being a professional Austrian, my observations would be:
1. EMH seems implausible on its face; the market continually changes, and by the time a participant receives information and adjusts plans, the market has changed. I think it’s impossible for all participants to be equally knowledgeable, or that participants will value all information in the same way. Thus, the idea of EMH that markets at any given moment reflect “equilibrium”, based on all available knowledge, cannot be.
2. Regarding savings=investment, I think the distinction needs to be made that credit differs from loans. We have a massive credit bubble, not due to increased savings/loans, but from increased fiat money/credit creation.

pravin February 15, 2010 at 8:18 am

fama,like most mainstream economists probably doesnt understand money too well. chicago types think that free markets are a must,except in money.what gives?. no idea at all. the disease started with friedman

david janello February 15, 2010 at 10:19 am

>> I don’t know what a credit bubble means. I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.

Fama is absolutely correct, and I can prove it beyond any doubt.

My challenge to Mr. Murphy, and all other opponents to the EMH is to define two things:

a) the approximate date that the housing bubble began, and

b) the approximate date that the housing bubble ended (if it has ended at all).

If critics cannot even approximately define the begin and end dates of the so-called ‘bubble’ it is ridiculous to even consider criticizing the EMH. All trades require an entry date, an exit date and a cost to enter and carry the trade. If EMH opponents cannot define the entry dates all of their arguments are meaningless.

More importantly, Austrian Economics already plays an important role in the EMH ecosystem. While it is possible to identify dozens of successful Austrian hedge fund managers (Jim Rogers, Nassim Taleb, Eddie Lampert etc), I challenge anyone on this list to name a SINGLE successful Keynesian fund manager.

This offers important empirical evidence that markets are allocating capital to the most efficient managers and bankrupting the laggards.

Right now the same EMH forces that bankrupted the Keynesian hedge fund managers are putting tremendous strain on Keynesian governments.

When the Keynesian policies are scrapped and sound money is re-introduced, the returns of the Austrian Fund managers will decline.

Exactly as predicted by the Efficient Market Hypothesis.

Jon O. February 15, 2010 at 10:44 am

EMH is a joke, and anyone who actually works in finance knows it. Only academics and their acolytes could believe such nonsense.

1) short squeezes and forced liquidations

2) Market gaps, then refilling of those gaps

3) negative t-bill yields

4) Steve Cohen, Paul Tudor Jones, George Soros, Jim Simons

5) frenetic oscillations after FOMC announcements

6) certain MBS going no bid or having untradable spreads during the crisis

7) the tendency of the market to respect certain support/resistance levels; the tendency of the market to work in 3 and 5 legged wave patterns; the tendency of the mark to head fake off the open; the tendency for the market to reverse after failed breaks; the tendency of the market to counter a mon-thurs move into the friday close etc. etc. etc.

8) the dow opening the day + 300, then dropping 500, then rallying 1000, then dropping 800 with no news coming out.

9) stop loss orders being targeted by locals/prop desks

10) Here’s my favorite because its so obvious: a trader is looking to buy 50 Comex gold contracts right at the high of the day, his finger slips and he actually buys 500 pushing the price a whole $5 higher than he wanted. At that point in time the market is wrong, because a rational actor made a mistake.

People aren’t robots and markets aren’t always efficient. If you want to learn about markets you should watch them, not read about them.

greg February 15, 2010 at 12:09 pm

The word “bubble” should be removed from all economic vocabulary and be replaced with “overshoot”. All we have is supply and demand in the markets and it is tied together by price. If you want to gauge the market’s performance, you should concentrait on prices.

If you base your investment decisions on Fed fund rates and money supply, you will loose.

If you base your decisions on market movements, you will loose.

Realize that no one is right all the time.

If someone takes one position and sticks with it all the time, they are idiots.

Never try to pick the top or bottom of a market. Pick targets for gains and losses.

What goes up fast, will fall faster. And on either side, the market will always overshoot.

Business cycles existed in the past and will exist in the future, with or without a Fed.

Having been a home builder for the last 25 years I have seen many downturns in my markets but I never have been stuck with spec inventory. The reason is simple, I paid attention to prices and reduced my activity when they rose to fast. Yes, I left money on the table because I cut back too soon but I was always in position to take advantage of the upswing. With construction and land cost low, if this is not the bottom, it is close and is a good time to get back in.

And Jon, if you really want to learn about markets, you should participate in them.

George F. Smith February 15, 2010 at 12:13 pm

Greenspan’s remarks on July 22, 1999, in his reply to Ron Paul, underscores Fama’s postmodernism:

“We cannot trace money supply to a speculative bubble. If a bubble, in fact, turns out to be the case, after the fact, we will have a considerable amount of evaluation of where it came from. But as I have said before this committee and, indeed, before the Congress on numerous occasions, we are uncertain as to the extent to which there is a bubble because, as I said in my prepared remarks, to presume there is a bubble of significant proportions at this particular stage and that the bubble isn’t significant doesn’t have any meaning; we have to be saying that we know far more than the millions of very sophisticated investors in the markets. And I have always been very reluctant to conclude that.”

Such humility about appraising the condition of the market – but such hubris when he runs the printing presses.

Six months later, on 2/17/2000, Greenspan told Paul:

“We very much believe that if you have a debased currency that you will have a debased economy.”

No argument there.

“The problem we have is not that money is unimportant, but how we define it. By definition, all prices are indeed the ratio of exchange of a good for money. And what we seek is what that is.”

So, the situation is, the people in charge of the money supply were conscientiously seeking what it was they were managing. While they were studiously investigating the nature of money, an invisible bubble came along and exploded. And a big Chicago school economist tells New Yorker readers he can’t see bubbles either, even while the monetary students at the Fed were adding trillions to M-3.


Eric February 15, 2010 at 2:32 pm

I agree that Fama does not come off well in the interview, but I don’t think Bob’s article does a good job discrediting EMH. Here’s why:

1) Bob (and others to be sure) differentiate between “fundamental” and “speculative” prices. I don’t see how this matters one bit. The price is the price is the price, who cares what is driving demand. Fundamentals may change over time, and the price will adjust according to the information that is available over time. Any spread between price and value doesn’t contradict EMH.

Quoting Bob:

In the grand scheme, I think Fama argues in a circle: in his view, investors can’t be blamed for pushing up housing and stock prices, since the market (a.k.a. investors) was pushing up housing and stock prices.

Buying drives up prices? Even without EMH’s whiz-bang math and academic praise this sounds like common sense. I don’t know if Fama is being as tautological as you describe him here, but this hardly seems like an arguable point.

2) Just because housing prices were higher than they have historically been (when compared to income, rental pricing, or whatever metric is used) does not mean it’s a delusion. Many Austrians and others rightfully predicted the housing market was inflated and would crash. But so what? Buying an asset that some say is “overpriced” and expecting it to net a profit is not necessarily irrational. Incidentally, if the people who rightly predicted the housing crash lobbed the I-told-you-so’s from the deck of their yacht bought with profits from shorting the housing market, they would have a more attentive audience, but I digress…

3) As for Fama’s awkward statement about predictability – I agree with much of David Janello’s comment, but with less emphasis on the trading details – I think Fama is just trying to quantify what a bubble is. Sure, many people in 2004 through 2006 thought housing was overpriced, but that doesn’t define what a bubble is. Mark Thorton’s compelling article aside, how is an asset bubble defined? Is it a a 5% increase over real historical prices when compared to metric #1, a 6.7% increase when compared to metric #2, or something else entirely? What I think Fama was getting at was that there currently isn’t a good way to model asset bubbles, so how does one predict future bubbles. He just didn’t explain it well (or wasn’t given the chance, or I’m just reading him wrong here).

4) I disagree with Fama that you can’t systematically beat the market without luck. Given that real-world markets are full of regulation, it’s very plausible to believe that people are capable of being one step ahead of either regulation itself or the unintended consequences. Even in hyper-efficient markets like high-volume options trading, there’s a lag in the market reacting to information. For that market it might be one second or minutes. The lag time for for the housing market was dramatically longer because of government intervention.

Walt D. February 15, 2010 at 5:08 pm

david janello wrote:
My challenge to Mr. Murphy, and all other opponents to the EMH is to define two things:

a) the approximate date that the housing bubble began, and

b) the approximate date that the housing bubble ended (if it has ended at all).
Using the archives of this site, Robert Murphy and Robert Blumen called this one way back when the Fed dropped interest rates in 2002 and 2003. The bubble effectively ended in September of 2008, around the time of the Bear Stearns collapse – large lenders such as Countrywide could not access the shadow banking system to fund new loans. There were several articles published on this site during this period warning that a bubble was forming. My favorite quote was from PIMCO’s Bill Gross to the effect - all bubbles are inflated one breath at a time by suckers blowing in unison!

Jonathan Finegold Catalán February 15, 2010 at 6:30 pm

The most accurate responses, within the Austrian capital theory framework, to those questions are:

1. When the last recession cleared and when credit expansion began.

2. When credit expansion slowed.

For empirical dates, credit expansion began when Greenspan dropped interest rates to inflate past the recession of 2001.

Bob Murphy February 15, 2010 at 8:37 pm

DJ said:

Fama is absolutely correct, and I can prove it beyond any doubt.

My challenge to Mr. Murphy, and all other opponents to the EMH is to define two things:

a) the approximate date that the housing bubble began, and

b) the approximate date that the housing bubble ended (if it has ended at all).

DJ did you just prove that the Renaissance and adolescence never happened, or human life for that matter? (Think of the abortion debate for the latter one if you don’t catch my drift.)

Just to clarify, I didn’t predict the housing bubble; Robert Blumen may have. Thornton and some others certainly did. I didn’t see this stuff until way late in the game, specifically July 2007 when I became an independent consultant and first used ABCT to look at the economy with fresh eyes.

Bob Murphy February 15, 2010 at 8:39 pm

Oops not sure what happened in the above post, but I didn’t italicize all of DJ’s question. I think you all can figure out where his question ends and my answer begins…

david janello February 15, 2010 at 10:43 pm

>> Just to clarify, I didn’t predict the housing bubble; Robert Blumen may have. Thornton and some others certainly did. I didn’t see this stuff until way late in the game, specifically July 2007 when I became an independent consultant and first used ABCT to look at the economy with fresh eyes.

Excellent! Now, once we identified that a bubble exists, we need to know the exact trades needed to OUTPERFORM the dummies in the market. This will prove once and for all that the markets are indeed inefficient and that the EMH is false.

Unfortunately Mr. Murphy was not around for the previous bubble, but he most certainly is around for the latest and greatest financial delusion : the Government Bubble. Unlike subprime housing, which provides something that at least some consumers want, the Government Bubble provides things like 170K transportation dept salaries to government apparachiks. Something that we all would all voluntarily chip in for out of our own pockets, right?

Does anyone argue that current administration policy is NOT a bubble? That the fat government paychecks, bailouts and ‘stimulus’ are NOT malinvestments?

Good! Let’s use today as a starting point to ‘outperform’ the inefficient markets using real trades.

So, what is the best way to exploit this bubble?

We can short US Treasury Bond futures with leverage and take a direct bet against Uncle Sam. All the folks who gave us the last debacle have not only been bailed out, but been promoted to government positions at the Fed and Treasury.

It is as close to betting against Enron management as is humanly possible short of paroling the Enron inmates and putting them in charge.

If you short the 30 year bond it will cost 4.5% a year to carry the position since short sellers have to pay out the bond coupons to the long holders of the bond. At 2x leverage this is about 9% a year. Retail investors can do this with the popular TBT 2x short bond ETF. Add another 1% for management fees for the ETF + another 1% to cover the futures roll and you are looking at 10-11% a year to cover the bet against Uncle Sam.

So if the current mismanagement takes 3 years to materialize, you need a 30-33% drop in the US30Y just to break even. This is not cheap. Because of the high cost most bond traders will tell you to wait, dont’ fight the Fed etc.

Personally, I believe that the short 30Y bond trade is a no-brainer and much safer than putting money in cash.

But, there are risks in this opinion. When Scott Brown got elected to the Senate Seat in Massachussetts bonds rallied and gold took a big hit.

If the Republicans win a supermajority of both Houses in November which is not impossible then Austrian friendly positions like long gold/short bonds/long oil/long timber etc will probably take a real beating.

The worst case scenario for an Austrian macro Fund manager is an Obama Impeachment/Ron Paul Presidential victory with a resurrection of the classical gold standard.

So let’s pick a start date of Feb 15 2010 for the Government Bubble, the managers are us, and the trades are whatever people submit.

Let’s keep tabs on the results. Not only do the positions have to outperform the overall market, we also have to compensate for less competent Austrian managers who enter the EMH competition at less opportune moments and give back some of the gains. Folks like the Hunt brothers who made huge bets in silver in 1980 only to go tapioca.

BTW I am still waiting for a citation of a successful Keynesian fund manager. These guys are rarer than Austrian economists in academia.

The Krugman Fund, anyone?

EIS February 16, 2010 at 1:32 am


Your experience in the housing industry does not make you an economist, as one must distinguish between entrepreneurship and the study of economics. As far as the validity of the EMH is concerned, the yield curve inverted in 2007, and yet the market did not correct itself. What else needs to be said? Can there be a more definitive refutation of this nonsensical doctrine?

newson February 16, 2010 at 2:43 am

to david janello:

keynes was a fairly successful fund-manager (for himself and his custodial funds). see skousen’ chapter

the emh would seem to be given the lie by the risk-adjusted returns of bershire hathaway and a small number of other long-term outperformers. odds of those sorts of superior risk-adjusted returns being explained by chance over such extended periods are extraordinarily low. still, nobody lives forever, so proof that it’s wrong isn’t going to be forthcoming.

the constant riskless arbitrage available in markets to me seems the most damning blow to the emh.

the bubble, or lack of it, has nothing to do with the emh, as least as far as i can see.

mushindo February 16, 2010 at 4:58 am

Im not completely dismissive of the EMH, nor do I buy it wholesale. IN the long run, irrationalities WILL get flushed out, be they based on erroneous information, erroneous theories informing buy/sell decisions, The problem of course, as one person whose name escapes me once remarked, is that markets can stay irrational longer than you can remain solvent.

EMH is one of those ideas that held more truth when it was first formulated than when it was widely disseminated . Ive aired this beofre somewher eon this forum, but at a technical level, the EMH is like a Zeno paradox: Market participants have to behave as if they believe it is not true, for it to be true. And if market participants behave as if it is true , it will be false.

lionel from france February 16, 2010 at 5:02 am

EHM is true and irrefutable because it is a tautology. In summary, EHM tells us if the information is perfect, then the markets are efficient. Unfortunately, people retain only the 2nd part of the sentence and forgets the first. EHM does not say that we can not beat the market but we can not beat the market if we all have the same level of information and the ability to interpret it at the same time which obviously is not completely possible.

Michał J. Górecki February 16, 2010 at 5:57 am

Eugene Fama is right in his analysis and the author seems not to understand the EMH. Austrian economics foremost teach us that notions as “fundamentals” and “speculative” does not make any sense. If we agree to introduce the notion of “bubble” the governement agencies will be free to manipulate any market which they perceive is “in bubble”.

Best explanation of the “bubble” problem I have read:

Allen Weingarten February 16, 2010 at 9:14 am

If I understand EMH, it denies the possibility of a Ponzi scheme. Yet such mechanisms provide the expectation of gain, not by performance, but by investments in the scheme. Doesn’t theory and historical evidence prove that this causes bubbles and their bursting?

lionel from france February 16, 2010 at 9:35 am

Take a two-column table. In the 1st, indicate whether you think the market will rise or fall in the month. In the second, indicate whether you were right or wrong. After 10 years, calculate your percentage of correct predictions. If you’re about 50%, then this means that the market is efficient (at least for you). Many people think they are talented because they have made a good prediction. Others think, in retrospect, the events were predictable because they are able to determine their causes after analysis. In addition, over millions of forecasters, there will always be those who have been right. This does not mean that their forecasts are always correct. Future is not certain (even for austrian economists!). In fact, most people have trouble with probability.

Ned Netterville February 16, 2010 at 9:48 am

Greg: “Business cycles existed in the past and will exist in the future, with or without a Fed.”

Regardless of its “independence,” so called, the Fed is the federal government. When Austrians decry the Fed’s manipulation of interest rates and blame the Fed for the consequences, not a single one of them fails to realize that with or without the Federal Reserve, if government has the power to mess with money it will mess with money; that it is this governmental interference in the market for money that is the problem causing business cycles, among other privative affects, regardless of what uniform government wears while doing its damage. Austrians blame the Fed because that is the costume this federal government currently wears when messing with our money. In a truly free market, including a free-market for money, the phenomenon of business cycles would be a thing of the past. One whose “market” experience has been preponderantly in housing, one of the least-free sectors of the American economy; a market essentially controlled by the Fed and other evocations of the government’s penchant for intervening, interfering, manipulating, subsidizing and otherwise controlling (viz., eliminating) people’s freedom, may find it hard to conceptualize what a truly free market would be like, but I think you’d grow to like it.

Byzantine February 16, 2010 at 9:34 pm

If markets are efficient in providing consumer goods, thereby driving down costs, then one would think they are efficient in the other direction as well, thereby driving down ROI.

Nick February 17, 2010 at 8:37 pm

I think that Fama was right on the issue of the recession pre-dating the financial crisis. Wasn’t it loan defaults and REAL economic weakness that unmasked the ridiculousness of the Wall Street MBS’s?

Scott February 18, 2010 at 3:06 pm

Paul McCulley of PIMCO is likely the most successful keynesian fund manager you will find today.

Lio April 13, 2011 at 11:17 am

FAMA is great and greater than many of his critics! Of course, he is not perfect. Everything he says is not true but more often true that what others write.

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