OK, bro, cool story. (#971046).
Also congrats, @Undisciplined, you and @byzantine resurrected the MONEY CLASS series
Markets are not efficient, but they are effective. They are effective at finding the current price. -post #971046
These are meaningless statements, but in elaborating how they are meaningless we can learn A LOT about finance, financial markets, theory, and economics. So let's go.
Eugene Fama (#875931), the father of/most influential name associated with the ideas the world has condensed into "efficient market hypothesis," starts his assessments with a very simple and extremely powerful observation that, if I had any influence, I would hammer into the epistemological being of every economist (or person, really): the joint-hypothesis problem. fr Wikipedia:
“Any attempts to test for market (in)efficiency must involve asset pricing models so that there are expected returns to compare to real returns.”
Bro, if you say a price is wrong you are saying two things, not one.
so, to even make the statement that something is overvalued or undervalued you’re implicitly testing two things. First, you’re “testing” for market efficiency; and second, you’re testing the asset pricing model you’re comparing against.
(not particularly sophisticated since you’re just verbally saying so, but still).
This is how I’ve put it in print before ("The Bubble That Never Was: Finance's Definition Problem"):
In a theoretical sense it’s a banal question: if the price of an asset is trading much higher than what it’s actually worth, it’s a bubble; if not, then it isn’t.
But who says? It’s not like we can rock up to the Chicago trading pits or the New York Stock Exchange and just observe an “actual” value next to the price, and quickly calculate a bubble ratio. There’s nobody around to, credibly and reliably, tell us what its real value is. When somebody inevitably does say what an asset is really worth, why would their opinion, unbacked by money (or biased by talking their own book), be more accurate than the sum total of the market that actually trades the asset?”
What the joint-hypothesis problem teaches us is that in your very words of saying “the market is not efficient because asset x is mispriced” you are making two tests, and outcomes can falsify/undermine either market efficiency or your asset pricing model. (=indeterminate.)
Simply put: the market could be inefficient, or your model could be incorrect.
What you’re doing when you’re approaching the world like that is to “disregard market prices as ephemeral fluff; they’re as arbitrary as other fads and can thus occasionally go mad.”
The hubris there, once you dig down into it, is Hayek’s The Fatal Conceit, the lack of humility on the part of those who think they know better than the sum total of market participants (i.e., "prices").
Like I said in the comment: we don't know that the price is "way too high" -- that is, to invoke that wonderful The Big Short scene in Michael Burry's hedge fund, what "makes it a bubble."
Regardless, we can only establish bubble-ness in hindsight. (and barely even that...)
efficient, in the efficient-market hypothesis framework here means something like "the globally, best guess, of current/publically available information about the future." = point being: there's no model/idea/conviction/belief that provides an improved pricing compared to it.
Guesses can be wrong, of course. But that's beside the point.
“The kindest thing I can say about those confidently throwing around the b-word at everything they dislike or don’t understand is that their judgments are premature.”
That's today's little money lesson.
Peace,
/J