What is KJ's problem?

[aurvandil]

Maybe we are all busy making plans to profit from the collapse and buy property to retire in the south of France.

397 over posts and all who dont want to provide global stability. Why aren't you all protesting outside the Istana or IMF then?

 

[Thick Face Black Heart]

Wait. So you're saying that the EMH assumes that the current mkt price reflects the collective sum of all OPINIONS in the mkt, rather than all the FACTS.

That is not my understanding. My understanding is that EMH talks about all the available INFORMATION is priced into the security at any moment. I take this to mean the FACTS are priced in, even if there is no individual or subset of the mkt pariticipants who know ALL the facts.

Under the EMH, let us assume there is an inefficiency. This inefficiency is not widely known. As a result of this, there is a pricing anomaly in the market.

Over time, news of the inefficiency starts to spread. While it gets known to a large number of people, it is not immediately recognized or accepted as an inefficiency. As it goes against convention, there will be many who doubt its validity. There would however sufficient interest in the inefficiency to generate more research into whether the inefficiency is real or false.

 

[londontrader]

I kind of knew you would raise this which is why I started the para with the carefully chosen words "classic rejoinder". The "puzzles" and "anomolies" are indeed a problem. However as I mentioned in the post, the anti-EMH clan haven't been able to use it to kill the EMH because the fabled universal anomaly does not exisit.

Neither side has yet to provide a knock out punch.
That's why all those aspiring Phds are busy hammering out papers on the topic
May even be a Nobel Prize in it for the guys who do deliver the knock out punch
Unfortunately, EMH invokes very strong emotions amongst the financial crowd (their rice bowl at stake and all that) and the people who fancy themselves as financial experts (commentators)
That's why one has to carefully separate the intellectually honest arguments and that other crap that tries to pass off as intellectual.

My own thoughts on the matter are as follows, If you follow the latest information paradigm for the EMH, it works fine if the empirical evidence emerging is conclusive and the market comes round to understanding and accepting the inefficency. When that happens, we then have a violent market correction.

The problem has to do with "persistence" (in the statistical sense)
It doesn't sit well with the latest paradigm at all
My feeling is that there are market microstructure issues that we haven't got a handle on yet (the field is relatively young)
Also, you can't talk about coin tossing & those "runs" tests etc.. (that's why statisticians are largely out of this debate)
Their underlying assumption is iid but the econometricians have found persistence + serial correlation
I would venture a prediction that the answer lies in re-defining the EMH, like Granger & Timmermann (but going even further)

You mentioned before that the greatest thing which ends careers in the market is hubris. The EMH is useful because it keeps us humble. It tells us not to think too much of ourselves because whatever we can dream up, our peers can look at us and dream it up too. If we find what appears to be an anomaly, think about it very carefully before jumping in as it could be spurious. And if you make spectacular dollar profits, don't get cocky as it could be just blind luck.

That's why I (and many peers) find the EMH useful but only as a stylised model.
It's a model about information revelation and evolution and good traders understand that they are in the information market.

But an unquestioning acceptance of the EMH should be avoided too.
The 2007 global liquidity crisis demonstrated that a belief in the EMH had leant weight to the view that solvent institutions (defined in accordance with the Basel accords) can always borrow from the wholesale funding markets. Therefore, Central Banks were unprepared for the sudden collapse of liquidity on the short end of the market, even for very solvent institutions.

 

[londontrader]

397 over posts and all who dont want to provide global stability. Why aren't you all protesting outside the Istana or IMF then?

We are very supportive of global stability (even GMS who only quibbles about the amount spent)
WE JUST LIKE TO BE ASKED FIRST AS OPPOSED TO THE PAP DECIDING FOR US!

 

[londontrader]

Wait. So you're saying that the EMH assumes that the current mkt price reflects the collective sum of all OPINIONS in the mkt, rather than all the FACTS.

That is not my understanding. My understanding is that EMH talks about all the available INFORMATION is priced into the security at any moment. I take this to mean the FACTS are priced in, even if there is no individual or subset of the mkt pariticipants who know ALL the facts.

How about an adaptive EMH:

1. In the long run, market prices do reflect all available information.

2. However, some of the facts they reflect are not exogenous (externally given facts); they are the opinions of market participants. (Others are exogenous, but hard to observe)

3. These opinions take time to form and test; the key mechanism for testing them is to attempt to make or take a price, and observe whether people accept it. For example, when selling a house, a seller may set a price 5% higher than that achieved by a neighbour, in order to find out whether buyers are willing to pay.

4. These tests, in turn, influence the opinions of other observers - those opinions then also become facts which are relevant to the price.

5. The nature of such price-setting tests are that they rarely jump straight to the "correct" level; buyers and sellers are rarely willing to pay a price wildly out of line with the last price paid, and so the increments are more gradual than the EMH would imply.

6. Over time, therefore, prices will gradually move towards a stable level which reflects external information; but in the meantime there may be a free lunch, if you are better or braver at interpreting the external information than the market on average.

 

[Thick Face Black Heart]

In summary, what you're saying is that the mkt exhibits mean-reversion over the long run.

But that's something which most people already accept (and there's overwhelming statistical evidence to support that), and there's no need to invoke any EMH (weak, semi-strong, strong, etc).

How about an adaptive EMH:

1. In the long run, market prices do reflect all available information.

2. However, some of the facts they reflect are not exogenous (externally given facts); they are the opinions of market participants. (Others are exogenous, but hard to observe)

3. These opinions take time to form and test; the key mechanism for testing them is to attempt to make or take a price, and observe whether people accept it. For example, when selling a house, a seller may set a price 5% higher than that achieved by a neighbour, in order to find out whether buyers are willing to pay.

4. These tests, in turn, influence the opinions of other observers - those opinions then also become facts which are relevant to the price.

5. The nature of such price-setting tests are that they rarely jump straight to the "correct" level; buyers and sellers are rarely willing to pay a price wildly out of line with the last price paid, and so the increments are more gradual than the EMH would imply.

6. Over time, therefore, prices will gradually move towards a stable level which reflects external information; but in the meantime there may be a free lunch, if you are better or braver at interpreting the external information than the market on average.

 

[aurvandil]

The EMH does not have a robust destinction between FACTS and OPINIONS. Both tend to be used interchangably. The example raised by LT on solvent instituitions in the post later is a good example. Is it a fact or an opinion? Also, FACTS in the financial industry get revised all the time. A good example are the the various economic numbers which are revised as and when new data comes in.

Also there are lots of variants to the EMH. THe strong, semi-strong,weak EMH is one of the earlier variants. Still very much in use but not considered on the cutting edge on the modelling of the information flow. The EMH variants which are of interest to me are the ones where the information flow model attempts to model market crashes. Market crashes once used to be cited as empirical evidence as failure of the EMH. The newer thinking is that in fact violent market crashes validate the EMH as market acknowledgement/acceptance of a previously hidden inefficency.

Wait. So you're saying that the EMH assumes that the current mkt price reflects the collective sum of all OPINIONS in the mkt, rather than all the FACTS.

That is not my understanding. My understanding is that EMH talks about all the available INFORMATION is priced into the security at any moment. I take this to mean the FACTS are priced in, even if there is no individual or subset of the mkt pariticipants who know ALL the facts.

 

[aurvandil]

Neither side has yet to provide a knock out punch.

Fully agree. One of the most interesting and endearing debates.

The problem has to do with "persistence" (in the statistical sense)
It doesn't sit well with the latest paradigm at all
My feeling is that there are market microstructure issues that we haven't got a handle on yet (the field is relatively young)

Fully agree on the market microstructure problem. In the past (e.g. SIMEX pit days), the instruments were relatively few so this was pretty much a non issue. Today, the universe of financial instruments give rise to the possibility of inefficeny by obscurity.

Also, you can't talk about coin tossing & those "runs" tests etc.. (that's why statisticians are largely out of this debate)
Their underlying assumption is iid but the econometricians have found persistence + serial correlation

The coin tossing is useful because it is used to show that the results observed in the markets (eg. some traders winning all the time) can occur even if the process is IID. Real life markets are serially correlated and hetroskedestic. The problem is that the persistence is not stable. With the benefit of hindsight, you can formulate a time series model which fits the past data resonably well. However if you apply the parameters for actual use, you find that they shift quite a bit. The gives large prediction error which render the model relatively useless. Hence while there is persistence, this can only be seen and modelled accurately with the benefit hindsight. The inability to reliability model the persistence into the future makes for the statisticans case that while there is no IID, we have a situation which is pretty similar. Ergo the relevance of those coin tossing arguements.

As an example, remember those old "optimisation" programs to extract the "optimum" moving average period to generate buy and sell signals. Always worked great in the simulation but lose you money when you try to use the "optimised" moving average to trade.

But an unquestioning acceptance of the EMH should be avoided too.
The 2007 global liquidity crisis demonstrated that a belief in the EMH had leant weight to the view that solvent institutions (defined in accordance with the Basel accords) can always borrow from the wholesale funding markets. Therefore, Central Banks were unprepared for the sudden collapse of liquidity on the short end of the market, even for very solvent institutions.

As I mentioned before, for me the most interesting work done is those which modify the information paradaigm so that market crashes are part and parcel of the EMH. These ideas are not mainstream at the moment. To me, the empirical evidence to support revising this long held market belief about the EMH is overwhelming. If it ever becomes mainstream, it would lead to a huge shake up in ETFs and pension funds which use (abuse?) the EMH to sell their products.

 

[aurvandil]

How about an adaptive EMH:

This basically utilises an adaptive expectations model for the information flow. If it were true, we would have gradual changes in the financial market. With this information paradigm, violent market crashes would continue to be anomolies.

 

[londontrader]

This basically utilises an adaptive expectations model for the information flow. If it were true, we would have gradual changes in the financial market. With this information paradigm, violent market crashes would continue to be anomolies.

Sometimes and in some markets, we do see gradual changes and sometimes the markets gaps violently.
The takeaway is that models rooted in general equilibrium theory sit very uncomfortably with the empirical data.
My feeling (from years of being a participant and interactions with academics on both sides of the debate) is that financial markets fit specific models for specific periods of time. Why? Because financial markets are endogenous.

 

[londontrader]

Today, the universe of financial instruments give rise to the possibility of inefficeny by obscurity.

Not to forget inefficiency by COMPLEXITY
I'm always shocked by how little many market participants actually know about the stuff they trade/sell, beyond the fluffy catch phrases that they pick up from some MBA cram sheet.
There were ABS people who didn't know what a copula is!

The coin tossing is useful because it is used to show that the results observed in the markets (eg. some traders winning all the time) can occur even if the process is IID.

The problem is the presence of serial correlation in the traders' performance. This runs counter to the memory-less property of coin tossing.

Real life markets are serially correlated and hetroskedestic. The problem is that the persistence is not stable. With the benefit of hindsight, you can formulate a time series model which fits the past data resonably well. However if you apply the parameters for actual use, you find that they shift quite a bit. The gives large prediction error which render the model relatively useless. Hence while there is persistence, this can only be seen and modelled accurately with the benefit hindsight. The inability to reliability model the persistence into the future makes for the statisticans case that while there is no IID, we have a situation which is pretty similar. Ergo the relevance of those coin tossing arguements.

The problem is that for EMH to be true, there should be no persistence at all or it should vanish very quickly. The evidence for Momentum runs counter to this. Even if the persistence is not stable, there is no reason why a simple moving average model can produce excess returns (even with out of sample data ie. not backtested) enough of the time to trouble the staunchest EMH defender.

The coin tossing exercise works because you can write an algorithm in MATLAB and simulate the tosses ad nauseum, with the same results as a person actually tossing coins (fairly of course)
Now, the same can't said for financial data, which mkt participants have learnt thru bitter experience.
That's why the EMH defenders have largely abandoned the Random Walk Argument (but of course you know that the EMH doesn't need the RW)

As an example, remember those old "optimisation" programs to extract the "optimum" moving average period to generate buy and sell signals. Always worked great in the simulation but lose you money when you try to use the "optimised" moving average to trade.

You'll be surprised!
A simple MA actually works much too often, even out of sample
Why? Because markets trend, drift etc...
This momentum has troubled academics on both sides of the EMH debate for years
In fact, a lot of the fancy econometrics used by these hedge funds are founded on simple trend following!
You just need to plough through the fancy matrix algebra and piles of MATLAB code

As I mentioned before, for me the most interesting work done is those which modify the information paradaigm so that market crashes are part and parcel of the EMH. These ideas are not mainstream at the moment.

Yes, I find it interesting too
The EMH is now a general equilibrium model + Rational Bubbles, Bounded Rationality, Limits to Arbitrage etc....
But early days still
Also, understandable that this stuff is not mainstream. You need a higher than average comfort level with Mathematics & Statistics to read the papers.
This stuff is already too tough for most MBA types, who populate banks these days.

To me, the empirical evidence to support revising this long held market belief about the EMH is overwhelming. If it ever becomes mainstream, it would lead to a huge shake up in ETFs and pension funds which use (abuse?) the EMH to sell their products.

If you truly believe that, then you have an arbitrage opportunity now!

 

[londontrader]

In summary, what you're saying is that the mkt exhibits mean-reversion over the long run.
But that's something which most people already accept (and there's overwhelming statistical evidence to support that), and there's no need to invoke any EMH (weak, semi-strong, strong, etc).

Yes, mean reversion is observed empirically BUT it's not a stable observation (life would a lot easier if it was!)
It's also something that can be consistent with an EMH type argument
My eg. of an Adaptive EMH is to show how people try and modify the model to fit observed anomalies like:

"New information is not always immediately incorporated into stock prices"

 

[steffychun]

Anyone else writing letters to Christine Lagarde ore flying to Washington DC to protest? huh? Why only KJ doing the protest to stop funds? Why not write to Jim Kim to stop Singapore's funding of the World Bank?

 

[Thick Face Black Heart]

Yes, mean reversion is observed empirically BUT it's not a stable observation (life would a lot easier if it was!)
It's also something that can be consistent with an EMH type argument
My eg. of an Adaptive EMH is to show how people try and modify the model to fit observed anomalies like:

"New information is not always immediately incorporated into stock prices"

It seems to be, after all the twists and turns that the EMH has gone thru, that what we need is actually an IMH - Inefficient Markets Hypothesis!

I have always invested on the presumption that there will always be portions of markets that are inefficient on either short or intermediate time horizons.

Most of the financial managers I follow operate on the axiom that markets are inefficient and sometimes hugely inefficient. They have made good money over the decades.

Stock prices (and prices of financial instruments in general) are caused IMO by sentiment and money flow, rather than "information". Information that is the handmaiden of volatility, the real driver is capital flows which are based on a multitude of factors, many of which totally ignore the FACTS.

Should I be sent to Buangkok green for thinking like this???

 

[Goh Meng Seng]

Not Surprising at all, as I have said, G8 controlled IMF will side EU and loses its usual control measures.



IMF economist accuses Fund of suppressing information


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By Lesley Wroughton
WASHINGTON | Fri Jul 20, 2012 9:16pm EDT
(Reuters) - A veteran economist at the International Monetary Fund has resigned in protest at what he calls the IMF's failure to head off the global financial meltdown and euro zone crisis, and accused the global lender of suppressing information.
In a resignation letter dated June 18 to the IMF's board and senior staff, Peter Doyle said the IMF's failures to head off both the 2009 global financial crisis and the euro zone crisis was a "failing in the first order" and "are, if anything, becoming more deeply entrenched."

His letter, a copy of which was seen by Reuters, has brought to light simmering tensions within the IMF over the Fund's credibility, which many worry is threatened by its role in the euro zone crisis.

IMF insiders, who asked not to be identified, told Reuters there are concerns within the Fund that it has over-stretched by lending to Europe without exercising the same level of independent judgment it would normally apply in bailouts to emerging economies.

Doyle, a division chief for Sweden, Denmark and Israel in the IMF's European Department when he resigned, also accused the Fund's leadership of being "tainted" by a selection process which always ensures that a European is at the helm.

He said the IMF had been "playing catch-up and reactive roles in the last ditch efforts to save" the euro zone from the "brink." The IMF has participated in rescue loans to Greece, Ireland and Portugal.

Doyle, who has worked for the IMF for 20 years, said the appointments of the Fund's heads over the past decade "have all-too-evidently been disastrous."

"Even the current incumbent is tainted, as neither her gender, integrity, or elan can make up for the fundamental illegitimacy of the selection process," Doyle said of Christine Lagarde's appointment last year as first female head of the IMF.

To be fair, the IMF has acknowledged many of its failures cited by Doyle in reports in 2009 and again in 2011 that honed in on mistakes in spotting the roots of the global financial crisis and not issuing loud warnings about the impending meltdown.

"Peter's remarks are well documented in the public record, including reports issued by the Independent Evaluation Office, via the Triennial Review of Surveillance, and in many statements by the managing director, including on the findings in these various reports," IMF spokesman William Murray said.

"We have no evidence his views were suppressed, nor any views were suppressed," he added.

The sudden departures of the IMF's last two managing directors have shaken the IMF. These include the resignation of former Spanish finance minister Rodrigo Rato in 2007 halfway through his term.

Dominique Strauss-Kahn, the former French finance minister, quit last year after he was arrested in May 2011 for alleged criminal sexual assault and attempted rape of a hotel maid, which he denied and have since been dropped.

Strauss-Kahn's push for an IMF role in the euro zone, including approval of big bailouts for Greece and Ireland, and more flexible IMF conditions, caused tensions with some members of the IMF board. Despite their concerns, many acknowledged that the IMF's involvement was necessary to ensure stability of the global financial system.

Lagarde's appointment just over a year ago followed a hard-fought battle between Europe and emerging economies fed up with the tradition of the head of the IMF always being a European, while the top job at the World Bank going to an American.

"There is certainly a concern that the MD is more a politician than an economist and that she can be swayed by those close to her," one insider said. "But she is certainly seen as a powerful messenger for the Fund's position."

(Reporting By Lesley Wroughton; Editing by Richard Chang)

 

[londontrader]

Not Surprising at all, as I have said, G8 controlled IMF will side EU and loses its usual control measures.

Read Peter Doyle's actual resignation letter (and not your reuters version with the spicy commentary)

http://cnnibusiness.files.wordpress.com/2012/07/doyle.pdf

You will see that Peter's criticism of the IMF (I agree with all of it) is nothing new at all ie. refer to Joe Stiglitz etc...

IMF insiders, who asked not to be identified, told Reuters there are concerns within the Fund that it has over-stretched by lending to Europe without exercising the same level of independent judgment it would normally apply in bailouts to emerging economies.

As for the above piece of spicy commentary,

These "concerns" were also expressed explicitly by the USA (Major veto power over IMF decisions). Therefore, the control mechanism is working despite some perception of a European bias. Any reckless lending to save Europe will incur the considerable wrath of the USA and other key non-european members. That's how a cooperative actually works!

 

[londontrader]

It seems to be, after all the twists and turns that the EMH has gone thru, that what we need is actually an IMH - Inefficient Markets Hypothesis!

Some people (even economists) actually argue along those lines ie. that the market is inherently inefficient, unstable, prone to failures etc.

I have always invested on the presumption that there will always be portions of markets that are inefficient on either short or intermediate time horizons.

And the empirical data agrees with you

Most of the financial managers I follow operate on the axiom that markets are inefficient and sometimes hugely inefficient. They have made good money over the decades.

The classic EMH counter to that is "Luck" (which I don't subscribe to)

Stock prices (and prices of financial instruments in general) are caused IMO by sentiment and money flow, rather than "information". Information that is the handmaiden of volatility, the real driver is capital flows which are based on a multitude of factors, many of which totally ignore the FACTS.

Actually, all that you have mentioned is aggregated as "information"
One should also becareful making statements about causation ie. what drives what
Markets are endogenous and there exists an Identification problem ie. A drives B or A is simply correlated with B????

Should I be sent to Buangkok green for thinking like this???

If so, maybe I need to join you there

 

[londontrader]

Anyone else writing letters to Christine Lagarde ore flying to Washington DC to protest? huh? Why only KJ doing the protest to stop funds? Why not write to Jim Kim to stop Singapore's funding of the World Bank?

Why don't you write a letter to George Osborne, congratulating him on his govt's ability to pledge transnational aid without Parliamentary approval. (That's what you claim!)
Would love to read George's response!

 

[aurvandil]

Why? Because financial markets are endogenous.

For the benefits of non stats people following this thread, this is what endogenous means.

http://en.wikipedia.org/wiki/Endogeneity_(economics)

In a statistical model, a parameter or variable is said to be endogenous when there is a correlation between the parameter or variable and the error term. Endogeneity can arise as a result of measurement error, autoregression with autocorrelated errors, simultaneity, omitted variables, and sample selection errors. Broadly, a loop of causality between the independent and dependent variables of a model leads to endogeneity.

 

[aurvandil]

Not to forget inefficiency by COMPLEXITY
I'm always shocked by how little many market participants actually know about the stuff they trade/sell, beyond the fluffy catch phrases that they pick up from some MBA cram sheet.
There were ABS people who didn't know what a copula is!

Call me backward but I fail to see the point of many of the new products. IMHO, the plain vanilla futures on the major exchanges are more than sufficent to cover almost anything you could reasonably want to do.

The problem is the presence of serial correlation in the traders' performance. This runs counter to the memory-less property of coin tossing.

As mentioned before, markets are serially correlated. Trader's performance are a function of the markets. Hence no surprise in the serial correlation of trader's performance. The problem is future predicton. Because of instability, you cannot accurately model the serial correlation of markets. In the same way, you cannot accurately model the future performance of traders (whole room goes silent and traders make the sigh of the cross and angry hissing sounds !).

The problem is that for EMH to be true, there should be no persistence at all or it should vanish very quickly. The evidence for Momentum runs counter to this. Even if the persistence is not stable, there is no reason why a simple moving average model can produce excess returns (even with out of sample data ie. not backtested) enough of the time to trouble the staunchest EMH defender.

The coin tossing exercise works because you can write an algorithm in MATLAB and simulate the tosses ad nauseum, with the same results as a person actually tossing coins (fairly of course)
Now, the same can't said for financial data, which mkt participants have learnt thru bitter experience.
That's why the EMH defenders have largely abandoned the Random Walk Argument (but of course you know that the EMH doesn't need the RW)

Here's the thing ! True idd only occurs in nature. Modern stats is based on statistcial computing which in turn is based on random number generators and pseudo random numbers. There are occasional discussions on whether the data from markets is closer to being random than a random number generator because markets are a function of nature.

You'll be surprised!
A simple MA actually works much too often, even out of sample
Why? Because markets trend, drift etc...
This momentum has troubled academics on both sides of the EMH debate for years
In fact, a lot of the fancy econometrics used by these hedge funds are founded on simple trend following!
You just need to plough through the fancy matrix algebra and piles of MATLAB code

Yes ... shocking. I sometimes think all the math is to con lay investors. Afterall, who will buy funds and pay management fees if you told them that the main basis of the technique is something a 12 year old can do on Excel. I think MA continues to be a work horse because it is so crude and primitive. It therefore handles parameter instability much better than more advanced techniques.

On momentum and other trading anomolies, they don't bother me so much because they are part of the information paradigm I subscribe to. I view them as part and parcel of the EMH when the data is inconclusive.