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Posts Tagged ‘efficient capital markets’

Predicting the stock market: it’s normally too late

With worries about Greek exit from the eurozone, with the unlikelihood of further quantitative easing in the USA and the UK, with interest rates likely to rise in the medium term, and with Chinese growth predicted to be more moderate, many market analysts are forecasting that stock markets are likely to fall in the near future. Indeed, markets are already down over the past few weeks. Since late April/early May, the FTSE is down 4.5%; the German DAX index is down 7.0%; the French CAC40 index is down 6.9%; and the US Dow Jones index is down 2.3%. But does this give us an indication of what is likely to happen over the coming months?

If stock markets were perfectly efficient, then all possible information about the future will already have been taken into account and will all be reflected in current share prices. It would be impossible to ‘get ahead of the game’.

It is only if market participants have imperfect information and if you have better information than other people that you can are likely to predict correctly what will happen. Even then, the markets might be buffeted by random and hence unpredictable shocks.

Some people correctly predicted things in the past: such as crashes or booms. But in many cases, this was luck and their subsequent predictions have proved to be wrong. When financial advisers or newspaper columnists give advice, they are often wrong. If they were reliably right, then people would follow their advice and markets would rapidly adjust to their predictions.

If Greece were definitely to exit the euro, if interest rates were definitely to rise in the near future, if it became generally believed that stock markets were overvalued, then stock markets would probably fall. But these things may not happen. After all, people have been predicting a rise in interest rates from their ultra-low levels for many months – and it hasn’t happened yet, and may not happen for some time to come – but it may!

If you want to buy shares, you might just as well buy them at random – or randomly sell any you already have. As Tetlock says, quoted in the Nasdaq article:

“Even the most astute observers will fail to outperform random prediction generators – the functional equivalent of dart-throwing chimps.”

And yet, people do believe that they can predict what is going to happen to stock markets – if not precisely, then at least roughly. Are they deluded, or can looking calmly at likely political and economic events put them one step ahead of other people who perhaps behave more reactively and emotionally?

Bond rout spells disaster for stock markets as global credit kraken awakens The Telegraph, John Ficenec (14/6/15)
Comment: Many imponderables for markets The Scotsman, Bill Jamieson (14/6/15)
How Ignoring Stock Market Forecasts Will make you a better investor Forbes, Ky Trang Ho (6/6/15)
The Predictions Racket Nasdaq, AdviceIQ, Jason Lina (21/5/15)

Questions

  1. Why may a return of rising interest rates lead to a ‘meltdown in equity prices’? Why might it not?
  2. Why have bond yields fallen dramatically since 2008?
  3. Why are bond yields rising again now and what significance might this have (or have had) for equity markets?
  4. Why may following the crowd often lead to buying high and selling low?
  5. Is there an asymmetry between buying and selling behaviour in stock markets?
  6. Will ignoring stock market forecasts make people better investors?
  7. “The stock market prices suggest that investors believe both the Federal Reserve and the Bank of England are bluffing about raising interest rates. That may be so, but it is an extremely risky game of chicken for investors to play.” Explain and discuss.
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Getting out the crystal ball

The New Year is a time for reflection and prediction. What will the New Year bring? What does the longer-term future hold? Here are two articles from The Guardian that look into the future.

The first, by Larry Elliott, considers a number of scenarios and policy options. Although not totally doom laden, the article is not exactly cheery in its predictions. Perhaps ‘life will go on’ and the global economy will muddle through. But perhaps a new recession is around the corner or, even worse, the world is at a tipping point when things are fundamentally changing. Unless policy-makers are careful, clever and co-ordinated, perhaps a new dark age may be looming. But who knows?

Which brings us to the second article, by Gaby Hinsliff. This argues that people are pretty hopeless at predicting. “History is littered with supposed dead certs that didn’t happen – Greece leaving the euro, the premature collapse of the coalition – and wholly unimagined events that came to pass.” And economists and financial experts are little better.

Two years ago, The Observer challenged a panel of City investors to pick a portfolio of stocks and rated their performance against that of Orlando, a ginger cat who selected his portfolio by tossing a toy mouse at a sheet of paper. Inevitably, the cat triumphed.

But is this fair? If capital markets are relatively efficient, stock prices today already reflect knowable information about the future, but clearly not unknowable information.

It’s the same with economies. When information is already to hand, such as a pre-announced tax change, then its effects, ceteris paribus, can be estimated – at least roughly.

But it’s the ‘ceteris paribus‘ assumption that’s the problem. Other things are not equal. The world is constantly changing and there are all sorts of unpredictable events that will influence the outcomes of economic policy and of economic decisions more generally. And central to the problem are people’s attitudes and confidence. Mood can swing quite dramatically, from irrational exuberance to deep pessimism. And such mood changes – often triggered by some exogenous factor, such as an international dispute, an election or unexpected economic news – can rapidly gather momentum and have significant effects.

Predicting the long-term future is both easier and more difficult: easier, in that short-term cyclical effects are less relevant; more difficult in that changes that have not yet happened, such as technological changes or changes in working practices, may themselves be key determinants of the future global economy.

One of the most salutary lessons is to look at predictions made in the past about the world today and at just how wrong they have proved to be. Perhaps we need to call on Orlando more frequently.

Why ‘life will go on’ thesis about global economy might not pass muster in 2015 The Guardian, Larry Elliott (28/12/14)
Who knows what the new year holds? Certainly none of us The Guardian, Gaby Hinsliff (26/12/14)

Questions

  1. Give some examples of factors that could have a major influence on the global economy, but which are unpredictable.
  2. Is economic forecasting still worthwhile? Explain.
  3. Look at some macroeconomic forecasts made in the past about the world today. You might want to look at forecasts of agencies such as the IMF, the OECD, the World Bank and the European Commission. You can find links in the Economics Network’s Economic Data freely available online. Explain why such forecasts have differed from the actual outcome.
  4. Why, if capital markets were perfect, might Orlando be just as good as a top investment manager at predicting the future course of share prices?
  5. In what ways is economic forecasting similar to and different from weather forecasting in its methods, its use of data and its reliability?
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Is the time right for a Tobin tax?

On several occasions in the past on this site we’ve examined proposals for a Tobin tax: see, for example: A ‘Robin Hood’ tax (Feb 2010), Tobin or not Tobin: the tax proposal that keeps reappearing (Dec 2009) and A Tobin tax – to be or not to be? (Aug 2009). A Tobin tax is a tax on trading in financial products, sometimes known as a ‘financial transactions tax’ (FTT). It could also be levied on trading in foreign currencies. It is considered in Economics (7th ed) (section 26.3) and Economics for Business (5th ed) (section 32.4).

The tax would be levied at a very low rate: somewhere between 0.01% and 0.5% and would be too small to affect trading in shares or other financial products for purposes of long-term investment. It would, however, dampen speculative trades that take advantage of tiny potential gains from very short-term price movements. Such trades account for huge financial flows between financial institutions around the world and tend to make markets more volatile. The short-term dealers are known as high-frequency traders (HFTs) and their activities now account for the majority of trading on exchanges. Most of these trades are by computers programmed to seek out minute gains and respond in milliseconds. And whilst they add to short-term liquidity for much of the time, this liquidity can suddenly dry up if HFTs become pessimistic.

The President of the European Commission, José Manuel Barroso, has announced that the Commission has adopted the idea of a financial transactions tax with the backing of Germany, France and other eurozone countries. This Tobin tax could be in operation by 2014. According to the Commission, it could raise some €57bn a year. Unlike earlier proposals for a Tobin tax (sometimes called the ‘Robin Hood tax’), the money raised would probably be used to reduce EU deficits, rather than being given in aid to developing countries.

The UK government has been highly critical of the proposal, arguing that, unless adopted world-wide, it would divert trade away from the City of London.

The following articles consider how such a tax would work and its potential advantages and disadvantages.

Theory inches ever closer to practice Guardian, Larry Elliott (28/9/11)
Osborne expected to oppose EU’s proposal for Tobin tax on banks Guardian, Jill Treanor (28/9/11)
Tobin tax could ‘destroy’ business models Accountancy Age, Jaimie Kaffash (30/9/11)
Tobin tax is likely, says banking chief Accountancy Age, Jaimie Kaffash (5/10/11)
Could a transactions tax be good for capitalism? BBC News, Robert Peston (3/10/11)
EU to propose tax on financial transactions BusinessDay (South Africa), Mariam Isa (5/10/11)
European politicians plot to block UK veto on ‘Tobin tax’ The Telegraph, Louise Armitstead (3/10/11)
Opinion Divided on EU Transaction Tax Tax-News, Ulrika Lomas (5/10/11)
Tobin taxes and audit reform: the blizzard from Brussels The Economist (1/10/11)

Questions

  1. What are HFTs and what impact do they have on the stability and liquidity of markets?
  2. Explain how a Tobin tax would work.
  3. What would be the potential advantages and disadvantages of the Tobin tax as proposed by the European Commission (the ‘financial transactions tax’)?
  4. Are financial markets efficient? Can a market be ‘excessively efficient’?
  5. How are ‘execute or cancel’ orders used by HFTs?
  6. Why do HFTs have an asymmetric information advantage?
  7. How does a financial transactions tax differ from the UK’s stamp duty reserve tax?
  8. Explain why the design of the stamp duty tax has prevented the flight of capital and trading from London. Could a Tobin tax be designed in such a way?
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The brutal face of supply and demand

Stock markets have been plummeting. The FTSE 100 index was 6055 on 7 July 2011; by 10 August, it was 17% lower at 5007. Since then it has risen as high as 5418, but by 13 September was down to 5092. Other stock markets have fared worse. The French index fell 30% between early July and September 13, and the German DAX index fell 32% over the same period.

These falls in share prices reflect demand and supply. Investors are worried about the future of the eurozone and the health of the European economy as Greek default looks more and more likely and as the debts of various other European countries, such as Portugal, Ireland and Spain, seem increasingly unsustainable in an environment of sluggish economic growth. They are also worried about high public-sector debt in the USA and the likelihood that global recovery will peter out.

The ‘bear’ market (falling share prices) reflects increased selling of shares and a lack of demand. Not only are investors worried about the global economy, they are also speculating that share prices will fall further, thereby compounding the falls (at least until the ‘bottom’ is reached).

But why have share prices fallen quite so much? And does it matter to the general public that this is happening? The following articles seek to answer these questions.

Articles
Shares tumble on fears over Greek default Guardian, Graeme Wearden (12/9/11)
European Factors-Shares set for steep fall on Greece worries Reuters (12/9/11)
Markets set for turmoil after G-7 letdown BusinessDay (South Africa), Mariam Isa (12/9/11)
What will happen if Greece defaults? The Conversation (Australia), Sam Wylie (12/9/11)
Germany and Greece flirt with mutual assured destruction The Telegraph, Ambrose Evans-Pritchard (11/9/11)
Market Swings Are Becoming New Standard New York Times, Louise Story and Graham Bowley (11/9/11)
The next bull market The Bull (Australia) (12/9/11)
Prepare For Recession And Bear Market Forbes, Sy Harding (9/9/11)
Eurozone crisis: What market turmoil means for you BBC News, Kevin Peachey (8/9/11)

Stock market indices
FTSE 100: historical prices, 1984 to current day Yahoo Finance
Dow Jones Industrial Average: historical prices, 1928 to current day Yahoo Finance
Nikkei 225 (Japan): historical prices, 1984 to current day Yahoo Finance
DAX (Germany): historical prices, 1990 to current day Yahoo Finance
CAC 40 (France): historical prices, 1990 to current day Yahoo Finance
Hang Seng (Hong Kong): historical prices, 1986 to current day Yahoo Finance
SSE Composite (China: Shanghai): historical prices, 2000 to current day Yahoo Finance
BSE Sensex (India): historical prices, 1997 to current day Yahoo Finance
Stock markets BBC

Questions

  1. What factors have led to the recent falls in stock market prices? Explain just why these factors have contributed to the falls.
  2. What is likely to happen to stock market prices in the coming weeks? Why is it difficult to predict this?
  3. What is meant by the efficient capital markets hypothesis? If markets were perfectly efficient, why would it be impossible to predict future movements in stock market prices? Why may stock markets not be perfectly efficient?
  4. What factors determine stock market prices over the longer term?
  5. How are share prices influenced by speculation? Distinguish between stabilising and destabilising speculation.
  6. Explain the various ways in which members of the general public can be affected by share price falls. Are you affected in any way? Explain.
  7. If Greece defaults, what will determine the resulting effect on stock markets?
  8. To what extent does the stock market demonstrate the ‘brutal face of supply and demand’?
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Precious metals getting even more precious

In the past few weeks, the prices of gold and silver have been soaring and have hit all-time (nominal) highs. Over the past 12 months, gold has risen by 31%, while silver has risen by 149% and 64% since the start of February. Part of this reflects the general rise in commodity prices (see also). Oil is trading at around $125 per barrel, up 43% on a year ago; wheat is up 66%, maize by 114%, coffee (Arabica) by 118% and cotton by 122%.

Part of the reason for the rise in the price of precious metals, however, has been the weakness of the dollar. In such times, gold and silver are often seen as a ‘safe haven’ for investors.

So why have commodity prices been rising and why has the dollar been falling? What is likely to happen to the prices of gold and silver in the coming weeks and months? Is their meteoric rise set to continue? Will the ratio of the gold price to the silver price continue to fall? The following articles investigate.

Articles
Gold and silver prices jump to new record highs BBC News (25/4/11)
Gold rises 7% in April as US dollar continues to weaken BBC News (29/4/11)
Gold and silver set new highs after S&P move Financial Times, Jack Farchy (22/4/11)
Real Interest Rates Explain the Gold Price Perfectly…Too Perfectly? The Market Oracle, Andrew Butter (25/4/11)
Silver, platinum to outshine gold Toronto Sun, Sharon Singleton (25/4/11)
Gold Bugs Beware Of Fed Extermination Forbes blogs: Great Speculations, Mark Sunshine (25/4/11)
Shock and Au: Hedging Against Fear EconomyWatch, Alice Briggs (26/4/11)
Keeping an Eye on the Gold/Silver Ratio Seeking Alpha, Evariste Lefeuvre (25/4/11)

Data
Commodity Prices Index Mundi
Commodities Financial Times
Commodities BBC Market Data

Questions

  1. Why have the prices of gold and silver risen so much recently?
  2. Why has silver risen more than gold?
  3. Why may higher rates of world inflation make investors turn to precious metals for investment?
  4. How are future decisions by the Fed likely to affect the price of gold?
  5. According to the efficient capital markets theory (strong version), the current price of a commodity should already reflect all knowable factors that are likely to affect the price? Does this mean that speculative buying (or selling) is pointless?
  6. How is the price elasticity of supply of silver and gold relevant in explaining the magnitude of their price movements?
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Macroeconomics – Crisis or what?

Whilst some economists predicted the banking crisis of 2007/8 and the subsequent global recession, many did not. Was this a failure of macroeconomics, or at least of certain macroeconomic schools of thought, such as New Classical economics? Or was it a failure to apply the subject with sufficient wisdom? Should the subject be radically rethought, or can it simply be amended to take into account aspects of behavioural economics and a better understanding of systemic risk?

The four linked articles below from The Economist look at the debate and at the whole state of macroeconomics. The other articles pick up some of the issues.

Will the ‘crisis in macroeconomics’ lead to a stronger subject, more able to explain economies in crisis and not just when they are working well? Will a new consensus emerge or will economists remain divided, not only about the correct analysis of how economies work at a macro level, but also about how to tackle crises such as the present recession?

What went wrong with economics The Economist (16/7/09)
The other-worldly philosophers The Economist (16/7/09)
Efficiency and beyond The Economist (16/7/09)
In defence of the dismal science The Economist (6/8/09)
How to rebuild a shamed subject Financial Times (5/8/09)
What is the point of economists? Financial Times – Arena (28/7/09)
Macroeconomic Models Wall Street Pit (23/7/09)
Macroeconomics: Economics is in crisis – it is time for a profound revamp Business Day (27/7/09)

Questions

  1. Distinguish between ‘freshwater’, ‘saltwater’ and ‘brackish’ macroeconomics.
  2. Explain why economists differ over the efficacy of fiscal policy in times of recession. To what extent does the debate hinge on the size of the multiplier?
  3. Why is the potential for macroeconomics higher now than prior to the recession?
  4. What is meant by the ‘efficient market hypothesis’? How did inefficiencies in financial markets contribute to the banking crisis and recession?
  5. Should economists predict the future, or should they confine themselves to explaining the present and past?
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Gambling on the future

When anyone buys assets – shares, a house, a car or whatever – one important consideration is their likely future value. But the future is uncertain. Your decision to buy, therefore, depends not just on the direct return of the asset (the rate of interest or the pleasure from using the asset) but also on your predictions about the future value of the asset and your attitudes to risk. But with the future of markets so uncertain, or at least the timing of market movements, what’s the best thing to do? The article below considers some of the issues.

The irrelevant future Investors Chronicle (6/4/09)

Questions

  1. Distinguish between ‘risk’ and ‘uncertainty’.
  2. What is meant by a ‘bear’ in the context of investing in shares? Explain why ‘intelligent bears’ would ‘leave some money in the market’.
  3. Faced with uncertainty, why might sticking to a simple ‘do nothing’ rule be the best policy?
  4. If capital markets were efficient in the strongest sense, where everyone has perfect information about the future, would people be able to make large returns on investing in shares and other assets?
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An asymmetrical crisis?

The economist Joseph Stiglitz won the Nobel Prize for Economics in 2001. Along with George Akerlof and Michael Spence, he worked out a theory of information asymmetry: a situation where both parties in a transaction have different levels of information. Could this theory have some relevance as an explanation of the current financial crisis?

In praise of …..Joseph Stiglitz Guardian (8/10/08)
Stiglitz lecture on financial crisis available online University of Manchester (13/10/08)

Questions
1. Explain what is meant by information asymmetry.
2. Explain how information asymmetry can lead to markets working imperfectly.
3. Discuss the extent to which the theory of information asymmetry may be relevant as a partial determinant of the current financial crisis.
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