Did the Crisis Just Prove that Markets are Not Efficient?

Our little Internet debate about reverse convertibles (my contribution here) prompted this post by Mike at Rortybomb. To simplify a little, some commentators defended reverse convertibles by saying, “it’s basically the same as writing a put option” – or, looking at it from the other side of the trade, “there are valid reasons to want insurance against a stock price falling.” To which Mike says, “just sell (or buy) the put option.”

But this is just a specific case of an important point that Mike has made before, but that is more clear when seen in the context of a specific security. Mike’s basic point is that efficient markets imply that financial innovation does not create value. The efficient markets hypothesis says that the prices of financial assets already reflect all available information; in other words, there is no such thing as a free lunch.

Here’s Mike’s example for those who may be unfamiliar with the idea:

Let’s look at regular markets: Let’s say that everyone knows that the energy market is a big deal over the next 10 years. You could buy land where oil is buried very deep and innovate digging techniques, you could start an innovative research firm to get better solar energy going, you could try and make an innovative super-carburetor. All of these, if you pull them off, are going to be very profitable and welfare enhancing. Markets work, so you’ll probably find capital and labor more willing to work with you.

Now what about financial markets. Let’s say that everyone knows that the energy market is going to be a big deal over the next 10 year. If you invest in energy stocks, are you going to make a killing? No. The prices of energy stocks have already been bid up to account for the fact that everyone knows this. The price of financial instruments moves to handle all possible information that is available. This is what it means for financial markets to be efficient.

If markets are efficient, the only way you can get higher expected returns is by taking on more risk. If some broker comes to you with a new product that offers higher returns with the same or lower risk – like a super-senior, “safer than AAA” tranche of a collateralized debt obligation – then there are two possibilities: (a) the product exploits some market inefficiency; or (b) the product doesn’t do what the broker says it does. Mike says that if you believe that markets are efficient, you also have to believe that (b) is more likely to be the case than (a). (The corollary is that financial innovation does create value when it exploits some market inefficiency.)

But wait, you may be thinking, didn’t the crisis just prove that markets are not efficient? Well, yes and no. I’ve been reading Justin Fox’s new book, The Myth of the Rational Market, which is basically an intellectual history of financial economics in the twentieth century, centered on the rise and fall of the efficient markets hypothesis. The strong form of the efficient markets hypothesis is that market prices, such as stock prices, accurately reflect fundamental values; in Eugene Fama’s words, “the actions of the many competing participants should cause the actual price of a security to wander randomly about its intrinsic value” (Fox’s book, p. 97). This proposition has not held up well recently – and has been on the defensive since at least the 1980s – unless you are willing to let prices wander very, very far from intrinsic values.

But there’s another version of the efficient markets hypothesis that I happen to believe holds for many markets: in the short term, you cannot beat the market. For example, stock prices can be irrationally, crazily high – when I was at Ariba, our market valuation went up to $40 billion, even though our annual revenues were less than $300 million and we had never turned a profit – but you still have no way of knowing if they will go up or down in the short term. That’s exactly what happens in a bubble; everyone knows that prices are no longer related to fundamentals, but enough people think they will be able to sell before the bubble bursts that prices keep on going up.

And if this is true for stocks, then it is even more true for derivatives linked to stocks, since the value of an equity-linked derivative is just a function of expectations about the price of the underlying stock. So coming back to reverse convertibles, if the basic purpose is to sell a naked put option on a stock, then you should go to the market and sell a naked put option instead of buying a reverse convertible, which has all sorts of complicated features. Here’s how Mike puts it:

I believe the best price of a put option on a stock is going to the market and getting the price of a put option. I believe that the implied price of a put option, married with odd extra risks and transaction costs, in this reverse convertible bond instrument is a worse price for the put option than the market one, because I believe the more markets vet prices the better they are. Nemo’s point is absolutely correct – if they were much different, the market would be arbitraging them away.

So . . . if you think the stock price of Coca-Cola will be higher in 2019 than the market thinks, then it may make sense for you to buy it, since it’s possible that the price is irrationally low at the moment. (Of course, it could be irrationally even lower in 2019.) But if you think you found a way to get a higher price for a one-year put option on Coca-Cola stock than just going to the market for one-year put options, you are probably wrong.

This brings us back to the main question: why do these things exist?

Some defenders of financial innovation say that because reverse convertibles exist, they must have value. This is the old “Chicago-school” assumption that even though individuals are irrational, markets behave as if people are perfectly rational. This assumption is at least plausible (though almost certainly wrong) when it comes to prices for heavily-traded stocks; there the argument is that a few well-capitalized, rational hedge fund managers are enough to counteract the irrational hordes. But the assumption completely breaks down when you are dealing with complex products that are sold by individual brokers to individual retail investors; it would be crazy for the retail investor in that situation to assume that the price must be fair, because otherwise the broker wouldn’t be offering it. (Do you make the same assumption about a used car salesman?) Or, as Larry Summers wrote in a now-famous though unpublished paper, “THERE ARE IDIOTS. Look around” (Fox, p. 199).

Here’s one answer, suggested by a friend of mine (who has been working in the financial sector for the last two decades):

I think given the existing array of financial instruments available, it is generally possible to construct a return profile of most things you can imagine, so it is hard to create something that has value over existing alternatives. [He gives a positive example, but it isn’t reverse convertibles.] . . .

I think that people may buy these instruments because they are new.  Outside the financial sector, “new” generally implies “better” or “improved”.  Computers, cars, phones, detergent, etc. all get a marketing lift on new models, since in order to stay competitive in most of these industries, your products have to get better and better.  In finance, almost everything is zero sum, so generally there is no better, just different packaging.  So unless the packaging has some value (which in some cases it does), consumers are not getting a better product.  But since it’s “new”, people might assume that they are getting something better.

That sounds about right to me.

(Note: In following Mike’s links I found that Ezra Klein raised this question about financial innovation a couple months ago on his old blog; he now blogs here.)

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