Bubbles Aren't Bubbles - Or Are They?

I'm generally a fan of efficient market theorist Eugene Fama, but I have to confess his argument in a recent Minneapolis Fed interview that bubbles aren't bubbles leaves me cold.

Region: Some economists—you know them well—say that the stock market crash of 1929 and the more recent climb and decline of the market in the early 2000s suggest that “irrational exuberance” affects the stock market. How do you reconcile this alleged evidence of herding behavior and animal spirits with the notion of market efficiency?

Fama: Well, economists are arrogant people. And because they can’t explain something, it becomes irrational. The way I look at it, there were two crashes in the last century. One turned out to be too small. The ’29 crash was too small; the market went down subsequently. The ’87 crash turned out to be too big; the market went up afterwards. So you have two cases: One was an underreaction; the other was an overreaction. That’s exactly what you’d expect if the market’s efficient.

The word “bubble” drives me nuts. For example, people say “the Internet bubble.” Well, if you go back to that time, most people were saying the Internet was going to revolutionize business, so companies that had a leg up on the Internet were going to become very successful.

I did a calculation. Microsoft (MSFT) was an example of a corporation that came from the previous revolution, the computer revolution. It was hugely profitable and successful. How many Microsofts would it have taken to justify the whole set of Internet valuations? I think I estimated it to be something like 1.4.

Region: About one and a half Bill Gateses.

Fama: That’s right. And Microsoft was a good example because the worse their products were, the more money they made [laughter]. Who didn’t struggle with DOS and then the first versions of Windows?

[Emphasis mine]

Let me get this straight. The market is efficient because the stock market crashes you cite weren't perfectly efficient? Maybe I'm just slow today, but I feel like Fama has out-cuted himself here.

Comments

[MattBlackman]

The market efficiency hypothesis is a myth. Anyone who trades for a living understands it and makes money through the inefficiencies in markets.

So how does Fama explain the latest credit bubble, the housing bubble and the internet bubble on the late 1990s after which the Nasdaq dropped more than 80%? Were those markets too big too? What a load of crap. A theory the requires goldilocks conditions (one that's neither too big nor too small, but is just right...) is useless. How can a market only reach efficiency when it reaches a certain size then loss efficiency when it surpasses that threshold? Seems to me that Fama is best at deluding himself like many in his field.

[Ned Baker]

Fama has said this before. I think I read it in one of his papers at SSRN. If I remember correctly, his point was that although markets are mostly efficient, the pricing mechanism has some built in error, so that sometimes markets overreact and sometimes underreact, but that in the aggregate, they price correctly. I think he just uses 1929 and 1987 as examples of this statistical distribution.

[Paul E.Meisel]

Ned -- you are right, and "efficient markets" are only somewhat efficient. On average, overall, they always correct, but how wrong are they, for how long? Anyone who understands statistical thinking can allow for error... now we are just talking about how much, like that famous woman of negotiable virtue.

[MattBlackman]

Just reading the above comments. Total hogwash.

"sometimes markets overreact and sometimes underreact,"? The tech bubble lasted for the better part of four years and the housing bubble began forming in 2000. Bubbles form when emotion (greed) takes over and end when the reality comes home (no pun intended) to roost. The year 1987 was a short-term correction but the Great Depression began in 1929 and didn't really end till 1939 with the advent of WW II. The Dow dropped 90%. Are you trying to tell me that the drop of 90% was the market correcting the short-term price inefficiencies? So when markets rallied, that was a correction of the previous overreaction to the first price inefficiencies? Give me a break!

Markets are highly emotional. Always have been and until they are run by robots, always will be. Emotions are anything but efficient.

Fama's theory is a myth and he is self-delusional which this article highlights quite clearly. Ditto for the Random Walk myth.

But hey, keep living in your dream world. Keep investing as if stocks were priced to perfection which means that with the exception of brief periods of inefficiencies, should return to their theoretical price based on fundamentals. Meanwhile, savvy traders who realize the large human factor in markets will continue to eat your lunch in bull and bear markets.