Wow, its already Friday. Ill feel that Ive short-changed you if we dont do some Finance Theory before I go.

Did you see this roundtable about the state of macroeconomics in The Economists Free Exchange. Fascinating stuff; in particular it became a bit of an odd defense of the Efficient Markets Hypthosis (EMH). A representative comment was made by William Easterly, in defense of EMH:

The most important part of the much-maligned Efficient Markets Hypothesis (EMH) is that nobody can systematically beat the stock market. Which implies nobody can predict a market crash, because if you could, then you would obviously beat the market. This applies also to other asset markets like housing prices.

This is not true, and I want us to walk through why it isnt. In March of 1997, Andrei Shleifer and Robert Vishny published a paper titled The Limits of Arbitrage (pdf) in the Journal of Finance. I think its the most important finance paper of the past 15 years, something everyone even remotely connected to financial markets should become familiar with. It builds on and summarizes a decade long research project, research they conducted with people such as Joseph Lakonishok and Brad Delong. In it they say that arbitrageurs, the very smart and talented traders at hedge funds who will take prices that are out of line and bring them back into line, making a good fee and making prices reflect all available information, the very building block necessary for EMH to work, cant do their job if they are time or credit constrained. Specifically, if they are highly leveraged, and prices move against their position before they return to their fundamental value if the market stays irrational longer than they can remain solvent theyll collapse before they can do their job.

And sure enough, a year later in 1998, Long Term Capital Management, very smart highly leveraged arbitrageurs, found themselves in a situation where prices moved away from them, and they had no capital with which to keep themselves afloat, just like Limits Of Arbitrage predicted. (This is the standard narrative in finance research seminars; it also appears this way, correctly, in Justin Foxs The Myth of the Rational Market. a very excellent book that gets these details correct.)

Theres an argument that says If the market is inefficient, why arent you rich? This gives us the framework to understand why markets could deviate from true value but there isnt a way to capitalize on bringing them back to true value sometimes there is risk inherent in arbitrage, and sometimes there are situations where it is difficult to get on the other side of a trade. And specifically, its risk that isnt compensated.

Heres an example of how this works. Lets say something is trading at $5. You are positive it is going to reach $10. Positive. It must. No chance it wont at some point in the future. So you buy it, telling your boss/manager/investors you are going to make $10-$5 = $5 for free. But the price goes to $2.50. What happens? You should buy a lot more. Now you are going to make $7.50! However your boss/manager/investor thinks you are insane and have lost them all kinds of money, as they now have half of what they gave you, and wants to pull your trading funds if you sell then, you lose money, and put downward pressure on the price. Also, depending on how you were leveraged, you may also be bankrupt. Thats how this works.

This gives us a guideline for figuring out how markets can get out of alignment with value if it is difficult to attract arbitrageurs, who are necessary to keep prices in alignment, we should expect the market to have prices that are more prone to manipulation and bubbles. What attracts arbitrageurs? The bond market it is easy to calculate the value of a bond, and easy to realize the value quickly. Foreign exchange markets its relatively easy for arbitrageurs to go after central banks attempts to maintain nonmarket exchange rates.

What doesnt attract arbitrageurs as easily? The stock market. The absolute and relative value of a stock is harder to estimate, and it may take a long period of time to realize your gain. (If you are comfortable with the terms, expected alpha doesnt increase in proportion to volatility if volatility includes fundamental risk read the paper, its excellent!) And though it isnt covered in the paper, housing.

Theres no real way to go short housing. You can go short the bank issuing mortgages, but if the bank has two internal businesses jumbo subprime loans and boring small business loans might it not be sensible for them to turn down the business loan division in response to the market shorting? You need to be able to exert price pressure directly onto the market itself the more intermediaries, the more likely it is your signal is converted into noise. Theres talk about how in the future well all trade derivatives contracts on each others neighborhoods; depending on how thats implemented, it would be something to say I want to go short Detroit and Peoria in my portfolio. Is there moral hazard to drive down those prices then? And life would be more interesting if the investment firm of My Ex-Girlfriends LLC could take out a derivative insurance contract that pays out to them if my house burns down over the next year. Thankfully that market is still some time away, if it ever gets here, so we can iron out the difficulties.

Theres a lot more research to be done here, but contrary to popular belief we do have an intellectual framework to know how markets can get out of whack, one that takes the EMH are brings it to a reality where we face actual constraints over scarce resources such as time and capital.