Saturday, October 10, 2009

Blast from the past: drooling over the EMH

I wrote this on Monday, October 14, 2002, but it seems to have lost none of its topicality in these boom days in the zona. The ever renewed discovery that the Efficient Markets Hypothesis is a pile of theoretical dung that does not even serve to warm the huts of yakherders seems, this time around, to have even reached the Economist.

So let’s play a song that was a hit before your mother was born, though she was born a long long time ago…

"The journalist beat

For months, LI has been beating on a drum that is made out of the cyber-skin of James Glassman. The disintegration of the business press, which in the last week saw two more casualties -- Forbes ASAP and Upside -- has not prompted the kind of investigative fervor that is revved up by, say, the kidnapping of blond California tykes. Still, there's a lot to say about it, and we've been boringly, boringly on target about this issue. Well, in memes we trust -- Washington Monthly has an article about this topic by journalist Philip Longman. Longman begins in the self-critical mode, although it never reaches a properly Maoist depth. Here's a couple of grafs from the meat of the article:

"I was once proud of my profession and resentful of those who criticized it. For more than 20 years, I rode the great boom in business journalism that began in the early 1980s. I like to believe that at least some of my stories helped to enlighten readers and remedy wrongdoing. But today, I'm more likely to admit--at least on a bad day--that I spent my youth hustling Tyco shares to senior citizens.

Just as Americans put far too much faith in the integrity and intellectual prowess of stock analysts and other supposedly disinterested financial watchdogs during the boom, they also put far too much stock in business journalism, and have a right to be disappointed and angry. Like many of the industries we once covered, business journalists built their own bubble during the last decade. And now--as is appropriate for an industry that grew rich by dishing out so much bad advice and flabby reporting--business journalism is currently suffering the same financial fate as Wall Street and Silicon Valley. The Industry Standard --where reporters once took time off from chronicling the achievements of dot-com heroes to enjoy in-house massages and open-bar parties graced by belly dancers--is history, along with many other formerly high-riding business rags. And even the most venerable and established business publications are in trouble. The Wall Street Journal has suffered huge layoffs. Forbes, no longer profitable, is reducing staff and executive salaries, eliminating the 401(k) plan, and raising cash by auctioning off old man Forbes's various art collections. Business Week , which championed the "new economy" and in the late 1990s proclaimed an end to the business cycle, saw its advertising plunge from 6,000 pages in 2000 to 3,786 last year, and may finish 2002 with even fewer."

So far, so good. Alas, Longman, revving up for some fancy shooting, never takes a nice shot at a named target -- besides the obvious Cramer and Glassman. This is one way to cover your behind: criticize the bubble of biz journalism without naming the journalists. Worse, Longman apparently believes strongly in the Efficient markets theory. That this theory conflicts with the use of the term bubble, which he sensibly employs, doesn't seem to phase him:

"Few business journalists spend much time analyzing balance sheets. But even if they did, they wouldn't be of much help to folks trying to figure out how to invest their 401(k)s. This truth was forced on me when I set out to learn high finance (after years of writing about it) at Columbia Business School. Here I was, a 40-something guy on a fellowship for mid-career business journalists, surrounded by 20-something whiz kids who would shortly go off with their newly minted MBAs to dazzle Wall Street. And what was the first lesson our finance professor drove home? That even after spending two years and $60,000 at Columbia Business School, none of them would be able to outperform the markets except by sheer luck or inside information."

If Longman really believes his second sentence, than he can't really blame business journalists for the negligence alluded to in the first sentence. Oddly, he doesn't reflect on the contradiction. LI thinks that Longman is right, if he is floundering towards the proposition that business journalists should not think of their jobs as that of advising investors, as opposed to informing the public.

Still, the idea that an MBA won't be able to outperform the market over the long hall is, firstly, contradicted by some well known instances (among them Warren Buffett); and second, depends on breaking up the market into time segments, and elastic definitions of risk that are convenient to the EMH guys. In fact, Longman's discovery of this principal couldn't have been worse timed. During a down market, the pick and chose method of investment emerges as a competitive speculative tool in comparison with the idea of parking your money with a money fund and forgetting about it.

A good critique of EMH is this paper written by Andrew Smithers and Stephen Wright. The discrepency between bubble talk and EMH talk is revealed by what Smithers and Wright call the "extreme form" of EMH: that financial markets adjust immediately and perfectly to new information. Thus, the three hundred some point rise in the NYSE Friday represented a perfect adjustment of markets to new information. That information has to do with the fundamental prices of stocks. Well, although EMH detours around the problem of short term volatility, I buy Smithers and Wrights story about predictable regularities in the market that count against the premises of EMH. Smithers and Wright talk about one of them that we are getting acquainted with over the past two years: "...stock returns are negatively correlated to over the long term, so that periods of high stock returns are typically followed by periods of low returns." The EMH view, which has an ideological quotient that satisfies your average libertarian economist, is what the Longmans will always hear in their classes at Columbia. Joseph Stiglitz won the Nobel Prize, a couple of years ago, for showing that perfect efficiency would collapse the market. The market will always be incomplete, and the information distributed through it will always be assymetrical. Neither Stiglitz nor the experiments of behaviorial economists have made, or will make, a dent in the equilibrium model.

So, Longman should have thought a little bit before unsealing his astonishing revelations among the hotshot MBAs."

The Nobel Prizes have been funny this year, but the funniest is yet to come: the Nobel looks like it is going to be awarded to Gene Fama for the EMH this year. This will be a beautiful and invigorating sign of the complete uselessness of economics to any but the wealthy - as of course EMH predicted, with unerring certainty, that there was no housing bubble and that we live in the best of all possible worlds, except for pesky government regulation! Which, I can confidently predict, will be the burden of Fama's little song when he accepts the Nobel. Never have the cheesiest looked cheesier - but remember, the elite have concluded that this unfortunate chapter in the looting of the masses is now closed, and the NYSE is set to leap and bound upward, under the tender loving gaze of Larry Summers.

Zona prediction - this is complete and utter horseshit. Zona prediction two - the lucky ducky economists are about to come out from under the covers when Fama takes his little Faux Nobel. Highlights will include the always wrong and often repulsive Casy Mulligan of the NYT Economix. I'm expecting some wetting of the pants, yelps of joy, and explanations that the big unemployment figures are an illusion, caused by our lucky ducky but perennially lazy working class. This should be good.

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