The commercial property market in London has been booming for several years. The Bank of England is concerned about yet another property bubble building up. The executive director for financial stability, strategy and risk at the Bank, Alex Brazier, warned in a speech last month that positive sentiment in the industry must be “tempered by experience of past business cycles”, so that we are not doomed to repeat previous booms and busts. The Bank is constructing an index for banks and investors to show how prices compare with lending and cash flow. If the market pays attention, there will be less risk of it getting carried away.
The existence of bubbles, whether in property or equities, creates problems for economists. It is only two years ago that the Chicago-based Eugene Fama received the Nobel Prize for inventing the so-called efficient markets hypothesis nearly fifty years ago. All public information is believed to be incorporated in the price. So any extra material which the Bank, for example, provides is redundant. Rational investors are already presumed to know it.
Less reverently, this view is sometimes referred to as the Groucho Marx theorem. Groucho would never want to be in a club which would have him as a member. And no rational agent would ever want to buy an asset which another rational agent is willing to sell. Both sides of the deal suspect that the other has private information which has yet to hit the market.
The joke is not meant to be taken literally, but like many good jokes it does have a strong element of truth. With economically rational investors, trading volumes would be low. Instead, they are huge. For example, in 2014, the total value of trading in the Standard and Poor’s 500 was $29.5 trillion, nearly double the size of US GDP.
There have been many technical attempts to explain why trading so large. But they all struggle with the sheer scale on which trading takes place. So economists are beginning to come to the view that markets might not be efficient after all. Overconfidence could be an inherent feature of asset markets. Overconfidence simply means having mistaken valuations and believing them too strongly. Investors credit their own talents and abilities for past successes. They blame their failures on bad luck, rather than reducing their level of overconfidence.
A paper in the recent issue of the top Journal of Economic Perspectives by American economists Kent Daniel and David Hirshleifer provides tons of evidence to support this view. For example, stock market trading increases during periods of high returns. It was over 100 per cent of US GDP in the 1920, collapsed in the 1930s and 1940s, and rose dramatically during the 1990s until the crisis.
Much their evidence is on equities, most of which are readily tradeable. So the returns on decisions which people make are obvious, and provide clear feedback. The property market is much less liquid. Overconfidence and mistaken valuations could build up even more. The Bank’s efforts might not be wasted after all.
Paul Ormerod
As published in City AM on Wednesday 11th November 2015
