Investors can profit from the insights of this year’s Nobel prizewinners in economics.  Though each award winner’s viewpoint seemingly contradicts the other’s viewpoint, together they provide insight into how securities markets are valued.

Eugene Fama of the University of Chicago is father of the Efficient Markets Hypothesis (EMH);   Robert Shiller of Yale University shot down his theory.  Both were awarded the Nobel Prize in economics last month.

This week we examine three articles on the contribution each man has made in our understanding of how securities markets work.  The first article is a basic introduction to the viewpoints of each.  The second article examines how each views the existence of asset price bubbles—the condition where asset prices deviated sharply from the level justified by fundamentals.  The third article examines real world applications of the thoughts of Fama and Shiller.

Investors can profit from the insights of this year’s Nobel prizewinners in economics.  Those who know the work of Eugene Fama and Robert Shiller may find it odd that they both are honored with the Nobel Prize in Economics in the same year.  Their approaches differ, yet there is much common ground.  “Fama’s great insight is the “efficient markets hypothesis,” which asserts that “movements in asset prices are not predictable in the short term

[emphasis added], and thus professional fund managers are unlikely to beat the market.”  Markets are quick to incorporate new information.  The underlying principle is “there are no free lunches to be had.”  Fama’s theory has some limits though.  Shiller found that “prices were much more volatile than their intrinsic value would suggest—something that is hard to square with the idea of efficient markets and ‘rationality’ of pricing. In the long term the valuation of assets tends to revert to the mean, and thus market movements are eventually predictable.”   In Mr. Fama’s world, price bubbles do not exist; in Mr. Shiller’s world, they do exist.  Shiller observes that when bubbles are forming “everyone wants to jump on the bandwagon.  It is no use hoping that ‘rational’ investors will drive prices back to fair value”….hence the bubbles in asset markets in the last decade. Shiller’s views, however, do not invalidate Mr. Fama’s insight that it is hard to make money from short-term trading. The Economist (tiered subscription model).

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The Nobel Laureates on equity bubbles.  This article presents the different perspectives of Fama and Shiller on asset bubbles—where “the asset price has deviated sharply from the level justified by fundamentals.”  “Fama basically thinks that most of the variation in asset prices is determined by changes in risk appetite [emphasis added].”  When investors as a whole are risk-seeking, the equity market level will be high, and return expectations low.  Shiller’s approach is different.  “He believes that it is implausible that the risk appetite in the financial markets changes in a manner which can explain the over-reaction of equities to the relevant economic fundamentals…in the absence of a plausible explanation based on risk appetite, he suggests that the explanation must lie in behavioral factors, including the possibility of irrational bubbles in the asset price….Shiller expects investors to be bullish at the top [emphasis added] of the market…in Fama’s world, this represents inefficient bubble-like behavior, which should be eliminated by an influx of rational investors taking the opposite point of view.  But in practice this does not seem to happen.  Instead investors behave in herd-like fashion in the short-term, driving asset prices higher and higher.”   The author further notes that based on Shiller’s market valuation measures, equities are not yet abnormally high [emphasis added].  Financial Times (tiered subscription model).

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Real World application of Fama and Shiller.  “The efficient markets hypothesis may not adhere very often in real life, but it provides a great framework, as its conditions are relaxed one by one, for analyzing the market’s inefficiencies.  One such inefficiency is the ‘small company’ effect—smaller capitalization stocks tend to outperform large ones in the longer term.  And there is a ‘value effect’—cheap stocks do better than expensive ones…there is also a ‘momentum effect’—once stocks have started moving in a particular direction, they tend to keep moving in that direction, counter to the random walk theory.  Whether these are attributable to risk factors or market inefficiencies does not matter…both Fama and Shiller are crucial figures in the ongoing academic attempt to understand how securities markets are valued.”   Financial Times (tiered subscription model).

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And in case you missed it, click here to read last week’s blog post which focuses on the recent Federal Reserve meeting and the housing slowdown.

We hope you enjoy reading these articles along with us and that you find them informative.  Please forward this to your friends and family.

 

J. Mark Nickell & Co.

 

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