Wednesday, March 22, 2006

Validation of the “uber-modern” economists

Martin Wolf of the Financial Times writes today about "why a long-term bet on the stock market may disappoint", an article in which I find my recent post "the uber-modern economist" validated. Mr Wolf is an "uber-modern" economist.

Yesterday, I wrote about a possible over-dependence of old-school economists on fundamentals in a world where fundamentals are being punched left, right and centre with no reply. This is not to suggest that tried and tested economic heuristics should be ignored, but increasingly, I am wondering whether we [economists] are behaving a bit like historians in that we account very well for past events, and can sometimes come across as looking just into the past to tell us what the future holds, instead of looking at the past, today and utilising current knowledge to forecast the future based on our appreciation of the wiener process.
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Mr Wolf asks the question:

"…If the market has enjoyed a run of exceptional returns, do you conclude that the prospects are for continued good returns, for relatively bad returns, or for either equally?"…And he answers that the future is random.
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But, Mr Wolf states that in its strictest form, the Efficient Market Hypothesis would suggest that stock markets are random. I don’t wholly agree with the efficient market hypothesis on the basis that arbitrage has existed because investors and fund-managers have been able to take advantage of some less random occurrings in the market. Additionally, it has been proven that through purchasing certain investment vehicles, investors seem to beat the market when it’s moving down, up, or sideways. This would not be possible in a world where the efficient market hypothesis was 100% effective.

The rule of thumb that investing in stock markets is less risky in the long-term than the short-term is nullified by Professor John Campell of Harvard University’s finding that:

"…if market returns were draws from the same random distribution every year, though the probability of losing money falls with the length of the investment, this is offset by the increasing size of possible losses over long periods"…which Mr Wolf and I both agree with.

In his article, Mr Wolf basically looks beyond fundamentals in explaining why equity markets have been so strong. He talks of cheap money, globalisation (something that I mentioned in my article), aggressively expansionary monetary policy, and more. In my last post, I stated that:
"The uber-modern economist accepts that it is rational to be irrational, and with this understanding, can better anticipate consumer and investor behaviour."
Mr Wolf mirrors this by stating:
"It is as if markets are expecting both inflation and deflation. That is not as irrational as it may seem."

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