Markets and the year of trouble

A related article in the The Economist entitled Beyond reason says:

... how do you explain the dotcom bubble, when companies with no profits and barely any sales had billion-dollar valuations? And what lies behind the continued existence of market anomalies, such as the tendency for smaller companies to outperform?

Academics have been discovering these effects for decades. There are seasonal patterns (stocks tend to do well in January and poorly during the summer). There are also valuation discrepancies (growth stocks tend to underperform). Some of these effects may be random. Analyse enough data and a few oddities will show up; plenty of people think some lottery numbers are “lucky” because they occur more often—though it would be odder still if they all turned up the same number of times. Other effects are real, but may be costly to exploit. For small companies, higher returns may be negated by higher costs, reduced liquidity and higher risk (smaller firms are more likely to go bust).

This is all very topical as the global economy comes to terms with stock, credit, housing and retail markets which do not appear to have behaved ‘rationally’ in recent months.

Mandelbrot has 5 rules about markets:

1/ Markets are risky
2/ Trouble runs in streaks
3/ Markets have a personality
4/ Markets mislead
5/ Market time is relative

I particularly like the idea of rule 3: this is useful to consider in the light of speculative bubbles (on a micro level) and economic booms and busts (in a macro level); perhaps this is akin to the animal spirits discussed by Keynes.

As for rule 2: to what extent 2008 turns out to be the year of trouble is yet to be seen.