Friday, November 6, 2015

The value premium and non-ideal information transfer

I always get nervous when everything I see appears to be confirmation of some pet theory I have. While this is in fact a property of a theory that is correct, it's also a property of confirmation bias and delusion. Of course, being able to ask the question is a sign that you're not delusional. Or is that just confirmation bias ...

Anyway, Noah Smith has an article that talks about an effect that appears to be confirmation of the information transfer model (ITM). It's called the value premium, and I'm it's disappearing.

I used the ITM to build a toy model [1] of stock prices in terms of book value to try to understand the so-called dark matter problem. However, if you consider non-ideal information transfer, prices should fall below their ideal price [2] (because the solutions to the differential equation act as a bound via Gronwall's inequality). Here's the picture from [2] (P is price, S is supply of "book widgets", called B in [1], D is demand, called M in [1] for market capitalization):


There would be stocks where the realized price (green line) was less than the ideal price (the black line bound). The so-called endowment effect would lead to more ideal information transfer over time if there are more and more trades -- assuming there wasn't some kind of non-ideal behavior leading to a fall in price.

A non-ideal price would be seen as a "value premium", and it would tend to vanish as the market for those stocks became more ideal.

1 comment:

  1. I would disagree with Noah- while the "value premium" has underperformed recently, investors are still way overpaying for growth and momentum. Also, the average PE ratio during this time has drifted upwards, such that there are fewer value stocks to buy. That does not sound efficient to me, rather that investing fashion has changed. My own opinion is that in our demand constrained, low growth, information trap world that investors are overvaluing growth. So bubbles continue to be blown and dissipate, perhaps without stocks really drifting down to their historic lows.

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