On Monday morning, February 9, 2015, the CME Group-MSRI Prize in Innovative Quantitative Applications was awarded to Jose Scheinkman, economics professor at Columbia and Princeton Universities and one of the world’s leading experts on financial modeling. Since much of his recent work is centered on friction in the financial markets, Monday’s award ceremony was preceded by a seminar titled “Bubbles in the Markets: Why Do They Form, When Do They Burst?” At the conclusion of the ceremony, Prof. Scheinkman sat down with John Lothian News editor-at-large Doug Ashburn to discuss his most recent work.
In 2006, CME Group teamed up with the Mathematical Sciences Research Institute (MSRI) to “reward exemplary work in the field of mathematical sciences and recognize the vital impact quantitative research and application play in shaping global financial markets.” The last three Nobel Prize winners in Economics, Jean Tirole, Robert Shiller and Lars Peter Hansen, are all past recipients of the CME Group-MSRI award. Perhaps this bodes well for Prof. Scheinkman.
For more on the prize and its past winners, click HERE
Monday’s talk was all about the bubbles and the professors who study them. Although there was a lot of math – yes, quantitative researchers do a lot of that and, besides, the “M” in MSRI does stand for “math” – the math boiled down to conventional wisdom regarding bubbles. Wei Xiong, who collaborated with Scheinkman in his seminal bubble-work, Overconfidence and Speculative Bubbles (2003), offered a quantitative demonstration that boiled down to the “Greater Fool Theory.”
Gadi Barlevy of the Chicago Fed was able to show that bubbles are frothiest when participants are gambling with other people’s money.
Princeton’s Harrison Hong agreed with hedge fund king David Einhorn, who recently said we are experiencing the “second tech bubble in 15 years.” Hong’s research links overvaluation and volatility to high beta stocks.
MIT’s Leonid Kogan argued that growth stocks can be used as a hedge against the “displacive effects of innovation,” and since there are more established players than there are new ones, the chase is on.
Finally, University of Chicago’s Pietro Veronesi reminds us that we generally cannot observe or label a bubble until after the fact. He said the best way to deflate and even prevent bubbles is to weaken short sale constraints, a sentiment that was echoed by other panelists, including Scheinkman. An unimpeded price discovery process – something we in the futures market have embraced for quite some time.
Among the best food for thought of the day, however, were remarks that came during the one-on-one session with Prof. Scheinkman, printed below in its entirety.
Q: Of all the topics covered on the panel, which area would you like to elaborate?
A: The discussion of bubbles has to go beyond prices. We need to look at other aspects of bubbles to help us determine the forces that lead to bubbles. There are three important facts. First, bubbles tend to occur during times of financial or technological innovation. Second, bubbles tend to be accompanied by trading frenzies, so there is a correlation between trading volume and bubbles. And the third is that bubbles end not because investors suddenly become rational and realize prices are too high, but that because smart people start creating substitutes for the assets in the bubble.
One recent example is during the creation of synthetic CDOs, which was a way of creating mortgage bond exposure without having to build more houses. This is an important lesson. When the government makes it difficult for the supply to increase, they make a bubble more likely. A lot of people blame synthetic CDOs for the size of the financial crisis, but the alternative is, had they not been created, we would have kept building houses, and had as big of a financial crisis, only with more houses remaining unsold. The market would have had further to fall, and at more real cost, as there would have been more houses that nobody wanted.
Q: When you say “trading frenzy” is that akin to the “greater fool theory” meaning that people become confident that, when a bubble has run its course, savvy investors will recognize it and hit the “sell” button, and have a liquid and orderly market in order to get out?
A: Yes, and that is a very important point. When you buy an asset, you are acquiring an option to sell it in the future, and that is dependent on a liquid market in the future. It is not that trading volume causes the bubble; that is not what I am trying to argue. They are both the result of the same phenomena, which is that people disagree on the value of the asset, and all believe in their own value of the asset, and on top of that, they believe that in the future they will find the greater fool.
Q: So does this get back to the asymmetry of information and asymmetry of trading access?
A: In main markets, getting long is much easier than getting short, that’s for sure. One of the panelists today mentioned David Einhorn. He tells this story about one time, when he was at a fundraising event full of financial types. One person came in and said to buy a certain stock, that it was sure to go up, which is part of the fun at these events. Einhorn came in and said the stock was going down and is a short opportunity. The next day he got a call from the SEC.
Q: This greater fool view gets back to some of your earlier work on overconfidence. What role does that play here?
A: Yes. One of the reasons you get disagreement is that people think they know more than they actually know. There are a lot of psychological experiments that show that. A person tends to trust too much his or her sources of information or what they think they know. And that is what causes this volatility of opinion. Not only is he overconfident, he is confident that there are others even more overconfident than he, and those people will still be there even when he has given up on the asset. That makes people pay even more than they think an asset is worth.
Q: Do you believe in the notion of what used to be called the Greenspan Put, which became the Bernanke Put, and now the Yellen Put, which essentially says that I can invest with abandon because I trust that, in a systemic event, the Federal Reserve will come to my rescue?
A: Certainly people thought it before the crisis. Aside from Lehman, the only big one where actual losses were taken. Lots of people went to bed one night holding debt from Bear Stearns and woke up with debt from the Federal government. That’s a very good trade. So they were right.