Two Bubbles in a Row Equals Progress!

I posted this for the first time August 2009 and its worth repeating…

Nobel Prize winner Dr. Vernon Smith is in my film Broke. I Interviewed him in his office in Arlington, Virginia. Reading a piece of research (PDF) by James Montier recently and Dr. Smith’s name popped up. An excerpt:

As long time readers may recall, I am a fan of the use of experimental markets to explore the dynamics of markets. The advantage of the lab is, of course, that information can be fully controlled in a way that just isn’t possible in the real world. The major authority within this sphere is Vernon Smith (joint winner of the Nobel Prize for economics in 2002). In a recent paper Smith and his co-authors explore some issues that may have lessons for the current juncture. They start by setting up an experimental market in which investors can trade an equity with a dividend payment each period. The actual payment is uncertain, but participants are told that there are four states of the world, and all are equally likely, and they are given the payouts that correspond to the various states of the world. Calculating fundamental value is therefore a trivial task of multiplying the probabilities by the payouts, and then multiplying that answer by the number of periods left in the game. (e.g. in round 1 of 15, fundamental value = 24×15 = 360). The chart below shows the path of fundamental value (slopping down from left to right as a dividend is paid out each period), plus the results from two games where participants trade this asset. In their first encounter with this asset, participants start off by enormously undervaluing the asset, trading at an 80% discount to fundamental value in the first few periods. However, as the game progresses, a huge bubble is created. Prices that are 3 or 4 times fundamental value are not uncommon! Eventually the bubble deflates towards the end of the game. The time series generated by this run is labeled inexperienced in the chart below. The same participants are then invited to return to the same market and try trading the asset a second time. Far from learning from their experience in the first round, participants generally go on to create yet another bubble! This time the bubble occurred earlier in the game, and wasn’t quite so pronounced as in the first game (with peak prices being around twice fundamental value!). When asked why the participants created a second bubble, the most common response was they thought they could get out before the top this time! The only tried and tested method of removing bubbles from such markets is to use players who are experienced twice over. The third time they play, you end up with a much tighter correlation between the market price and fundamental value. As Smith says “Once a group experiences trading a bubble and a crash over two experiments and then returns for a third experiment, trading departs little from fundamental value.”

Interesting…

In interviewing Dr. Smith for Broke, my first question, a softball, resulted in a 37 minute answer! Yes, Nobel Prize winners think in great detail!

8 thoughts on “Two Bubbles in a Row Equals Progress!

  1. Good posting, Mike. Trend following, to me, is a art of identifying bubbles early, riding them, and carefully getting out of them before they burst.

    It is beginning to trouble me nowadays that trend following also provides the positive feedback loop to inflate the bubbles faster and bigger.

    Oil bubble, housing bubble and financial bubble, all provide a joy ride, but when they burst, the contents spill over farther. I am sure trend followers make money in the bursts too, nowadays, due to leveraged derivatives.

    Would like to know your thoughts on this, or am I reading too much?

  2. After this move i think the shorts are in a difficult position even on the euro. Just a matter of time. Lets see how it plays out.

  3. The take away here is crowd psychology and how people behave, not a trading strategy.

  4. Funny how a 2-3 week 15% decline is the damn evil speculators that are manipulating the market, and in a day a 10-12% rise in the markets, is just normal stabilization…

  5. Its how you look at it. Psychology sometimes reinforces the price action and gives you a clue as to wether this is going to be a big range bound play or if its going to be a break-out.

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