Trading Strategies and Market Efficiency

Here is David Merkel's tenth rule:

The more entities manage for total return, the more unstable the financial system becomes.

The shorter the performance horizon, the more volatile the market becomes, and the more index-like managers become. This is not a contradiction, because volatile markets initially force out those would bring stability, until things are dramatically out of whack...

Momentum persists in the short run, so play it if you must, remembering that the market gets more volatile when many play momentum.

This is an important point with some very interesting implications for market efficiency and volatility clustering.

In a well functioning market, asset prices are supposed to reflect the best available information about anticipated earnings flows and the risk-sensitive rates at which these should be capitalized. But the only way in which such information can come to be reflected in prices is through the trading activity of those who are alert to changes in information. A market dominated by such "information traders" will tend to be stable in the sense that prices will reliably track changes in information about underlying asset values.

Such adjustments may be rapid but they are never instantaneous. This means that in a market that is functioning well, price movements (and other market data) can reveal some information about changes in underlying values to those who have not incurred the resource costs of acquiring the information directly. This, in turn, can make technical analysis profitable.

On the other hand, in a market dominated by technical analysis, changes in prices and other market data will be less reliable indicators of changes in information regarding underlying asset values. The possibility then arises of market instability, as individuals respond to price changes as if they were informative when in fact they arise from mutually amplifying responses to noise.

But if market stability depends on the composition of trading strategies, what determines this composition itself? A key determinant is past performance: strategies that have recently given rise to strong returns will come to represent a greater share of total trading volume both because wealth has been transferred to those executing such strategies, and because they will attract new funds. In stable markets with informative price movements, the incidence of technical analysis will grow. If it grows too much, the market will be destabilized and an asset price bubble could form. Information based strategies will initially suffer from this, but those with the confidence and liquidity to persist in using them will prosper eventually once the inevitable correction arrives.

In other words, one ought not to expect markets to be efficient or inefficient, but rather to experience periods of relative efficiency that are interrupted from time to time by severe disruptions. This is a phenomenon I described in a 1996 paper as endogenous regime switching:

Behavior conducive to stability... may be most profitable when the market is unstable, and behavior conducive to instability... may be rather lucrative in a stable market when it is costly to collect information about fundamentals. There is a sense in which the two groups of speculators enjoy a symbiotic relationship with each other: each group benefits from an increase in the numbers of the other.... As a result, one would expect heterogeneity of practices to persist in the long run, with the dominance of one set of practices giving way to that of the other. The implication for speculative markets is that periods of tranquility are likely to be punctuated from time to time by periods of excessive volatility.

This paper builds on work by Beja and Goldman and Carl Chiarella, who had earlier examined the price implications of heterogeneous trading strategies without allowing for endogenous changes in population composition. The model itself is simple and stylized, but I believe that the basic idea underlying it is sound. Destabilizing strategies will prosper and spread when they are sufficiently rare, giving rise at some point to market instability, and the eventual return of stabilizing strategies. Neither perfect efficiency nor drastic inefficiency can last indefinitely, as each regime gives rise to changes in behavior that serve to undermine its own existence.

Some Further Comments on the Leverage Cycle

In a previous post I discussed a paper by John Geanakoplos on the Leverage Cycle (due to appear in the NBER Macroeconomics Annual later this year). I presented this paper in the Columbia finance reading group last Thursday, and have posted my slides in case anyone is interested in taking a look.  

The paper is considerably more accessible to the general reader than most of the recent theoretical literature on the financial crisis. It avoids the standard theorem-and-proof format, and consists instead of a sequence of elaborate numerical examples that fit together like a jigsaw puzzle. It also contains a number of very interesting ideas and insights, many more than I was able to discuss in my earlier post. 

One of the key features of the Geanakoplos model is that the same set of physical assets can serve as collateral multiple times for loans of different maturities. For example, housing serves as collateral for long-term loans in the mortgage market, while the loans themselves (after securitization and tranching) can serve as collateral for short-term borrowing in the repo market. Geanakoplos shows that the extent of leverage in the long-term market will endogenously be such as to allow for a positive probability of default, and is interested in the effects of bad news in this market (interpreted as an increased likelihood of eventual default) on the market for short-term loans backed by financial rather than physical assets.

Among the main insights in the paper is the following: a decline in the expected terminal value of the physical assets will result in a far greater decline in the prices of the financial assets that they back. This happens for three reasons. Most obviously, there is a decline in fundamentals. But the effects of this are amplified because the initial prices (before bad news arrives) reflect the beliefs of the most optimistic market participants, who borrow from the pessimists in order to buy their asset holdings. In other words, the marginal buyer is (endogenously) very optimistic and this is reflected in the market price. The decline in fundamentals not only wipes out these highly leveraged optimists, but also substantially reduces equilibrium leverage in the market. As a result, the decline in the financial asset price is far greater than any market participant's expectations concerning the terminal value of the physical asset.

The careful reader will note that incomplete markets and maturity mismatch play a critical role in this argument. One of the most interesting aspects of the model is that both market incompleteness and maturity transformation arise endogenously, and the asset prices at various points in the tree of uncertainty are all correctly anticipated. The results are driven not by irrational exuberance or systematic biases, but by heterogeneous preferences and beliefs, and changes over time in equilibrium leverage. It's a precise, rigorous and carefully constructed interpretation of recent events, based on work that was done well before this crisis erupted.

In response to my earlier post on this paper, David at Deus Ex Macchiato agreed that the work is important, but added:

What astonishes me however is that this is in any way news to the economics community. Ever since Galbraith’s account of the importance of leverage in the ‘29 crash, haven’t we known that leverage determines asset prices, and that the bubble/crash cycle is characterised by slowly rising leverage and asset prices followed by a sudden reverse in both?

This is a good question. A lot of the less formal work in this area never made it into the canonical models taught to successive cohorts of graduate students in economics. Geanakoplos doesn't mention Galbraith explicitly, but he does mention Minsky and Tobin, who themselves were surely familiar with Galbraith's work on the crash. Implicit in David's question is the accusation that the training of professional economists has become too narrow, and on this point I believe that he is absolutely correct.

Claiming Ancestors

Here is Ta-Nehisi Coates on the subject of cultural ancestry, at the end of an expansive post on slavery, the Civil War, and Robert E. Lee:

Finally, there's the question of how we claim ancestors, a question that is more philosophical than biological. Africa, and African-America, means something to me because I claim it as such--but I claim much more. I claim Fitzgerald, whatever he thought of me, because I see myself in Gatsby. I claim Steinbeck because, whether he likes it or not, I am an Okie. I claim Blake because "London" feels like the hood to me.

And I claim them right alongside Lucille Clifton, James Baldwin and Ralph Wiley, who had it so right when he parried Saul Bellow. The dead, and the work they leave---the good and bad--is the work of humanity and thus says something of us all. And in that manner, I must be humble and claim some of Lee, Jackson, and Forrest. What might I have been in another skin, in another country, in another time?

It is not often that one encounters such willingness to recognize and lay claim to one's cultural ancestors in defiance of contemporary racial boundaries. But in America, of all places, the scope for such appropriation is enormous. Ralph Ellison explained the reasons for this with crystal clarity in a remarkable essay published forty years ago:

For one thing, the American nation is in a sense the product of the American language, a colloquial speech that began emerging long before the British colonials and Africans were transformed into Americans. It is a language that evolved from the king's English but, basing itself upon the realities of the American land and colonial institutions—or lack of institutions, began quite early as a vernacular revolt against the signs, symbols, manners and authority of the mother country. It is a language that began by merging the sounds of many tongues, brought together in the struggle of diverse regions. And whether it is admitted or not, much of the sound of that language is derived from the timbre of the African voice and the listening habits of the African ear...

Its flexibility, its musicality, its rhythms, freewheeling diction and metaphors... were absorbed by the creators of our great 19th century literature even when the majority of blacks were still enslaved. Mark Twain celebrated it in the prose of Huckleberry Finn; without the presence of blacks, the book could not have been written. No Huck and Jim, no American novel as we know it. For not only is the black man a co-creator of the language that Mark Twain raised to the level of literary eloquence, but Jim's condition as American and Huck's commitment to freedom are at the moral center of the novel.

In other words, had there been no blacks, certain creative tensions arising from the cross-purposes of whites and blacks would also not have existed. Not only would there have been no Faulkner; there would have been no Stephen Crane, who found certain basic themes of his writing in the Civil War. Thus, also, there would have been no Hemingway, who took Crane as a source and guide...

Without the presence of blacks, our political history would have been otherwise. No slave economy, no Civil War; no violent destruction of the Reconstruction; no K.K.K. and no Jim Crow system. And without the disenfranchisement of black Americans and the manipulation of racial fears and prejudices, the disproportionate impact of white Southern politicians upon our domestic and foreign policies would have been impossible. Indeed, it is almost impossible to conceive of what our political system would have become without the snarl of forces—cultural, racial, religious—that makes our nation what it is today.

I came across the essay thanks to Andrew Sullivan, who posted an excerpt on his blog last October. Sullivan independently discovered the truth of Ellison's claims through the fresh eyes of an immigrant to the United States:

It struck me almost at once, if only in the music I heard all around me - and then in so many other linguistic, cultural, rhetorical, spiritual ways: white Americans do not realize how black they are. Even their whiteness is partly scavenged from the fear of - and attraction to - its opposite... From the beginning, in its very marrow, this country was forged out of that racial and cultural interaction.

Rod Dreher, himself a product of the American South, came to the same realization while traveling overseas:

I'd spent several weeks traveling around Europe the summer before my junior year in college, and came to understand after being around all those fellow white people that deep down, we Americans have been deeply shaped by the black experience... for a white Southern boy like me to spend six weeks in the Heart of Whiteness was to feel my own Americanness to the marrow for the first time... and to surprise myself by recognizing that the main reason I was so different from these people who looked just like me was because I had been raised in a culture profoundly shaped by black Americans. 

Ta-Nehisi Coates is right to insist that the question of how we claim our ancestors is "more philosophical than biological." And it is entirely appropriate that he began his post with a quotation from Ralph Wiley, who answered Saul Bellow's famous taunt "Who is the Tolstoy of the Zulus?" with the brilliant and wise retort "Tolstoy is the Tolstoy of the Zulus -- unless you find a profit in fencing off universal properties of mankind into exclusive tribal ownership."

For me personally, it was liberating to see Coates claim Fitzgerald and Steinbeck and Blake alongside Clifton and Baldwin and Wiley. I too claim Baldwin, whose Notes of a Native Son I first read with choking emotion in a village in Sierra Leone at the age of twenty-one, and whose funeral service at the Cathedral of St. John the Divine I attended just a few weeks after first entering the United States as a graduate student. He is no less an ancestor of mine than Rushdie or Kureishi, and I am no less a descendant for not having his blood coursing through my veins.

The Astonishing Voice of Albert Hirschman

Albert Hirschman is 95 years old today.

Four decades ago, he published Exit, Voice and Loyalty, a slim volume that contains more insights per page than just about anything else I have read. I consider it to be among the finest books ever written by an economist. For reasons discussed below, it also has enormous contemporary relevance.

The subtitle of the book is "Responses to Decline in Firms, Organizations and States." Hirschman's concern is with "repairable lapses" in organizational performance: declines that could be corrected with the right balance of information, incentives and flexibility of response. This is not a subject to which economists had paid much attention, and he begins by asking why:

While moralists and political scientists have been much concerned with rescuing individuals from immoral behavior, societies from corruption, and governments from decay, economists have paid little attention to repairable lapses of economic actors. There are two reasons for this neglect. First, in economics one assumes either fully and undeviatingly rational behavior, or, at the very least, an unchanging level of rationality... In other words, economists have typically assumed that a firm that falls behind... does so "for a good reason"; the concept... of a... "repairable lapse" has been alien to their reasoning.

The second cause of the economist's unconcern about lapses is related to the first. In the traditional model of the competitive economy, recovery from any lapse is not really essential. As one firm loses out in the struggle, its market share is taken up and its factors are hired by others... in the upshot, total resources may well be better allocated. With this picture in mind, the economist can afford to watch lapses of any one of his patients... with far greater equanimity than either the moralist who is convinced of the intrinsic worth of every one of his patients (individuals) or the political scientist whose patient (the state) is unique and irreplaceable.

But is the neglect justified? Hirschman argues that it is not, because the vision of a "relentlessly taut economy" operating at or close to its productive potential is inapplicable to technologically modern societies capable of producing a substantial surplus relative to the needs of subsistence. The very existence of the surplus implies that considerable slack in the level of efficiency can be tolerated without disastrous consequences. As a result, firms and other organizations are "permanently and randomly subject to decline and decay, that is, to a gradual loss of rationality, efficiency, and surplus-producing energy no matter how well the institutional framework within which they function is designed."

It is critically important, therefore to consider the "countervailing forces" that can arrest and reverse such decline. Hirschman identifies two such forces: desertion and articulation, or exit and voice. Exit refers to the fact that the customers of a firm (or members of an organization) can simply leave and attach themselves to a competing firm or organization. Voice refers to the expression of discontent: the natural human tendency to complain, protest, and generally "kick up a fuss." Each of these mechanisms is interesting in its own right, but it is the interaction of the two (and their connection to loyalty) that gives rise to the most intriguing possibilities.

One of Hirschman's key insights is that exit will not serve as a reliable recuperation mechanism if it occurs too rapidly in the face of organizational decline:

For competition (exit) to work as a mechanism of recuperation from performance lapses, it is generally best for a firm to have a mixture of alert and inert customers. The alert customers provide the firm with a feedback mechanism which starts the effort at recuperation while the inert customers provide it with the time and dollar cushion needed for this effort to come to fruition.

In addition, rapid rates of exit can deprive an organization of precisely those customers (or members) who, had they remained, would be most inclined to utilize voice:

[Those] customers who care most about the quality of the product and who, therefore, are those who would be the most active, reliable, and creative agents of voice are for that very reason also those who are apparently likely to exit first in case of deterioration.

As a result, the "rapid exit of the highly quality conscious customers... paralyzes voice by depriving it of its principal agents."

While it is commonly believed that most organizations would prefer that their customers or members had no exit option at all (as in the case of a monopoly) Hirschman argues, instead, that monopolists would welcome a modest degree of competition in order to shed their most vociferous customers:

[There] are many... cases where competition does not restrain monopoly as it is supposed to, but comforts and bolsters it by unburdening it of its more troublesome customers. As a result, one can define an important and too little noticed type of monopoly-tyranny: a limited type, an oppression of the weak by the incompetent and an exploitation of the poor by the lazy which is the more durable and stifling as it is both unambitious and escapable.

This is why those holding power in dysfunctional states "have long encouraged their political enemies and potential critics to remove themselves from the scene through voluntary exile."

More generally, the performance of near-monopolistic service providers may be worse than that which would prevail if monopoly power were absolute. This has enormous and wide-ranging implications. The poor performance of a national railway system might persist indefinitely if the most demanding customers also have recourse to road transportation. Public schools might deliver worse learning outcomes if private or parochial options are available to the most quality conscious parents. A small decline in neighborhood quality could turn into a precipitous collapse if those most affected by it simply move elsewhere. And the ease with which common stock can be sold implies that the most vigilant shareholders will liquidate their holdings rather than attempt to improve the performance of management.

While most environments are such that either exit or voice is the dominant response to decline, there is one arena, that of political competition, in which both mechanisms are critical. In this setting, taking account of voice leads to sharply different predictions than theories based only on exit. Hirschman's critique of the Hotelling-Downs analysis of political competition (and the median voter theorem it implies) is devastating:

As soon as the Hotelling model had been thus refurbished by Downs, its power to explain reality was again cast into doubt by the undisciplined vagaries of history. The selection by the Republican party of Goldwater in 1964... testified to the extreme reluctance of at least one party to conform to the Hotelling-Downs scenario...

[It was not] Hotelling's original assumption of inelastic demand... that was wrong or unrealistic, but the inference that the "captive" consumer (or voter) who has "nowhere else to go" is the epitome of powerlessness. True, he cannot exit... but just because of that he... will be maximally motivated to bring all sorts of potential influence into play so as to keep... the party from doing things that are highly obnoxious to him... in a two-party system a party will not necessarily behave as the Hotelling-Downs vote-maximizer because "those who have nowhere else to go" are not powerless but influential.

With modern communication technologies able to transmit, coordinate and amplify voice to an unprecedented degree, these insights have more relevance than ever. 

As Hirschman's title suggests, the interplay between exit and voice depends critically on the presence or absence of loyalty:

When loyalty is present exit abruptly changes character: the applauded rational behavior of the alert consumer shifting to a better buy becomes disgraceful defection, desertion, and treason. 

By making exit less appealing, loyalty to an organization can therefore be functional; it can "neutralize within certain limits the tendency of the most quality conscious customers or members to be the first to exit." But since "the effectiveness of the voice mechanism is strengthened by the possibility of exit," too much loyalty will stifle voice. In particular, the active promotion of loyalty by an organization can be detrimental to its own long run functioning:

[Loyalty] promoting institutions and devices are not only uninterested in stimulating voice at the expense of exit: indeed they are often meant to repress voice alongside exit. While feedback through exit or voice is in the long-run interest of organization managers, their short run interest is to entrench themselves and to enhance their freedom to act as they wish, unmolested as far as possible by either desertions or complaints of members.

From this perspective, a key determinant of organizational performance is the price of exit (which may or may not arise from loyalty):

Such a price can range from loss of life-long associations to loss of life, with such intermediate penalties as excommunication, defamation, and deprivation of livelihood. Organizations able to extract these high penalties for exit are the most traditional human groups, such as the family, the tribe, the religious community, and the nation, as well as such more modern inventions as the gang and the totalitarian party... Since the high price of exit does away... with the threat of exit as an effective instrument of voice, these organizations... will often be able to repress both voice and exit. In the process, they will largely deprive themselves of both recuperation mechanisms.

And the absence of recuperation mechanisms can have catastrophic consequences, as the current predicament of the Roman Catholic Church vividly illustrates.

I could go on, but the point has been made. This is a book with dozens of sparking insights tied together by a coherent vision. The vision allows for a broad range of human motivation, encompassing (but not limited to) standard hypotheses regarding rational behavior. Economic actors in Hirschman's world shop for lower prices and higher quality, to be sure, but they also capable of making a nuisance of themselves, engaging in self-deception, and displaying fierce loyalty to organizations with which they are affiliated. This rich, complex conception of human behavior allows for a sweeping analysis that is as penetrating as it is ambitious.

My birthday wish for Albert Hirschman today is nothing less than that which he has long deserved: the Nobel Memorial Prize in Economics.