David R. Henderson  

A Proposed Bet for Bob Murphy

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As regular readers of Econlog probably know, I had a bet with Bob Murphy a few years ago about inflation and I won. Bob is a good sport and he paid up. I follow this part of co-blogger Bryan Caplan's Better's Oath:

When I win a bet, I will not shame my opponent, for a betting loser has far more honor than the mass of men who live by loose and idle talk.

I bet for reasons similar to, but not exactly the same as, Bryan's reasons.

The reason we have in common is that we like inducing people to put their views to the test.

Another reason, which I think Bryan and I have in common, is that I like putting my own views to the test. It makes me less sloppy and more careful in predicting.

Another of my reasons that I haven't seen Bryan mention is that betting is just plain fun: more fun when I win but even fun when I lose.

With that introduction, I want to propose another bet to Bob Murphy. On his blog, Bob wrote the following:

Nobody knows the future, but I think the stock market is clearly in a bubble-with a little help from our friends at the Fed.

I propose to Bob the following bet:
I bet that by May 27, 2020, the S&P 500, adjusted for inflation measured by the CPI, will not be more than 10% lower than it was on May 27, 2015. Even odds with a bet of $500.

Of course, you could argue that Bob and I have already made much bigger bets than that. I haven't checked exactly, but about 45% or more of my net worth is in stock funds, both U.S. and international. I'm guessing that, given his views, well under 25% of his net worth is in stock funds.

So why bet with each other? The main reason is that it's fun. The other reason is that we save all the transactions costs that would be involved with buying, and renewing, puts and calls.

So, Bob, do we have a deal?


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COMMENTS (17 to date)

You must be working, David, with a model of macroeconomy which differs substantially from Bob's.

I think Bob makes his model evident in his writing, but I can't recall learning about your model, David. I'd like to.

David R. Henderson writes:

@Richard O. Hammer,
You must be working, David, with a model of macroeconomy which differs substantially from Bob's.
Not really. I don’t have what could be called a model of the macroeconomy. So I guess it is different, in the sense that nothing is different from something.
But that is all unrelated to the bet. I’m offering Bob a bet about the stock market, not the macroeconomy.

E. Harding writes:

"I bet that by May 27, 2020, the S&P 500, adjusted for inflation measured by the CPI, will not be more than 10% lower than it was on May 27, 2015. Even odds with a bet of $500."
-I think Bob will win. A recession is bound to come by 2019 due to the Fed raising rates.

Borrowed_Username writes:

There's a convexity bias in your bet because of your index for inflation. If inflation is high and it causes you to lose you win fewer dollars in present terms than if inflation is low and that causes you to win.
It's much smaller in this bet than the previous one because you're betting on the price of an asset.

Also if you're an EMT guy you're starting way ahead on this bet.

Mark Bahner writes:

I'm not interested in big-money bets, but I'd be happy to give Bob Murphy 2-1 odds for $20 on that bet. (He wins, I give him $40, he loses, he gives me $20.)

I don't think this figure is adjusted for inflation, which would presumably lower the returns (except during the Depression). But in any case, the S&P 500 seems to almost never produce negative returns on a 5-year rolling average. (Note: The post-2000 period seems particularly bad, which would probably give a wiser man pause. ;-))

S&P 500 5-year returns

Plus, the benefits of artificial intelligence should become very apparent somewhere between 2015 and 2030:

Why economic growth will be spectacular

Jason Clemens writes:

David,

This isn't a good bet for Bob because it largely rests on timing. If you look historically, most market corrections don't last all that long and recover fairly quickly. This means that if Bob took the bet, he's really making a narrower wager than it first appears, which is that the market will correct in 2019. It could correct in 2016, 2017 or 2018 but the likelihood, based on past evidence, is that it will have corrected by 2020. If I were Bob, and interested in the bet (which I'm not), Bob should re-negotiate the terms.

~FR writes:

Good Evening Professor Henderson,

Which part of Mr. Murphy's statement are you trying to test with this bet? That the stock market is in a bubble, or that our friends at the Fed are causing it?

If it is the former, then wouldn't the proper bet be something along the lines of: 'there will not be a 30% correction in the next 4 years?' (Although there are external reasons why a sudden correction might occur that have nothing to do with bubbly behavior.)

If you are going after the latter, I'm not sure how you would structure a bet that would test that.

BC writes:

One problem with this bet is that one of you is essentially selling the other a binary option. For example, David is offering to pay Bob $500 for a binary call option on the S&P that will pay $1000 if the S&P finishes above strike, $0 otherwise. Option values generally do *not* depend on one's directional outlook for the underlying because one can hedge by trading the underlying. Volatility (and perhaps higher-order characteristics like skew and tail risk) are what determine fair option value. So, the implicit bet here is about the higher-order return statistics, not the direction (expected return) of the S&P.

Philo writes:

Jason Clemens has a point. If the S&P drops, say, 25% by the end of 2015, Bob Murphy can plausibly say that the level right now is seen, in retrospect, to have been a "bubble." But if the level then recovers by 2020, David Henderson will win the bet--unless he meant that "between now and May 27, 2020, the S&P 500, adjusted for inflation measured by the CPI, will never have been more than 10% lower than it was on May 27, 2015."

Philo writes:

"Of course, you could argue that Bob and I have already made much bigger bets than that." The real worry is that you have made bets in the opposite direction, hedging and thus, in effect, nullifying your bet with each other. Only your total portfolio constitutes your "putting your money where your mouth is," not a single bet of a relatively small size. Small single bets can be no more than tokens or gestures, of no real significance for assessing your sincerity.

Market Fiscalist writes:

David,

I admire your free-market but common sense approach to these kinds of things.

I also love Bob's blog.

Are you able to expand on why you are offering Bob this bet ?

Do you disagree there is a bubble in the stock market, or just think it will last beyond 2020? Or perhaps other reasons ?

Nathan writes:

Maybe David has been listening to Scott on the existence of bubbles. :)

blink writes:

Talk about a one-sided bet! If you believe we are not in a bubble, then you ought to take the upside on S&P over the next five years vs. historical trend.

In fact I agree with you that we are not in a bubble, but even flat returns over the next five years would count as strong evidence that I am wrong. Your lopsided terms belie your strongly worded belief.

Bob Murphy writes:

Here's my answer, David. I'm not as fun as I used to be.

Barry "The Economy" Soetoro writes:

"I think Bob will win. A recession is bound to come by 2019 due to the Fed raising rates."

I agree we're due for a recession, but the CAUSE is not the Fed manipulating rates, but rather BAD INVESTMENTS IN THE ECONOMY.

Roger McKinney writes:

That's not a good bet for Bob because if he will think about how the business cycle affects the stock market he will see that a recession in the near future will cause a market crash, but the following expansion will boost the market. Also, the Fed will rapidly expand credit and add more fuel to the market. By 2020 the market will have recovered from the next recession and be in bubble mode again. I explain how the ABCT impacts the market on my blog.

Most Austrian economists got price inflation wrong after the last recession because we forgot Mises' warnings that the next worse mistake to ignoring the quantity theory of money was to assume it worked mechanically.

High inflation, like that of the 70's, needs massive government spending to catch on and the winding down of the war prevented that. Plus the debt level was too high.

Individuals haven't borrowed and instead paid down loans, which works to shrink the money supply. Businesses didn't borrow to invest because taxes are too high and regulations are strangling business. Much of the new money the Fed created went overseas as investments or to buy imports.

Finally, banks have been reluctant to loan because they could earn good money on the carry trade of borrowing from the Fed and loaning to the government or keeping excess reserves at the Fed and earning interest.

Massive indebtedness is keeping the economy, and inflation, hog tied.

Roger McKinney writes:

PS, if Dr. Henderson would like to make a bet that the stock market will not be lower than 10% below the May 27, 2015 S&P 500 at its lowest point next year, I would gladly put some money on that one!

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