Friday, August 22, 2008

The Interaction Of Market Disequilibrium And Price Dynamics: A Boom/Bust Sequence In Financial Market

It has long been shown that most of the major market fluctuations have been predisposed to certain degree of market disequilibrium as advocated by Soros himself which the rational expectation model fails in explaining such phenomenon. With reference to the classical properties cycle as it has happened in US now, the market is spurred by growing optimism that has yet to be justified in the initial phase of such cycle. In other words, people are not solely buying on valuation basis but most importantly on the perception that they could reap attractive capital gains from their property arbitrages. This exerts an upward pressure on the property prices as a result of the underlying demand for properties itself.

Morever, it has also created a spilled over effect on the demand for their factors of production (ie raw material, labour and utility overhead) and hence causing their respective prices to rise in an upward spiral. Producers may even slow or control the production of these factors of production in anticipation of future price hikes that would eventuate some day. This is often self-perpetuating to such an extent that it exacerbates the rate of inflation growing in the near future. The inflationary effect attributed from the demand for properties and the cost pressure from building materials, labour wages and rising utility overhead further create a multiplier effect on the prices of goods and services across the board until prices reach to a level that could not be sustained anymore. Eventually, inflation will take its toll on the everyday living of the people.

Most central banks might even rise their key interest rate in order to keep the inflationary environment under control. The interest rate hikes itself may erode both realised and unrealised capital gains from property arbitrages because of the fact that home owners are made to shoulder additional mortgage charges in excess of what they really could afford. They might even find that these arbitrages are becoming harder and harder to execute as the liquidity of property market runs dry; a typical situation when prices rise too fast and too steep.

Inflation by itself will act as an implicit tax to our tax payers' pocket in the sense that it forces them to pay more for the usual basket of goods and services then before. It dampens consumer spending and affects growth in an economic system at large. If the inflation condition has coincided with a slow down in economic growth as we might experience right now (as a result of the situation mentioned above), recession will eventually set in.

At this point, this is where the investment and consumption confidence of the people collapse giving way to relentless price cuts in attempt to entice more deals in an already growth stifled environment. On the other hand, people will hoard more cash for future contingencies and less on consumption spending and investment; as a classical instance where rational expectation plays out a self-adjusting and reinforcing process on peoples' consumption and investment behaviour. Cost cutting measures are also put in place in order to enhance the competitiveness of economies in the production of goods and services. As peoples' ability to produce cheaper goods and services increases, this enables them to accumulate more wealth in terms of their ability to churn out greater value of good and services for the economy. This in turn translates into greater purchasing power for the people while the inflation condition is therefore reversed paving the way to a sustained economic recovery.

Thursday, August 21, 2008

Flaws In Rational Expectation: A Blessing In Disguise II

Why are the flaws in rational expectation model considered as a blessing in disguise? According to Soros, people regardless of how rational they might seem, are in actual fact dealing with incomplete information in an imperfect market nowadays which leads them to develop lop-sided views on where the actual market is heading. This imperfect understanding about the market forces causes poeple to engage in different betting or hedging positions for any underlying financial instruments in any financial markets which in turn induces active market participation at the end of the day. This creates more trading opportunities as well as liquidity for market participants in general. The way to make money as perceived by Soros is to look for ways to capitalize on these vagaries in betting positions, to identify and search for the unexpected developments that associate with the opposing market positions and bet on it.

Thursday, August 14, 2008

Flaws In Rational Expectation: A Blessing In Disguise I

Despite being said about the explainatory validity of rational expectation in addressing peoples’ formation of expectation based on available market information, it is too costly in gathering this typical information which is supposedly not readily available to the ordinary people. Even though the so-called optimal forecast (best guess of the future) is the best that closely represents the actual situation, it might be even too expensive to achieve in its entirety. The rationale is that the future cannot be predicted, so that no expectations can be truly “rational”.

Owing to the fact that people are neither perfectly rational nor perfectly informed, it is unreasonable to believe that business owners generally fix their prices with reference to the macroeconomic trends. It might be difficult to get hold of current information on the Federal Reserve's rates and policies as well as the inflation and unemployment rates or even the nation's GDP growth. Even more improbably, how would the people set their budget, prices and wage demands by these indicators accordingly and accurately? This leads the market to have reacted in disequilibrium as opposed to the suggested one and only market equilibrium in rational expectation; as empirical evidence shows that income does not rise in tandem with the escalating cost of living lately.

Lastly, the application of rational expectation hypothesis fails to account for human behaviour in its totality. It simply means that individuals might not draw behavioral references from the prescribed norm that is representative of the group behaviour. People have mixed views and are just biased right through their skins!!! “…..Even if all individuals have rational expectations, the representative individual describing these behaviours may exhibit behaviour that does not satisfy rational expectations (Jansen 1993). In other words, they might have reacted differently given the same set information available in the market place.

Extrapolations have been made from these perceived weaknesses of the rational expectation model, will be discussed in full details later…..

Rational Expectation: A Paradigm Shift

Owing to the limitation of adaptive expectation principle in modeling peoples’ expectation about the future economic conditions based on past experience, the assumption had been relaxed to accommodate the proposition that people form their expectations by making use of all the available information in the market in such interference on these economic conditions is drawn. The concept of rational expectations asserts that outcomes do not differ systematically (i.e., regularly or predictably) from what people expected them to be (the market equilibrium results). The concept is motivated by the same thinking that led Abraham Lincoln to assert, "You can fool some of the people all of the time, and all of the people some of the time, but you cannot fool all of the people all of the time." It does not deny that people often make forecasting errors, but it does suggest that errors will not occur at random order. (Rational Expectations, Thomas J. Sargent)
In the rational expectation model, the actual price denotes as P is the equilibrium price in a simple market, determined by supply and demand. The actual price is equal to its rational expectation as shown as follows:

P = P* + e; e = 0
E(P) = P*

where P* is the rational expectation and e is the random error term, which has an expected value of zero, and is independent of P*. The rational expectation model suggests that the actual price (P) will only vary from the expectation if new set of information of unforeseen nature prevails in a simple market (e). The rational expectation hypothesis draws attention to the way people make decisions by taking all available information into consideration as it is also strongly purported in the efficient market hypothesis (efficient market theory). In a situation where the price of shares does not reflect all the information about it, then an arbitrage opportunity arises; people can buy (or sell) the security to make a profit, thus pushing the price towards equilibrium to the extent that the profit margin will be squeezed to zero. In this instance, all prices are accurately representative of the current market fundamentals (ie capital gains and dividend streams in the future) as they have reflected information about their true values.

Tuesday, August 12, 2008

Dawn of expectation theories

Most of the contemprorary economic models involving the interference of individuals’ perception towards decision making were first derived from the adaptive expectation principle which holds that the future value of economic variables like economic growth, interest rates or inflation can be projected based on past figures inclusive of their margin of error. This simply means that past figures have crucial bearing over future figures unless new set of figures prove otherwise. However, adaptive expectation principle has not been able to account for the ever changing variables and concentrates only on past trends to such an extent that the proposition was abandoned in the early study of hyper inflation.

Let’s us explain this fact in light of the dividend growth model,

Po = [Do x (1 + g)] over (r -g )
Po denotes as the share price at period 0
Do denotes as dividend payout at period 0
g denotes as growth rate
r denotes as interest rate

The proposition suggests that share price is determinant of its dividend payout (Do) growing at a factor of g discounted by the real interest rate (r – g) which is also known as the interest rate adjusted for inflation.

In real life, the dividend growth is pretty much affected by the GDP growth of the economy where dividend growth [D0 x (1 + g)] is a function of GDP growth. On the other hand, the interest rate has an inverse relationship with dividend earnings that implies a higher interest rate erodes profits and hence dividend earnings distribution in terms of having a higher borrowing cost serviced. The interest rate variable is primarily determined by the current state of inflation so to speak; a higher interest rate is needed to curb a higher state of inflation. Empirical evidence also shows that a higher growth rate correlates with a higher level of inflation and thus interest rate might be rise to keep inflation at bay. All these factors are intertwinely fluctuating or even at times evolving on their accord. Hence, the adaptive expectation principle fails to explain the complexity of these economics indicators as progress over time.