"Does trend-chasing explain financial markets?"
Noah Smith at The Week:
Two researchers take an extremely simple (and effective!) approach to answering this question
"How can you know, how can you know/ Which is which, who's doin' what?/ I guess that you can ask 'em"
- Dan Bern, "Tiger Woods"
A lot of interesting unexplained phenomena in finance are related. Bubbles. Long-run reversion. Excess volatility. "Overreaction." All of these have to do with the general thing known as long-run stock return predictability. In other words, it really is possible to know when stocks are "cheap" or "expensive." This is one of the insights for which Robert Shiller won the Economics Nobel this year.
But why do stock prices mean-revert in the long run? This is the subject of an ongoing controversy — perhaps
the most important controversy in finance. Some people say that it's
because of time-varying risk premia with Rational Expectations; others
say that it's because of people's incorrect information processing, and
expectations are non-rational. In other words, it could be because what people want is kind of funky, or because how people think
is messed up. But without some kind of independent measurement of
either A) people's desires, or B) people's expectations, we'll never really resolve the controversy.
So that's why this 2012 paper
by Andrei Shleifer and Robin Greenwood is so interesting. They take an
extremely simple approach toward measuring people expectations: Just ask people what they think is going to happen!
Actually, what they do is to take data from six different surveys of
the stock market expectations of individual investors. For those who
don't know, this is a pretty maverick thing to do; financial economists
traditionally have not trusted survey data to reveal investors' true
expectations.
So the first and most obvious question
is: Do these "survey expectations" represent people's real beliefs?"
The authors answer this in two ways. They first check that the six
survey measures are correlated with each other; in fact, they are strongly correlated.
Second, and more importantly, they check that survey expectations are consistent with investors' actions.
In fact, they are strongly consistent. Here's a graph displaying
reported expectations (according to one of the surveys) alongside the
amount of money flowing into equity mutual funds:
As you can see, when people say they expect stocks to do well, they actually put money into stocks....MORE
