More circularity posing as profundity from Scott Sumner on the Efficient Markets Hypothesis (EMH):
The past five years should have been an absolute gold mine for the anti-EMH types that supposedly dominates the hedge fund industry. Just think about it. Shiller says stocks are way too volatile, and the US stock market has been incredibly volatile since 2007. No need to worry about the market staying irrational for too long, the long run adjustments occurred quite rapidly. Then we had the mother of all housing bubbles in 2006, another great opportunity for people to rake in profits from market inefficiency. The year 2008 should have seen extraordinary profits to the hedge fund industry, with all that “irrationality” being corrected. Instead they lost more than they’d made over the previous decade.
OK, so if I understand Scott’s argument, it runs something like this:
(1) Hedge funds tend to be dominated by people who don’t believe in the EMH.
(2) If hedge funds do poorly, it means the EMH is true.
(3) Hedge funds did poorly in the last five years.
(4) Therefore the EMH is true.
So if that’s right, then if we could find a period where hedge funds did very well–as in, they beat other sectors of the market–then that should be an argument against the EMH.
Well, we do have such a period, from 2000-2007 or so. I know about it, because Scott discussed it about 3 paragraphs earlier in that same blog post.
As I pointed out in one of my favorite articles, “Economists Can Be Hilarious,” the EMH is a tautology, it’s a way of viewing the world. When Wall Street is doing great, believers of the EMH will say, “See? You can’t beat the market. These hedge funds have physics PhDs and supercomputers running crazy algorithms that squeeze every last ounce of arbitrage out of mispricings. Don’t even try to compete with these boys, just put your money in a mutual fund.”
Then, when the market crashes and all the hedge funds blow up, the believers of the EMH say, “See? What’d we tell you? It’s really hard to beat the market, even these billionaires can’t do it. Just put your money in a mutual fund.”
Last point: I’m not even saying the EMH is a bad pair of binoculars to wear, or that Sumner’s worldview is bad. I’m saying, Sumner thinks he is being empirical, when in fact no matter what happens, he will see his “theory” passing with flying colors.
P.S. Gene Callahan has a good critique of Scott’s post too.