Thursday, January 28, 2010

Do Not Burst Bubbles: The Alternative Universe To Compare Economic Results Does Not Exist

EMH [Efficient Market Hypothesis]does not say anything about fundamental values because fundamental values are an undefined term. Fundamental values seem relevant after the fact because we focus on the particular meaning that makes the price appear over valued.

For example, for stocks, there are many 'fundamental value' criteria. Is it price to earnings, price to dividends, price to sales, price to cash flow, price to free cash flow, Gordon dividend growth model (with what growth rate), discounted cash flow (what growth rate, what discount rate), price to EBIT, price to competitor ratios, breakup value, etc.

For options, you write, "Event studies such as these are not quite enough to address Hanson's concern, since they do not consider false alarms: situations in which the prices of options signaled an increase in volatility that did not eventually materialize."

You are saying if I call the fire department everyday, and if one of those days my house is on fire, I have a good strategy. [I should have said people who call for the Fed to burst bubbles instead of 'you'.] Using implied option volatility that does not lead to a bubble collapse means, the Fed will do the wrong thing many times in order to make sure it does the right thing in a bubble. That is like telling a surgeon to cut into everyone to remove his or her appendix to prevent appendicitis. How many unnecessary recessions and periods of high unemployment are you willing to endure to prevent one bubble?

EMH says several things, but two important ones are:

It says past prices and past gains are irrelevant for determining the future gains and prices tomorrow, next week, next year, etc.

It says public information, including past public information, in addition to price information does not give you any ability to generate a better return than anyone else can or to tell what the price will be in any future time period.

Hindsight is wonderful. It tells the quarterback (The Fed) what play (money supply, interest rate policy) he should not have done. It does not guarantee that a different action would succeed. Many say Fed's loose money policies caused the housing bubble. Do we know that a tight money policy at that time would stop the housing bubble?

Even if we can call a bubble as it is happening and the Fed acts and the bubble crashes, is the economy worse or better off than if the bubble crashes without Fed action? Without a bubble, could we put ourselves in a worse economy than we currently are? We do not know. No models or predictors of the bubble crash predicted the severity of this recession. Without the ability to predict this recession from a bubble burst, how do we know it would not have been worse without the bubble?

How do we know that any Fed action to reduce asset prices in a bubble (housing), will only affect that asset (housing) and not other assets not in a bubble. Could the remedy cause a deflationary spiral across many assets and be worse than the bubble?

What do we gain and lose by interfering with bubbles? If we had stopped the dotcom bubble, would we have never had companies such as Amazon and EBay, to name two, or Google years later?

The alternative universe for us to compare economic results does not exist. We will never know if the proposed cure works or does not, or if the economy is better or worse for bursting a bubble.

I posted the above as a comment on Rajiv Sethi:thoughts on economics, finance, crime and identity... Blog, "Identifying Bubbles."

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