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"Maybe the future will be perpetually irrational about asset prices" is not really a compelling economic story. There is indeed a mathematical relation between

"Maybe the future will be perpetually irrational about asset prices" is not really a compelling economic story. There is indeed a mathematical relation between long run asset prices and the income generated by those assets. In the short run you can do whatever you want, but the long run constraint is predictably enforced by arbitrage. (it is left as an exercise to construct the most entertaining arbitrage play in a world where stock prices diverge indefinitely from the value produced by the underlying assets via some magic.)

dragonwriter 10y ago
> "Maybe the future will be perpetually irrational about asset prices" is not really a compelling economic story. Perhaps, but then we are getting into rational expectations and not mathematical constraints. (Though, really, given that rationality requires perfect knowledge of future utilities, "the future will be perpetually irrational about asset prices" is pretty much guaranteed to be true except for intermittent times when it isn't momentarily largely by chance; even a consistent divergence in a particular direction from rationality isn't surprising, given what we the particular ways in which people tend to be deviate from economic rationality in practice.) > There is indeed a mathematical relation between long run asset prices and the income generated by those assets. No, there is a mathematical relation between reasonable asset prices and expected income streams that the assets will generate. > In the short run you can do whatever you want, but the long run constraint is predictably enforced by arbitrage. "In the long run, we're all dead" -- Keynes Even granting your point for the sake of argument, what must ultimately be true in the long run assuming an infinite time horizon need never actually be true in the physical universe we inhabit. Irrationality in prices can be maintained indefinitely, even though not infinitely -- but then, the market can't actually exist infinitely, anyway.
- smallnamespace 10y ago
  Betting that the market reverts to 'rational' pricing in any short time frame is a risky bet, but I'll claim it's much, much more reasonable than assuming that irrationality persists indefinitely. OTOH, there's another story to why equity returns are higher than GDP returns: equity investors are being compensated for the higher risk.
  - h4nkoslo 10y ago
    It's not even that "irrationality persists indefinitely", it's that it increases towards infinity. Equity > GDP as a return to risk would require you to be able to "invest in GDP" in a relatively variance-free way. Social Security or seizing control of the government (or at least its taxing power) is about as close as you can get, but neither is really securitizable.
    - smallnamespace 10y ago
      > Equity > GDP as a return to risk would require you to be able to "invest in GDP" in a relatively variance-free way Technically no, it just requires one to be able to construct a basket that approximately returns GDP growth (along with GDP variance). Note that total returns to equity include dividends, so you can easily have equity give outsize returns without total market cap approaching 100% of assets.
  - adwn 10y ago
    > OTOH, there's another story to why equity returns are higher than GDP returns: equity investors are being compensated for the higher risk. This gets mentioned very often in such debates, but the implied causal connection is wrong: There is no guarantee that higher risk leads to higher returns. It's not like the stock market says "We should keep up increasing stock prices so that equity investors are being compensated for their risk." Over long timespans, stock prices are coupled to the performance of the underlying companies (mostly their income streams), not to risk. So far, there has been a correlation, but there has never been a guaranteed causal relation between risk and stock returns.
    - smallnamespace 10y ago
      > There is no guarantee that higher risk leads to higher returns. It's not like the stock market says "We should keep up increasing stock prices so that equity investors are being compensated for their risk." The mechanism is much simpler: asset prices of risky assets today will fall because willing buyers demand a higher return for the risk. E.g. you have a stock and a bond both at $100 with the same expected return. Investors aren't happy with that, so they refuse to buy the stock until its price falls and its implied return rises.
- h4nkoslo 10y ago
  I am talking about a long run relation between two long run quantities, which either fluctuates in a certain band around equilibrium, or allows the economic equivalent of perpetual motion. You seem to be predicting a diverging trend in that relation towards infinity, which is insane, as infinities tend to be. I conclude from this you're misunderstanding the notion of "long term equilibrium" as stronger than it is in reality. Construct a model that simultaneously allows infinite divergence between securitized asset prices and their associated incomes, and disallows easy arbitrage, or we have nothing to talk about. Every fool digs up that Keynes quote when his model is wrong.

dragonwriter 10y ago

> "Maybe the future will be perpetually irrational about asset prices" is not really a compelling economic story. Perhaps, but then we are getting into rational expectations and not mathematical constraints. (Though, really, given that rationality requires perfect knowledge of future utilities, "the future will be perpetually irrational about asset prices" is pretty much guaranteed to be true except for intermittent times when it isn't momentarily largely by chance; even a consistent divergence in a particular direction from rationality isn't surprising, given what we the particular ways in which people tend to be deviate from economic rationality in practice.) > There is indeed a mathematical relation between long run asset prices and the income generated by those assets. No, there is a mathematical relation between reasonable asset prices and expected income streams that the assets will generate. > In the short run you can do whatever you want, but the long run constraint is predictably enforced by arbitrage. "In the long run, we're all dead" -- Keynes Even granting your point for the sake of argument, what must ultimately be true in the long run assuming an infinite time horizon need never actually be true in the physical universe we inhabit. Irrationality in prices can be maintained indefinitely, even though not infinitely -- but then, the market can't actually exist infinitely, anyway.

smallnamespace 10y ago
Betting that the market reverts to 'rational' pricing in any short time frame is a risky bet, but I'll claim it's much, much more reasonable than assuming that irrationality persists indefinitely. OTOH, there's another story to why equity returns are higher than GDP returns: equity investors are being compensated for the higher risk.
- h4nkoslo 10y ago
  It's not even that "irrationality persists indefinitely", it's that it increases towards infinity. Equity > GDP as a return to risk would require you to be able to "invest in GDP" in a relatively variance-free way. Social Security or seizing control of the government (or at least its taxing power) is about as close as you can get, but neither is really securitizable.
  - smallnamespace 10y ago
    > Equity > GDP as a return to risk would require you to be able to "invest in GDP" in a relatively variance-free way Technically no, it just requires one to be able to construct a basket that approximately returns GDP growth (along with GDP variance). Note that total returns to equity include dividends, so you can easily have equity give outsize returns without total market cap approaching 100% of assets.
- adwn 10y ago
  > OTOH, there's another story to why equity returns are higher than GDP returns: equity investors are being compensated for the higher risk. This gets mentioned very often in such debates, but the implied causal connection is wrong: There is no guarantee that higher risk leads to higher returns. It's not like the stock market says "We should keep up increasing stock prices so that equity investors are being compensated for their risk." Over long timespans, stock prices are coupled to the performance of the underlying companies (mostly their income streams), not to risk. So far, there has been a correlation, but there has never been a guaranteed causal relation between risk and stock returns.
  - smallnamespace 10y ago
    > There is no guarantee that higher risk leads to higher returns. It's not like the stock market says "We should keep up increasing stock prices so that equity investors are being compensated for their risk." The mechanism is much simpler: asset prices of risky assets today will fall because willing buyers demand a higher return for the risk. E.g. you have a stock and a bond both at $100 with the same expected return. Investors aren't happy with that, so they refuse to buy the stock until its price falls and its implied return rises.
h4nkoslo 10y ago
I am talking about a long run relation between two long run quantities, which either fluctuates in a certain band around equilibrium, or allows the economic equivalent of perpetual motion. You seem to be predicting a diverging trend in that relation towards infinity, which is insane, as infinities tend to be. I conclude from this you're misunderstanding the notion of "long term equilibrium" as stronger than it is in reality. Construct a model that simultaneously allows infinite divergence between securitized asset prices and their associated incomes, and disallows easy arbitrage, or we have nothing to talk about. Every fool digs up that Keynes quote when his model is wrong.