Risk Markets And Politics

Thursday, June 09, 2005

Overcrowding

Right now people are hungry for yield and several investment markets and strategies exhibit overcrowding. Speculators thrive on market inefficiencies, but when speculators are successful and/or numerous, these inefficiencies tend to dissipate, driving their profits down. Speculators are thus always on-the-search for new markets, ideally where they can transfer a tested methodology to a hopefully naive arena. Falling yields can indicate a demand for new markets.

Strategy overcrowding is less apparent in non-zero-sum markets, and markets undergoing reflexive buying/selling episodes ("bubbles"). The reflexive buying and price-multiplier effects that accompany bubbles are however only a secondary cause. The primary cause of bubbles has more to do with the markets themselves becoming overcrowded. Unlike strategy overcrowding, this tends to increase average profits in non-zero-sum markets. The prices predicted by fundamental valuation models are sometimes inadequate when trumped by supply/demand factors extrinsic to the models. Fundamental valuation often assumes the form of yield, but yield can be pushed arbitrarily low by market forces of demand for the underlying security or property. Whether it be interest paid on bonds, or earning- and dividend-yields on stocks, or rent yields in real estate, yields can be pushed to seemingly irrational levels by extrinsic factors often relating to demographics, market structure (including globalization), and, commonly, developments in other markets.

For example, since the equity market is non-zero-sum and skewed sharply to the long side (most people own stocks as opposed to "being short" stocks), option implied-volatilities, which determine the value of options, exhibit their familiar pattern of relatively high put prices, as there is relatively more demand by hedgers (puts allow you to profit from the market going down.) Likewise, in online prediction and sports gambling markets, longshots tend to be overvalued, and favorites undervalued due to the reluctance of sellers and buyers of risk, respectively, at severely unfavorable risk/reward ratios. In both of these cases, structural factors external to the assumed exclusive content of the valuation models (which are interpretations of the markets specifying an implied probability or volatility) cause the models to malfunction and produce incorrect results, in the short run at least.

The housing market is another example where valuations are driven by factors extrinsic to yield-based valuation models, and I would like to stress the demographic aspects of the current trend. The housing market is doubly and perhaps triply driven by demographics. First, there are the oft-cited combined effects of the baby boom and increased life expectancy. Secondly, and this is an Austrian interpretation, the fact that the average age in the US is increasing at about 0.1 year per year currently should put a downward pressure on yields, especially on yields more than several years out. This is intuitive, as older folks tend to want their money more immediately. Lower yields of course help housing prices, but as people begin to retire "later" this effect will be mitigated. Perhaps the outcome of the housing market and other conundrums will be resolved around the same time as the social security debate, when the average retirement age will probably move sharply higher.

3 Comments:

  • Yo. Am I the first to comment at your blog?

    Woo hoo!

    By Anonymous bejammin075, at 1:56 PM  

  • Ah, finally someone is here to appreciate how accurate my predictions are: at least 2-for-2 so far, so welcome..

    By Blogger Jason Ruspini, at 10:18 PM  

  • Looking back on this post, it contained some good points, but the bit at the end was somewhat silly. My appeal to time preference was wrong.. i was thinking of accumlated savings and supply of credit.

    By Blogger Jason Ruspini, at 1:41 PM  

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