inefficient markets and herd behavior

Discussion in 'Strategy Development' started by ssrrkk, Nov 14, 2011.

  1. ssrrkk


    You often hear that obvious "edges" in systems or setups disappear quickly because everyone exploits it. This is a corollary of the efficient market hypothesis. But I think there is a serious flaw in that hypothesis. The flaw is that economists assume there is the "correct" answer to the markets, a fundamental value that ties in supply and demand and macroeconomic and geopolitical factors. The economists argue that if only we were able to monitor all the factors that influence the markets and combine them into one great big equation, we will be able to predict the markets, and therefore we can spot deviations from theory and exploit it as soon as they appear. The problem is that a huge part of the markets is not based on fundamental facts. A few examples are: the earnings multiple that a stock trades on; the interest rate appropriate for a given perceived risk; the appropriate break-even time analysis for any investment, the appropriate or safe level of debt, the appropriate level of unemployment, the safe level of leverage, etc etc. Perhaps some might argue that the black-scholes for premium pricing is a great example of something that people didn't realize there was a fundamental rational answer for until it was discovered -- and many professionals might argue that such a solution is waiting to be uncovered for all the non-fundamental examples I listed. I would disagree. I think that all of those things I listed are based on collective sentiment governed by prevailing social norms, and any student of history knows that social norms can very tremendously throughout the ages. For example, just until recently, it was required to have a 20% down payment for the purchase of a home but of course, that requirement has been changing for better or for worse. Or you might argue that 5% unemployment is not necessarily the correct average given the progress in production efficiencies and correct distribution of wealth that promotes social stability while enabling incentives for growth.

    Given that background, I feel that there is a potentially related paradox in market behavior. That is to a certain extent, when the markets are in this high VIX high "uncertainty" mode, then in fact, it pays to have everyone act on a pattern and run with it. In other words, it pays to have everyone "exploit" a market pattern because it becomes a self-fulfilling prophecy. I think perhaps 90% of profits made through day-trading is based on this kind of setup rather than something based on exploiting a market inefficiency until the market goes back to its "correct" value. Of course, these facts are all obvious to any trader (e.g., pivots, previous day close high low, double tops, double bottoms, long term resistances, round number multiples of indexes, morning highs and lows, etc.) but the question I have is why not many academics care to admit this undeniable market behavior and also admit that a huge part of markets is based on unknowables -- i.e., the prevailing sentiment or fashion of the times or of fundamental irrational and repeatable human behavior.

    I suppose the answer is that they have admitted it in "behaviorial economics".