In the age of information, quotes become books and books religion, almost. Robert Shiller’s Irrational Exuberance was a voice of caution that appeared in March 2000, before the start of a decade-long sequence of negative fluctuations. The book itself was written about economic bubbles and investor psychology.
Shiller based his work on his 1981 research paper in the American Economic Review, where he had shown the divergence between fundamentals and market prices. He took the present value (PV) of dividends paid on the S&P composite stock price index, discounted by a constant real discount rate for the period (1871-2002). He illustrated that the PV behaved remarkably like a stable trend. In contrast, the stock price index gyrated wildly up and down around this trend. Shiller’s contention was that the divergence was much larger than what valuation could explain. Price change was driven by psychology, not by fundamentals. He suggested feedback dynamics between human interactions as the explanation for excessive volatility or bubbles.
Who owns the truth?
On the one hand, Shiller and other new-age experts highlighted the weakness in the assumption of efficiency; but, on the other hand, was it correct to swing to total irrationality (inefficiency)? Why could we not give the benefit of doubt to earlier thoughts on rationality (normality)? After all, there were no terabytes of data and real computing power. In the hindsight, the rationalist argument might have gaps, but how do we think tomorrow would judge the irrationalists?
A recent award-winning paper by David N Esch in the Journal of Investment Management addresses the non-normality facts and fallacies. The author reinitiates the century-old debate by suggesting that normal efficient models can’t be simply rejected i.e. market rationality can’t be just junked.
Could the reality of markets lie between rationality and irrationality, between efficiency and inefficiency? Could randomness have an order? Could the efficient and inefficient be connected? The overwhelming commonality between sciences and economics is getting so discomforting for some that we have published papers titled ‘Warning: Physics envy may be hazardous to your health’.
Why are the economists worried? The whole idea of a ‘Big Bang’ was thought to be random. The singularity was unexplained. Human life was thought to be a rare accident. Scientists failed to explain why low entropy could co-exist in a high-entropy environment, like human life (a lot of order) in an otherwise expanding universe (high entropy). In other words, how can order exist in a world that is meant to be disordered?
Boltzmann brain (after Austrian physicist Ludwig Boltzmann) was hypothesised as a self-aware entity that arose due to random fluctuations out of a state of chaos. Boltzmann advanced an idea that the known universe (order) arose as a random fluctuation. Sean Carroll re-tweaked Boltzmann’s working and explained that though fluctuations could explain the reason for life, living in a fluctuation (an extreme rare event) was not enough to explain the visible order. There was too much order in randomness. The random event of a perfect preciseness of the distance of the moon to the earth, a rare combination of the cold earth planet and a burning Sun star was not rare. The fact that we are close to finding more habitable planets like the earth challenges the theory that life is a rare fluctuation.
The temporal fluctuation
Fluctuations are present all over the place, be it the universe, stock markets or Google search data. A performance divergence plot from Shiller’s exuberance can be juxtaposed with a divergence in scientific or social data. It was not just stock market data that was fluctuating; every other organic data set was fluctuating, frequently. We tested a host of data sets for stationarity (a statistical test for mean reversion) and found confirming results. The fluctuating outliers were reverting temporally, suggesting Shiller’s hypothesis of fluctuation owing to social mood could be incorrect. Inefficiency could be linked with time rather than chaos or psychology.
Killing the outlier
If society would have a choice, it would eliminate the business cycle and create everlasting prosperity. This is strange, because, on the one hand, we talk about fluctuating inefficient markets; and, on the other, we seek societal efficiency (peace) and a world free of poverty. On the one side we want to kill the outlier, while on the other we cannot live without it. We are shadow fighting, as we have limited knowledge, which oscillates between efficient solutions till we hit a fluctuation. This is why most of Shiller’s solutions to address market fluctuations are wishful and utopian. The exuberance, as it turns out, is temporally rational.
The author is CMT, and co-founder, Orpheus Capitals,, a global alternative research firm