I read the first 40 pages of "4 steps to the epiphany" at http://www.stanford.edu/group/e145/cgi-bin/winter/drupal/upl.... It's remarkably dense reading but for someone who was not around during the 2000 bubble, it contains valuable information about what happened.
"There are five types of participants: Smart Money, the Shills, the Marks, the True Believers and the Promoters." I want this to be the start of action movie then you get to see each type of character and how the situation plays out.
It's to do with the asian and russian crises of the late 90s, which he felt showed that the black-scholes models were wrong and inferior to his own multifractal view of the market. After those crashes, he wrote articles and books attacking those ideas.
When you model equities as log-normal ie. log(stock price) is normally distributed, and then use the geometric brownian motion to model the underlying, which spits out derivative prices using Black-Scholes.
The problem is that normal distribution is thin-tailed ie. 5 sigma events are extremely rare.
So use a fat tailed distribution - which is what Mandelbrot did. He used a power-law ( Pareto ) distribution because its infinite variance permitted wider swings in price than the Gaussian. However the simplicity of using a Normal distribution is what makes Black Scholes so robust. If a thousand statisticians look at market data over a time window & model it to fit a lognormal usaing MLE, they'll come up with approximately the same parameters, so calibration is relatively easy. In fact this is one of the standard exercises in any MFE pgm - to calibrate a derivatives model corresponding to underlying data over a time window.
With Mandelbrot's Paretian distribution, calibration is virtually impossible. No two people get the same parameters given the same data points on a Paretian model. There is quite a bit of literature on this very topic, in both Taleb's last book & elsewhere. Mandelbrot points out how given different time windows, the Paretian distribution can be calibrated to fit virtually anything, but the parameters will change wildly.
Essentially, given the choice between an inaccurate robust simple Gaussian model with high predictive power and a supposedly accurate but un-usable Paretian model, financial engineers choose the former & add fudge-factor explanations ( eg. the vol-smile ) to augment the data.
Every trader knows black-scholes doesn't work. According to black-scholes the volatility curve should be flat, but it is actually a smile. Believing black-scholes works is like believing the earth is flat.
BS is one of the most robust computationally amenable closed-form pricers out there.
What does that mean ?
1. Closed-form computationally amenable:
Most pricers aren't closed form. They require you to evaluate an integral using finite differences or a million montecarlo simulations to trace out paths over a binomial tree. MC introduces huge variance so you need antithetic methods & control variates to damp.
http://en.wikipedia.org/wiki/Antithetic_variates
BS is a simple closed form formula that has been programmed in over 30 languages in like 10 lines of code ( Objective-C/iPhone, F#, Autoit, Fortress, Lua, APL, SAS, Mathcad, J, MEL, Postscript, VB.NET, Clean, Ruby, Lisp, Prolog, PL/SQL, LyME, ColdFusion, K, C#, HP48, Transact SQL, O'Caml, Rebol, Real Basic, Icon, Squeak, Haskell, JAVA , JavaScript, VBA, C++, Perl, Maple, Mathematica, Matlab, S-Plus, IDL, Pascal, Python, Fortran, Scheme, PHP, GNU, gnuplot )
2. Incredibly robust:
BS requires very few free params to spit out a ballpark price. That ballpark price is remarkably accurate.
eg. A 3 month at-the-money call should cost
"one-fifth spot times vol. " ( they make us memorize this in class :)
That's it! That's a frequently used Black-Scholes approx.
So call price = S times sigma/5.
So a Cisco September $15 call should be about
15 times 30%/5 = 90 cents.
Guess how much its trading at right now ?
That's right, 88 cents!
See for yourself: http://finance.yahoo.com/q/op?s=CSCO&m=2011-09
Can't get any more robust than that.
It is remarkably accurate ATM, and there are well-known fudge-factors & rules of thumb you can employ as you go deep ITM or deep OTM.
"According to black-scholes the volatility curve should be flat, but it is actually a smile"
Ummm...BS doesn't say anything about a vol curve. It says vol is a single param. A const. A final. So BS assumes vol is constant at all maturities. If you plot a vol curve by graphing vol vs maturities, you will obviously get different shapes in practice. Sometimes you get a smile ( bonds ), other times a skew ( stocks ), other times other weird shapes. Essentially the shape says people prefer ATM options to deep ITM or deep OTM, but obviously prices are dictated by supply-demand, not by some model. So BS is mispricing OTMs & ITMs, but to imply "BS says vol curve should be flat but its not really flat" is backwards. BS assumed vol to be a fixed single param, and any model that assumes vol to change ( say Heston's stochastic local vol ) over maturities will have a really tough time calibrating params for that model. Heston itself requires 5 params...not easy to calibrate.
http://en.wikipedia.org/wiki/Stochastic_volatility
"Believing black-scholes works is like believing the earth is flat."
No its not. 1000 times not.
Believing black-scholes is like believing the earth is a sphere. Is the earth a sphere ? No, its a geoid. ( http://en.wikipedia.org/wiki/Reference_ellipsoid )
But is a sphere a good ballpark approx ? Yeah, a very good one, in fact. Well then, so is BS.
Google around for "fractal stock market" and you'll have some fun. (I don't exactly know where to start suggesting the read, or I'd give a more concrete suggestion.)
Mr. Blank makes some great arguments, and I tend to agree with him.
What's fantastic is that we're so recently removed from a bubble (in housing) that it's entirely familiar. Take his arguments, like the "five types of participants", and apply them retroactively to that bubble. Perfect fit.
Denying the next bubble is futile. They exist; always have, always will.
Not just a housing bubble but a bubble in the exact same industry sector as well!
Of course, a bubble is fundamentally a gross mismatch between future expectations and actual returns. That's why there's no learning from the past, and why it's always "different this time."
More importantly, bubbles don't occur in a vacuum. The 1990's tech bubble wasn't just because the internet was new, and everyone thought it was going to be great. The 1990's also featured low interest rates, the repeal of Glass-Steagall, and other loose policies conducive to asset bubbles. Sound familiar?
Such policies force money to chase yield, which means risk. As it does so, the market sends false signals about the true value of its companies, which reinforce themselves until some "Black Swan" event reveals the imbalances. In 2008, that event was the fall of Lehman Brothers.
As I noted below, if the national government continues to tighten its fiscal and monetary policy, then this bubble will be over before it really began. If, however, the government reloosens after the end of QE 2, it will most likely be full steam ahead.
"Smart Money" ... "but they don’t hype it, talk about it or fan the flames."
"Promoters" ... " they are a small subset of the Smart Money" ... "They loudly tell the Marks and Shills that everything is just fine, enticing them to buy into the bubble,"
Promoters can't be a subset of Smart Money because Smart Money doesn't talk about it, but Promotors talk about it very loudly.
For a couple years now, I've been looking at the market and trying to figure out how to take advantage of the trends. Be 'Smart Money' in other words. I don't think I have the financial sense to make it happen, though.
I think what he meant to say, is that the Smart Money typically does not talk about it or hype it up. However, there are exceptions - and promoters are those exceptions. Perhaps he's making a moral value call, saying how most good investors aren't actively trying to screw the public?
“the size and scale of these new markets have never been seen before; some of these applications and companies will reach billions of customers, generate unprecedented revenues and profits,”
Statements like that always come with bubbles too. They are necessary, but not sufficient. The old dot com bubble was all about a new economy that defied standard valuations -- so you couldn't apply historical models to new these new "internet companies".
Wait, Steve is making the argument that the bubble only exists for new tech companies? Considering there only a handful of IPOs of social/web/mobile/cloud companies, how exactly will this supposed bubble form?
None of these stocks has done well. The market has corrected or is correcting all of them. If there is a bubble and we are on the upswing, it is the least impressive bubble ever.
I think a lot of conventional analysis of investments is looking more foolish than usual because the market isn't keying off what people think it is. Three major things have dominated market movements since the 2008 crisis:
All of these things, through mechanisms both simple and complex, have driven money into equities and speculative investments such as start-ups.
While interest rates will remain low for quite a long time and deficits will no doubt continue, QE2 expires at the end of the month. Additionally, the proportion of the deficit is moving away from stimulus into structural spending such as Medicare. The natural response by the major market players is profit taking. Hence, the IPOs at bubble-like valuations (LinkedIn, Pandora, etc) are running into the teeth of a "smart money" evacuation of the stock market.
If the Fed and government overcome political pressure against further loose policy (always possible if the economy continues to weaken), then I imagine the LNKDs and Ps of the world will pop back up to the eye-watering valuations they attained at the time of their IPOs.
If national fiscal/monetary policy continues to tighten, then the bubble will have been ended before it really began. In which case, LNKD and P will continue to decline, and I would not be surprised to see some of the other hot properties like Zynga delay their market entries. The market for VC funding will also become substantially tighter.
Getting a little tired of "former entrepreneur" professors like Steve and Vivek playing the wet blanket in tech. It's too easy to be negative, especially with the first dot-com bubble so fresh in our minds. It's a lot harder, and more rigorous, to be positive in a frothy market. You have to be smart about it, but you still have to be in it.
It's not about following the herd - it's about being where the herd is (because that indicates there is something big there) but choosing your bets carefully and controlling what you can control. I think it's too easy for these people to throw everything out altogether like we should all just go home and not even try.
I don't think that you'll find many people arguing that there aren't still good things happening in the tech world, nor that there is no money to be made.
The problem is the "this time it's different" sentiment. It never is.
"The issue is whether the next 100+ tech IPO’s carried by this bubble will be worth their offering price in 8 years."
Ask yourself that question. We're going to see a lot more IPO action, and 8 years from now, I think many will be gone.
As an aside, I strongly recommend Steve's book "4 steps to the epiphany." It's the equivalent of a graduate school level course on entrepreneurship.