The bursting of two bubbles in less than a decade has effectively gutted the case for the efficient market hypothesis. Once a proud cornerstone of modern financial market theory, EMH posits that asset prices ultimately deviate little from their fair values, and taking on more risk is the only way for investors to “beat the market.”
The core article of faith for EMH is the conviction that market participants are rational, a view difficult to maintain after the dizzying cycle of wealth creation and destruction we have witnessed over the past ten years. Small compensation it may be, but the latest financial crisis also allows us to reconcile a couple of other paradoxes of received economic theory.
Twenty-five years ago, US economists Rajnish Mehra and Edward C. Prescott wrote one of the most influential academic articles in finance and economics, “The Equity Premium: A puzzle.” Reviewing the years 1889–1978, they observed that the yield on US equities as measured by the S&P 500 index outperformed that of US short-term debt by more than six percentage points per year. If investors were really rational agents, then this premium could only be reconciled by assuming an implausibly high level of risk aversion.
The equity premium puzzle initiated hundreds of research papers. Even today it resists a broadly-accepted answer. But the latest financial crisis suggests two explanations. First, given two major stock market corrections in a decade, the case for an equity premium has simply vanished. The second explanation can be derived from the massive losses of the latest market corrections. If, as behavioral economists assert, investors experience the pain of a loss much more than the joy of a similar gain, it is little wonder that they will demand a much bigger premium for a volatile investment than a rational approach would suggest.
Similarly, another paradox that found favor between 2002 and 2008, namely the carry trade, has recently regained some traction. As explained below by Tom Flury, our FX strategist, standard economic theory would have interest rate differences between two currencies match the appreciation of the low- versus the high-yielding currency. But the carry trade demonstrates the exact opposite: over longer periods, low-yielding currencies tend to decline against high-yielders, delivering a nice, supposedly risk-free, return for investors.
Again, the financial crisis offers an insight into this paradox. The size of the losses suffered by carry-traders during last autumn’s abrupt realignment of currencies dwarfed the gains they had enjoyed over the previous several years. A fitting verdict here can be found in a remark attributed to John Maynard Keynes: “The market can stay irrational longer than you can stay solvent.” But, as Milton Friedman noted: “There is no such thing as a free lunch.”
No comments:
Post a Comment