Nov

25

Black was right: Price is within a factor 2 of Value:

J. P. Bouchaud, S. Ciliberti, Y. Lempérière, A. Majewski, P. Seager & K. Sin Ronia Capital Fund Management, 23 rue de l'Université, 75007 Paris, France

Abstract:

We provide further evidence that markets trend on the medium term (months) and mean-revert on the long term (several years). Our results bolster Black's intuition that prices tend to be off roughly by a factor of 2, and take years to equilibrate. The story behind these results fits well with the existence of two types of behaviour in financial markets: "chartists", who act as trend followers, and "fundamentalists", who set in when the price is clearly out of line. Mean-reversion is a self-correcting mechanism, tempering (albeit only weakly) the exuberance of financial markets.

See also: "the holy hand grenade"

Doc Castaldo writes: 

"Black was right: Price is within a factor 2 of Value"

This goes back to a famous difference of opinion between Robert C. Merton and Fischer Black.

In trying to explain Efficient Markets to a student audience, Merton said that to him an Efficient market was one where prices are within 5% of true value 95% of the time. This was his subjective estimate of how efficient he thought the stock market was, and a way of communicating the idea of high but not perfect efficiency to the audience.

Fischer Black had a looser concept and said that to him, efficiency only meant that prices are within a factor of 2 of true value at least half the time. The rest was what he called "noise", i.e. random divergences from true value.

The problem of course is that these are only analogies and no one knows what the "true value" is and therefore how far away from it the market is.


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