Nobel Prize a Nod to Our Murky Understanding of Markets

This year’s Nobel Prize in economics was recently awarded to three different economists: The University of Chicago’s Eugene F. Fama (pictured left) and Lars Peter Hansen, as well as Yale University’s Robert J. Shiller. Each of the three men have focused on different areas of economics and finance. What is perhaps most notable is that the views of Fama and Shiller are in many ways incompatible.

Fama is, of course, famous for his work on efficient-market hypothesis (EMH), claiming that professional investors cannot outperform the market. In fact, his seminal work helped launch the index-fund industry. In contrast, Shiller’s work emphasizes the imperfections of markets and their penchant for developing predictable bubbles in asset prices. Shiller issued prescient warnings about the bubble in security prices in the late 1990s and, likewise, warned of a real estate bubble in the 2005–2006 time frame.

So, who’s right, Fama or Shiller? In nominating both Shiller and Fama, it seems that the Nobel Foundation recognizes that many open questions about the operation and efficiency of financial markets remain.

It is thought by some that Hansen’s work is the quintessential missing link between Fama and Shiller. Over the years, Hansen has developed statistical modeling techniques that have enabled researchers to explicitly identify previously implicit assumptions embedded in their analysis, helping to clarify cause and effect in the macroeconomy. These models have even greatly influenced other Nobel Prize winners, including Thomas Sargent.

The contrasts among the work of these three men highlights the murky, unresolved nature of our knowledge about how markets function. Nevertheless, the prize committee seems to have recognized that even conflicting theories can both be right, if only at points in time.

Here are some CFA Institute resources to help readers navigate the issues.

• An Experienced View on Markets and Investing: At the 65th CFA Institute Annual Conference in Chicago, Robert Litterman interviewed Eugene F. Fama to elicit his views on financial markets and investing.
• Unapologetic after All These Years: Eugene Fama Defends Investor Rationality and Market Efficiency: Addressing the 65th CFA Institute Annual Conference, Fama recounted a lifetime of distinguished scholarship and achievement. The unofficial “father of modern finance” took on recent criticisms of the efficient markets hypothesis and issued stinging rebukes of “too big to fail” banks, underfunded pension plans, active investment management, and behavioral investors.
• Size, Value, and Momentum in International Stock Returns: Fama and Kenneth R. French observe higher average returns of value stocks relative to those of growth stocks in four regions (Asia Pacific, Japan, Europe, and North America). The value premiums decrease as stocks increase in market capitalization (size). Momentum is also present in every region (except Japan), and it decreases with increases in size.
• Luck versus Skill in the Cross-Section of Mutual Fund Returns: Fama and French study luck versus skill in actively managed equity mutual funds, assuming that active funds with positive α are balanced by those with negative α. In a cross-section, they find that true α in net returns is negative for most active funds. With gross returns, they find evidence of positive and negative skill.
• The Anatomy of Value and Growth Stock Returns: Average returns on value and growth portfolios are broken into dividends and three sources of capital gain: (1) growth in book equity, primarily from earnings retention, (2) convergence in price-to-book ratios (P/Bs) from mean reversion in profitability and expected returns, and (3) upward drift in P/B during 1927–2006. The capital gains of value stocks trace mostly to convergence: P/B rises as some value companies become more profitable and their stocks move to lower-expected-return groups. Growth in book equity is trivial to negative for value portfolios but is a large positive factor in the capital gains of growth stocks. For growth stocks, convergence is negative: P/B falls because growth companies do not always remain highly profitable with low expected stock returns. Relative to convergence, drift is a minor factor in average returns.
• Capitalism and Financial Innovation: At the 2012 CFA Institute Financial Analysts Seminar, Shiller discussed his view that capitalism must be constantly updated through innovation in order to be successful in its purpose of achieving society’s goals. Three recent innovations — the benefit corporation, crowd funding, and the social impact bond — are good examples of how finance and financiers can contribute to attaining these goals.
• Irrational Exuberance Revisited: Speculative bubbles have long been a feature of financial and asset markets, both in the United States and elsewhere. Although the bubble in the US stock market collapsed in roughly 2000, housing prices now appear to be dramatically overvalued. Indeed, recent dramatic home price increases in the United States cannot be explained by fundamentals. Over the long run, real home prices may not increase by as much as investors expect today. Real estate is America’s second largest asset class, and a new futures market now enables investors to hedge or to speculate against changes in residential home prices in 10 large U.S. cities, offering a portfolio diversification benefit provided the fledgling derivatives market flourishes.
• Current Estimates and Prospects for Change: The equity premium puzzle and the foundations of behavioral finance are inseparable. The equity premium puzzle is a puzzle only if we assume that people’s expectations are consistent with past historical averages, that expectations are rational. But behavioral finance has shown repeatedly the weakness of the assumption that rational expectations consistently drive financial markets. This presentation explores, in the context of recent stock market behavior, a number of reasons to doubt that rational expectations always find their way appropriately into stock prices. The reasons stressed have to do with psychological factors: (1) the difficulty that committees, groups, and bureaucracies have in changing direction, (2) the inordinate influence of the recent past on decisions, (3) the tendency (perhaps the need) to rely on “conventional wisdom,” and (4) group pressure that keeps individuals from expressing dissent.
• Reflections on Finance and the Good Society: Shiller examines whether the actions of financial institutions help people pursue their individual goals and feel at peace with society. He concludes that finance can be redesigned to fit better with the notion of the “good society.”
• Book Review: Finance and the Good Society: Shiller is renowned for identifying the stock market bubble as early as 1996 and the real estate bubble in 2006. One might assume that he is not a fan of the financial industry, given its past excesses and ensuing wealth destruction, but one would be wrong. In Finance and the Good Society, Shiller suggests that the industry can serve the common good rather than be a parasite. He makes the case that financial innovation can create the kind of inclusive society in which all can benefit. Shiller contends that the recent financial crisis was caused not by greed and dishonesty but by the structural shortcomings of financial institutions.

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