Wednesday, October 7, 2009

Trend momentum and bubbles - an asset pricing model

The post-mortem after the sub-prime mortgage crisis has called to question many of the fundamental tenets of modern financial and capital markets theory, none more so than the ability of efficient market hypothesis (EMH) to explain the risk-return dynamics in asset pricing and the build up of bubbles. The prevailing belief, arising from the modern financial theories, that market prices were efficient - prices of all traded financial assets reflect all known information and nobody can predict the market and thereby beat it on a sustained basis - gave no place for harmful aberrations like asset bubbles and therefore rendered the need for intrusive government regulatory interventions superfluous.

Dimitri Vayanos and Paul Woolley (full paper here) are the latest to question the relevance of EMH, relegating it to a more specific and limiting case of asset pricing, and propose their version of asset pricing model "in terms of a battle between fair value and momentum driven by principal-agent issues", in which "investment agents’ rational profit seeking gives rise to mispricing and volatility".

The trace the crucial flaw in existing capital market theories as the assumption that prices are set by the army of private investors with investors investing directly in equities and bonds, ignoring the reality of professional intermediaries -banks, fund managers, brokers - who, as agents, trade on behalf of the overwhelming majority of their principals, the investors. This delegation, coupled with the incentive distortions in the prevailing executive pay structures, creates principal-agent problems and mis-aligns the interests of investors and intermediaries.

Vayanos and Woolley introduce agents into their asset pricing models and point attention to the importance of price trending or momentum which are commonly observed in financial markets. As momentum builds up on a sector (or an asset class), funds invested in value sectors/assets (or those with traditionally strong fundamentals) languish and cause investors to demand (on their fund managers) higher returns by switching to the trend (or growth) sectors/assets, thereby further adding to the momentum on those growth sectors/assets. Faced with the risk of losing their investors, value managers are left with no alternative but to join the growth bandwagon and the trend momentum. They write that asset pricing becomes a battle between fair value and momentum, and propose a rational theory of momentum and reversal based on delegated portfolio management,

"Momentum is incompatible with an efficient market and has proved difficult to explain in the traditional framework... Central to the analysis is that investors have imperfect knowledge of the ability of the fund managers they invest with. They are uncertain whether underperformance against the benchmark arises from the manager's prudent avoidance of over-priced stocks or is a sign of incompetence. As shortfalls grow, investors conclude incompetence and react by transferring funds to the outperforming managers, thereby amplifying the price changes that led to the initial underperformance and generating momentum... rational profit seeking by agents and the investors who appoint them gives rise to mispricing and volatility. Once momentum becomes embedded in markets, agents then logically respond by adopting strategies that are likely to reinforce the trends.

Explaining the formation of asset pricing in this way seems to provide a clearer understanding of how and why investors and prices behave as they do. For example, it throws fresh light on why value stocks generally outperform growth stocks despite offering seemingly poorer earnings prospects. The new approach offers a more convincing interpretation of the way stock prices react to earnings announcements or other news. It also shows how short-term incentives, such as annual performance fees, cause fund managers to concentrate on high-turnover, trend-following strategies that add to the distortions in markets, which are then profitably exploited by long-horizon investors."

Building up on the momentum trading model of asset pricing, Mark Thoma outlines three pre-conditions to generate a bubble,

"First, an idea that makes people believe that higher returns are available without assuming more risk needs to be present. Second, there must be a source of liquidity to inflate the bubble. This can come from external sources such as high saving or low interest rate policy, or it can come from reallocation of existing investments (e.g. when people in the U.S. stopped loaning to foreign governments prior to the Great Depression so that they could chase the higher returns at home). And third, there must be regulatory and/or market failures that allow the bubble to inflate with little or no resistance."

In other words, asset bubbles can get blown even without a liquidity build-up by mere reallocation of investible funds to the momentum sector/assets (itself a market failure). The perception that there is some great idea at work that is driving up these prices can come from different sources. During the Great Depression, it was the conviction that electricity and the internal combustion engine (among other technological advances) had ushered in an era of higher productivity; the dot com bubble promised higher productivity from the internet; and in the present crisis, financial innovation coupled with the idea that policymakers and the market could maintain the Great Moderation led to the idea that higher returns could be generated without a corresponding increase in risk.

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