Wednesday, December 01, 2004

Bubbles and timescales

It seems to me that the persistence of a financial bubble is related to temporal limits on the arbitrage process. In the strong efficient market view (which I don't subscribe to), there are no bubbles because the price incorporates all available information (questionable, due to information asymmetries and bounded cognition) and arbitrage acts to eliminate any mispricing. However, even if all parties are smart and have equal information, it is not always possible to sustain a bet against a bubble long enough to collect.

During the tech bubble of a few years ago, many investors strongly believed that the market was mispriced (I was convinced by '99). But, it takes mucho cojones to sustain a bet against the market for several years - the best I was able to do is just stay away from techs during this period. An institutional investor is in an even worse position, as he or she may have performance-based compensation that effectively precludes trades taking more than a quarter or perhaps a year to reach fruition.

This conclusion is supported by a recent paper in the Journal of Finance, which shows that hedge funds were riding the tech bubble, not betting against it. Hedge funds are subject to redemptions by investors over quarterly (or at most yearly) timescales, and managers are compensated based on annual performance, so again really long-term bets are off the table. It seems to me that in the financial markets there are almost no actors capable of taking long term bets against a persistent bubble. (To be more precise, the fraction of total capital controlled by such actors is very small.)

The current housing bubble is an even more egregious example. Because real estate is not a very liquid investment - the typical family has to move and perhaps change jobs to adjust to mispricing - the timescale for popping a bubble is probably 5-10 years or more. Further, I am not aware of any instruments that let you short a real estate bubble in an efficient way.

Finally, one can consider the FX case. Everyone thinks the dollar will have to fall on a trade-weighted basis over the coming years. But one doesn't know when or how, due to possible intervention by central banks. Any individual hedge fund that leverages up and bets against the dollar is taking a big risk. We won't see large moves until a critical mass of capital is willing to take that risk.

The market can remain irrational longer than you can remain solvent!

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