Blog Profile: Rajiv Sethi, Academic Reflections of Current Markets

A Professor of Economics, Barnard College, Columbia University & External Professor, Santa Fe Institute. Rajiv Sethi helps to tie in academic work with current market events. He seems to also be a rather open minded professors which engages the econblogosphere in a meaningful way and also supports them in their logic and well displayed ideas.

He has made some insightful on the recent flash crash on 7 May.

The point I was trying to make is this: the problem lies not so much with the method of trading (algorithmic or otherwise) but with the underlying strategies that are being implemented. Algorithmic trading allows technical strategies to profit and proliferate, and markets dominated by technical analysis will tend to be unstable. If destabilizing strategies are prevented from taking losses when they misfire, the result will be more frequent and significant departures of prices from fundamentals. Hence my concern over the cancellation of trades.

He also points out that if market stability depends on the composition of trading strategies.

The determination of the composition would be past performance: strategies that have recently given rise to strong returns will come to represent a greater share of total trading volume both because wealth has been transferred to those executing such strategies, and because they will attract new funds.  If it grows too much, the market will be destabilized and an asset price bubble could form.

Elsewhere he also comments on Paul Volckers Lecture which highlights that there are declining margins of safety in the financial markets. This could possibly why we underwent a severe breakdown in 2007/8.

He goes on to provide evidence for the theory based on changes in a broad range of variables during the post-war period. For non-financial firms, these include the debt-asset ratio and the ratio of liquid assets to short term liabilities. For commercial banks he examines the ratio of loans to bank credit and the ratio of capital to risk assets. For the stock market he looks at the price-earnings ratio and the dividend yield. In all cases he finds evidence of declining margins of safety.

Lastly he also differentiates market efficiency into 2 aspects

1) Informational efficiency which  states that active management strategies that seek to identify mispriced securities cannot succeed systematically, and that individuals should therefore adopt passive strategies such as investments in index funds.

2) Allocative efficiency is satisfied when the price of an asset accurately reflects the (appropriately discounted) stream of earnings that it is expected to yield over the course of its existence. If markets fail to satisfy this latter condition, then resource allocation decisions that are based on price signals can result in significant economic inefficiencies.

However he notes that although markets  can be hard beat which means its informationaly efficient. However the markets can generate significant departures of prices from fundamentals from time to time and hence be allocatively inefficient.   Which means that the market is never totally efficient but instead move between periods of high and low efficiency where prices are relatively stable to periods of bubbles and recessions where they are significantly over priced and under priced respectively.

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