mwengler comments on Blind Spot: Malthusian Crunch - Less Wrong

4 Post author: bokov 18 October 2013 01:48PM

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Comment author: gwern 21 October 2013 04:06:06PM *  1 point [-]

gwern, I find your position against bubbles to be incredibly unlikely, and that is post my studying economics and finance informally for the last 3 decades.

(Forgive me when I read this mentally as "And that is post my being a random Internet pundit for decades".)

As far as real estate bubble, first I would point at Mortgage Backed Securities (MBS) rather than the direct real estate market. These were rated AAA, insured for less than a penny on the dollar, and purchased by ancient and venerable banks and others. And then in 2007/2008 they almost uniformly as a class blew up. Returned pennies on the dollar. Caused multiple firms and banks around the world to go bankrupt.

I don't think it's very useful to define a 'bubble' as "any large price increase followed by a price decrease".

I'd rather use a more powerful EMH-focused definition: a bubble is large price increase which represents an inefficiency in the market which is predictable in advance (not in hindsight), exploitable, and worth exploiting. Merely pointing out some disaster, or some large price decrease, does not demonstrate the existence of bubbles, because that observation could result from unavoidable or unobjectionable causes like the inherent consequences of risk-taking, mistaken analyses, perverse incentives, etc.

People make mistakes; disasters happen. If they never happened, and AAA never went bust, couldn't one make a lot of money by exploiting that inefficiency in the market and picking up pennies in front of the non-existent steamroller?

I am thinking of Buffett and Munger referring to MBS derivatives as Weapons of Financial Mass Destruction BEFORE the blowup, and I had in print in a book printed before the destruction a speecy by Munger talking about how there was going to be a tremendously horrible event because of derivatives "in the next 5 to 10 years" in a speech he gave in I think 2002. While MBS were hot, they were so in demand that brokers such as Salomon would create "synthetic" MBS, which were essentially just well documented bets that would pay off exactly as an MBS would pay off over their life, but were made up because there was still demand for MBS even after the last homeless person with a pulse in the US had been given a 100% non-doc mortgage to buy a house which would not be sellable for even 80% of what was financed two years later.

How much money did Munger & Buffet make off their shorts of housing, exactly? How much has Paulson made post-housing? (Does making billions off housing, and then losing billions on gold & China, look more like skill & inefficient markets or luck & selection effects?) How many economists did one hear of post-2008 who suddenly turned out to be Cassandras? You can go onto Bitcoin forums and tech websites right now, and watch people predict 20 out of the last 3 Bitcoin 'bubbles'. Finance is just the same. Post hoc selection of people warning something vaguely similar (derivatives? that's a rather roundabout way of predicting a housing bubble, which could have been powered by all sorts of financial instruments, not just derivatives) is worthless.

Is even this not a bubble? Not the market chasing a dream instead of a business proposition and trying to fly up to heaven with the dream and failing?

Housing prices in SF, Australia, London, Canada, Manhattan, China are holding steady at bubblelicious prices or trying to fly up to heaven. (Again, I borrow this point from Sumner.) Perhaps they are using technology from the Apollo program.

The NASDAQ composite peaked in early 2000 at over 4000. More than 13 years later it is STILL not back up to that level. Perhaps at least some of the investors in AMZN and AAPL in 1999 were not caught in a bubble, but what about the bulk of the money, of which about 70% of the value evaporated in less than 3 years, and which on the whole has not crept back up to even yet?

Why is this not just mistaken beliefs about the value of those loser companies and about high-tech business models? (Notice how the big IPOs lately all have pretty clear revenue streams from advertising.) How could one know in advance that Pets.com would not be Amazon.com, or vice-versa? How does a VC know which of his investments will go bankrupt and which will own an industry? Tell me: if tomorrow a break is discovered in the core Bitcoin protocol/cryptography and the price goes to $0.00, was Bitcoin a bubble or a mistake?

To summarize: I think you are grasping at surface features, not thinking about the anti-bubble arguments or are just unfamiliar, and are engaged in post hoc analysis where you select out of the buzzing hive of argument and disagreement a few strands which seem right to you with the benefit of many years of data.

Comment author: mwengler 22 October 2013 06:09:21PM 0 points [-]

I'd rather use a more powerful EMH-focused definition: a bubble is large price increase which represents an inefficiency in the market which is predictable in advance (not in hindsight), exploitable, and worth exploiting.

I'm happy with that definition. EMH (Efficient Market Hypothesis) for those of you following along at home.

In my case I had amassed a small fortune by October of 1999 by simply holding the stock options I had been granted on taking the job 4 years earlier. They were up more than 10X at that point. Actionable? My very intelligent college roommate owned his own financial advising firm. He spent two weeks on the phone with me convincing me that it would be gigantically more sensible to cash out these options and give them to him to invest "in case, in the future, people get up in the morning, put their clothes on, and go outside instead of sitting in front of their PCs all day ordering stuff off the internet." He sent me books to read including this one first published in 1841. This describes witch hunts as well as South Sea, Tulip and other financial bubbles. Jim, my roommate, had been referring to tech as a bubble for a year or two before I talked to him in October of 1999. The action he was taking with his other clients was to simply not get in to tech. This was a horribly unsatisfying strategy until about the middle of 2000 when tech was well into its slide from the top.

By the time I cashed out and handed him the money in about december 1999, the stock had more than doubled again. The human in me wanted to hold on to it because, obviously, this was a stock which kept on doubling. He explained to the rationalist in me that whatever the case for investing that money in something else was at half the price, the case was TWICE as good at twice the price, unless we had learned something quite important and positive about the business in the last two months. Which we hadn't of course. What we had learned is that there was no shortage of "greater fools" willing to buy in AFTER all that price appreciation had already happened on old information that was not changing nearly as fast as the price.

Over the next three years the stock I had sold in December 1999 gave back about 75% of its price gains. Meanwhile, my friend invested my money in REITs, Berkshire Hathaway, banks, and a bunch of other asset classes not even dreamed about by most of my fellow techies. The money I had given him grew by 40% more or less, I don't remember exactly, while the nearly half of my original stock grant I had kept in my employers stock contracted to 20% of its peak value.

So yes, to me the internet bubble appears to have been actionable before it burst. The "investors" who stayed with the bubble, myself included with what started out as nearly half of my fortune and ended as about a tenth of it. The shift of 60% of my money out of the bubble preserved my wealth at a level that may well have been unique among my peers at this company.

I realize you can't get a drug approved with this kind of evidence. But you realize that most of what we "know" is the best model we can come up with in the absence of double blind studies. I've detailed the one best example in my life. I agree it is HARD to act on bubbles, shorting them is scary and fraught with risk, you are betting you can stay solvent longer than the market can stay stupid, which is quite a bet indeed. So bubbles, so spectacularly obvious in retrospect, may be no more reliably useful for making money than is any mispricing, even smaller more temporary ones.

Out of curiousity, are you enough of an EMH'er that you don't believe in mispricings? Or at least not in publicly traded financial securities markets? Do you think it is just a roll of the dice that 9 students of Ben Graham all ran funds which had long term returns above market averages? I think a bubble is just a particular kind of mispricing, a particular kind of inefficiency. It may be no easier to exploit than the other kinds of mispricings, but it is probably not harder to exploit. And shorting is not the only way to exploit bubbles or mispricings, just sticking with a discipline which on average avoids them appears to work for a broad range of investors, including such low-entropy categories of investors as former students of one professor who espoused value investing.

Comment author: gwern 22 October 2013 08:51:14PM *  0 points [-]

Actionable? My very intelligent college roommate owned his own financial advising firm. He spent two weeks on the phone with me convincing me that it would be gigantically more sensible to cash out these options and give them to him to invest "in case, in the future, people get up in the morning, put their clothes on, and go outside instead of sitting in front of their PCs all day ordering stuff off the internet."

This actionable advice is also 100% justifiable without recourse to claims of superior perception simply by the high value of diversification. Keeping a large sum of money in a single stock's options is really risky, even if you think it's +EV, and even if you think some EMH conditions don't apply (you had insider knowledge the market didn't, the market was not deep or liquid, you had special circumstances, etc). Same reason I keep telling kiba to cash out some of his bitcoins and diversify - I am bullish on Bitcoin, but he should not keep so much of his net worth in a single volatile & risky asset.

He sent me books to read including this one first published in 1841.

MacKay is not the most reliable authority on these matters, you know. The book I mention punctures a few of the myths MacKay peddles.

Jim, my roommate, had been referring to tech as a bubble for a year or two before I talked to him in October of 1999. The action he was taking with his other clients was to simply not get in to tech. This was a horribly unsatisfying strategy until about the middle of 2000 when tech was well into its slide from the top.

An anecdote, as you well realize. You recall the hits and forget the misses. How many other bubbles did Jim call over the years? Did his clients on net outperform indices?

Meanwhile, my friend invested my money in REITs, Berkshire Hathaway, banks, and a bunch of other asset classes not even dreamed about by most of my fellow techies. The money I had given him grew by 40% more or less, I don't remember exactly

And would have grown by how much if they had been in REITs in 2008?

I agree it is HARD to act on bubbles, shorting them is scary and fraught with risk, you are betting you can stay solvent longer than the market can stay stupid, which is quite a bet indeed.

It's not just that you're betting that you can stay solvent longer, you're betting that you have correctly spotted a bubble. There was a guy on the Bitcoin forums who entered into a short contract targeting Bitcoin at $30. Last I heard, he was upside-down by $100k and it was assumed he would not be paying out.

Do you think it is just a roll of the dice that 9 students of Ben Graham all ran funds which had long term returns above market averages?

As a matter of fact, someone a while ago emailed me that to try to argue that EMH was false. This is what I said to them:

A cute story from long ago, but methinks the lady doth protest too much - he may say he has not cherrypicked them, but that's not true: the insidious thing about datamining and multiple comparison is that there's nothing false about the results, if you slice the data such-and-such a way you will get their claimed result. And even if there are no other employees or contractors or students quietly omitted and we take everything at face value, he hasn't shown that they aren't counted in the coin-flipping orangutans given a loaded coin producing 7% returns a year. Why aren't his former coworkers giving away dozens of billions of dollars? If they were beating 7% like he says they were, they should - in 2012, 28 years later - be sitting on immense fortunes. Buffett himself seems, these days, to generate a lot of Berkshire profit just from being so big and liquid, in selling all sorts of insurance and making huge purchases like his recent railway purchase.

I don't think that even begins to overturn efficient markets, sorry.

Speaking of Buffett's magical returns, I found http://www.prospectmagazine.co.uk/economics/secrets-of-warren-buffett/ interesting although I'm not competent to evaluate the research claims.

Out of curiousity, are you enough of an EMH'er that you don't believe in mispricings? Or at least not in publicly traded financial securities markets?

Pretty much. I believe in inefficiencies in small or niche markets like Bitcoin or prediction markets, but in big bonds or stocks? No way.

It may be no easier to exploit than the other kinds of mispricings, but it is probably not harder to exploit.

I have watched countless people, from Paulson to Spitznagel to Dr Doom to Thiel, lose billions or sell their companies or get out of finance due to failed bets they made on 'obvious' predictions like hyperinflation and 'bubbles' in US Treasuries since that housing bubble which they supposedly called based on their superior rationality & investing skills. It certainly seems like it's harder to exploit. As I said, when you look at complete track records and not isolated examples - do they look like luck & selection effects, or skill & sustained inefficiencies?

Comment author: mwengler 29 October 2013 07:59:47PM 0 points [-]

Speaking of Buffett's magical returns, I found http://www.prospectmagazine.co.uk/economics/secrets-of-warren-buffett/ interesting although I'm not competent to evaluate the research claims.

I heartily endorse this analysis. I would recommend actually the original paper rather than the review of that paper cited by gwern.

At no point that I could find in this paper did they find that they needed to appeal to luck or random outlier quality to explain Buffett's performance. Indeed, except that it is decades after the fact, it seemed fairly simple for them to explain Buffett's performance quantitatively from picking stocks that the author's say systematically outperform the market, sticking with his method of picking stocks in good and bad times for his portfolio or the market as a whole, and in using a moderate amount of leverage, they estimate about 1.6.

Not rocket science, not snake oil, and not a long sequence of lucky coin-flips.

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