Wednesday, May 14, 2014

"Does trend-chasing explain financial markets?"

Noah Smith at The Week:
Two researchers take an extremely simple (and effective!) approach to answering this question 
"How can you know, how can you know/ Which is which, who's doin' what?/ I guess that you can ask 'em"
- Dan Bern, "Tiger Woods"

A lot of interesting unexplained phenomena in finance are related. Bubbles. Long-run reversion. Excess volatility. "Overreaction." All of these have to do with the general thing known as long-run stock return predictability. In other words, it really is possible to know when stocks are "cheap" or "expensive." This is one of the insights for which Robert Shiller won the Economics Nobel this year.

But why do stock prices mean-revert in the long run? This is the subject of an ongoing controversy perhaps the most important controversy in finance. Some people say that it's because of time-varying risk premia with Rational Expectations; others say that it's because of people's incorrect information processing, and expectations are non-rational. In other words, it could be because what people want is kind of funky, or because how people think is messed up. But without some kind of independent measurement of either A) people's desires, or B) people's expectations, we'll never really resolve the controversy.

So that's why this 2012 paper by Andrei Shleifer and Robin Greenwood is so interesting. They take an extremely simple approach toward measuring people expectations: Just ask people what they think is going to happen! Actually, what they do is to take data from six different surveys of the stock market expectations of individual investors. For those who don't know, this is a pretty maverick thing to do; financial economists traditionally have not trusted survey data to reveal investors' true expectations.

So the first and most obvious question is: Do these "survey expectations" represent people's real beliefs?" The authors answer this in two ways. They first check that the six survey measures are correlated with each other; in fact, they are strongly correlated.

Second, and more importantly, they check that survey expectations are consistent with investors' actions. In fact, they are strongly consistent. Here's a graph displaying reported expectations (according to one of the surveys) alongside the amount of money flowing into equity mutual funds:


As you can see, when people say they expect stocks to do well, they actually put money into stocks....MORE