"Why the Efficient Market Hypothesis (Weak Version) Says Nothing about the Ability to Identify Bubbles"

I found this post by Peter Dorman interesting for a couple of reasons. First because it was, well, interesting -- it had something insightful to say about an important subject -- and second because it took a question that is normally framed in terms of arguing assumptions (are markets efficient?) and showed that the question had nothing to do with those assumptions.

Let’s put aside the possibility that even the weak EMH can be wrong from time to time. We don’t need to go there; the error is more basic than this.

Let’s put ourselves back in 2005. It is two years before the unraveling of the financial markets, but I don’t know this; all I know is what I can see in front of me, publicly available 2005 data. I can look at this and see that there is a housing bubble, that prices are rising far beyond historical experience or relative to rents. The “soft” warning signs are all around me, like the explosion of cheap credit, the popularity of credit terms predicated on ever-rising prices, and the talk of a new era in real estate. Based on my perceptions, I anticipate a collapse in this market. What can I do?

If I am an investor, I can short housing in some fashion. My problem is that I have no idea how long the bubble will go on, and if I take this position too soon I could lose a bundle. In fact, anyone who went short in 2005 and passed on the following two years are price frothery grossly underperformed relative to the market as a whole. Indeed, you might not have the liquidity to hold your position for two long years and could end up losing everything. Of course, it is also possible that the bubble could have burst a year or two early and your bets could have paid off. What the EMH tells us is that, as an investor, not even your prescient analysis of the fundamentals of the housing market would enable you to outperform more myopic investors or even a trading algorithm based on a random number generator.

The logical error lies in confusing the purposes of an investor with those of a policy analyst. Suppose I work for the Fed, and my goal is not to amass a personal stash but to formulate economic policies that will promote prosperity for the country as a whole. In that case, it doesn’t much matter whether the bubble bursts in 2006, 2007 or 2010. In fact, the longer the bubble goes on, the more damage will result from its deflation. At the policy level, the relevant question is whether trained analysts, assembling data and drawing on centuries of experience in financial manias, can outperform, say, tarot cards in identifying bubbles. The EMH does not defend tarot.

To profit from one’s knowledge of a market condition one needs to be able to outperform the mass of investors in predicting market turns, which the EMH says you can’t do. Good policy may have almost nothing to do with the timing of market turns, however.