tag:blogger.com,1999:blog-279146381231845671.post5700241741214382875..comments2023-08-16T04:32:23.376-07:00Comments on Bad Outcomes: The EMH Isn't Testable and That's OK - Part IRobert H.http://www.blogger.com/profile/09454933755396275755noreply@blogger.comBlogger7125tag:blogger.com,1999:blog-279146381231845671.post-30595002762240105682012-11-28T20:46:31.538-08:002012-11-28T20:46:31.538-08:00Here's me and Simon Grant on equity premium
h...Here's me and Simon Grant on equity premium<br /><br />http://papers.ssrn.com/sol3/papers.cfm?abstract_id=925964John Quigginhttps://www.blogger.com/profile/10830215234726229924noreply@blogger.comtag:blogger.com,1999:blog-279146381231845671.post-8859231597425236872012-11-28T19:41:59.482-08:002012-11-28T19:41:59.482-08:00P.S. Thanks for pointing out the error in editing ...P.S. Thanks for pointing out the error in editing (and miraculously reading through what I was trying to say).<br /><br />I've fixed it now to say:<br /><br />"This is obviously not true; for instance, I think I'll get a PhD, but I might not. I could flunk out. I'd love to buy insurance against that possibility, but I can't. Does that mean IBM’s stock isn’t fairly priced?"Charlie Clarkehttps://www.blogger.com/profile/02079017903923824877noreply@blogger.comtag:blogger.com,1999:blog-279146381231845671.post-72550860491503455282012-11-28T19:14:54.595-08:002012-11-28T19:14:54.595-08:00I should have said GE instead of RBC, since Mehra ...I should have said GE instead of RBC, since Mehra and Prescott (1985) formulate the approach with Lucas (1978) and not an RBC model.<br /><br />Here's the seminal pape:<br /><br />"Historically the average return on equity has far exceeded the average return on short-term virtually default-free debt. Over the ninety-year period 1889-1978 the average real annual yield on the Standard and Poor 500 Index was seven percent, while the average yield on short-term debt was less than one percent.The question addressed in this paper is whether this large differential in average yields can be accounted for by models that abstract from transactions costs, liquidity constraints and other frictions absent in the Arrow-Debreu set-up. Our finding is that it cannot be, at least not for the class of economies considered. Our conclusion is that most likely some equilibrium model with a friction will be the one that successfully accounts for the large average equity premium."<br /><br />Translated: we have this model we like and it makes predictions about the equity premium. Those predictions fail to match the historical equity premium. We need a better model, probably one with incomplete markets.<br /><br />They could have said, "our model must be right. People are overly pessimistic and don't invest enough in stocks. The EMH must be wrong."Charlie Clarkehttps://www.blogger.com/profile/02079017903923824877noreply@blogger.comtag:blogger.com,1999:blog-279146381231845671.post-21680360621507817382012-11-28T18:25:03.315-08:002012-11-28T18:25:03.315-08:00Hi John,
Thanks for your comment! This will sure...Hi John,<br /><br />Thanks for your comment! This will surely lead to a post.<br /><br />Respectfully, I disagree. The equity premium puzzle is a macro puzzle. It says the RBC model makes predictions about what the equity premium should be and these predictions don't match the historical premiums that have actually been observed. If markets are inefficient, there is no puzzle. Perhaps, its the market that's wrong. Who can say otherwise? This is the joint hypothesis problem.<br /><br />Here is Fama on the equity premium puzzle:<br /><br />http://www.dimensional.com/famafrench/2009/04/qa-equity-premium-puzzle.html<br /><br />"Has the equity premium puzzle gone away?<br /><br />EFF: There never was one. The "puzzle" comes out of a simplified economic model that says the average spread of the equity market return over the t-bill return has been too high, given the risk of equities. It is easy to show that this argument is silly. Thus, the returns from equity investing are quite risky. As a result, if the high average stock return of the past is the true long-term expected return, the high volatility of stock returns nevertheless means that getting a positive equity premium (of any size) is highly likely only for holding periods of 35 years (an investment lifetime) or more. Given this result, the historical equity premium does not seem too high.<br /><br />The simplified model that produces the equity premium puzzle, says that the premium (the difference between the expected returns on stocks and bills) should be about 1% per year (or even less). If the premium were this small, the required holding period to be relatively sure of getting a positive premium would be about 1600 years. Who would be willing to hold equity on these terms?"Charlie Clarkehttps://www.blogger.com/profile/02079017903923824877noreply@blogger.comtag:blogger.com,1999:blog-279146381231845671.post-77100625806472442982012-11-28T15:50:24.466-08:002012-11-28T15:50:24.466-08:00" I think I’d love to buy insurance against t..." I think I’d love to buy insurance against the possibility that I don’t [something missing here, I think, and I'll add for concreteness "keep my job"] Does that mean IBM’s stock isn’t fairly priced?"<br /><br />In this case, the answer is yes as long as equity returns are correlated with uninsurable employment risk. It doesn't mean that IBM is unfairly priced with respect to other similar stocks, but that the rate of return to equity is too high - this is the equity premium puzzle.<br /><br />John Quigginhttps://www.blogger.com/profile/10830215234726229924noreply@blogger.comtag:blogger.com,1999:blog-279146381231845671.post-47699522929633989342012-11-27T21:11:13.942-08:002012-11-27T21:11:13.942-08:00Thanks for the comment.
Definitely, check out the...Thanks for the comment.<br /><br />Definitely, check out the book. He's a smart guy, and it's a good critique. But alas, I always end up underwhelmed, when it comes to what should we do instead? He definitely doesn't try to offer a replacement or a solution, but he does address at the end of the chapter how we should move forward.<br /><br />He offers policy recommendations. They aren't so radical as no stock. Mostly classic, social democrat type stuff. He thinks ideas like the EMH implicitly have political statements, which is a premise I don't bye. But for example, he says the gov't should try to funnel money out of bubbles (ie. limit housing credit when prices are "too high").<br /><br />He offers some ideas for better theory. He likes behavioral finance. He wants more study on bubbles and the limits to arbitrage. He quotes Robert Shiller approvingly (who is well known for bubble research), so presumably more of that. <br /><br />Maybe it is too much to ask for a solution. I think he's trying to give his best guess for where the answers are.<br /><br />Charlie Clarkehttps://www.blogger.com/profile/02079017903923824877noreply@blogger.comtag:blogger.com,1999:blog-279146381231845671.post-22870509770106448852012-11-27T19:25:35.804-08:002012-11-27T19:25:35.804-08:00You make a good point with "How volatile shou...You make a good point with "How volatile should prices be?" Is there a better example of "how volatile prices are" than... how volatile prices ARE? Does he propose a replacement for the public ownership of corporations through stock? Is there, ostensibly, a better solution in his opinion?<br /><br />I really want to read this material now. Hope I have some extra time in the next few days.Ultramericanhttps://www.blogger.com/profile/00713401972357624190noreply@blogger.com