Today’s post is from Gert Wehinger of the OECD’s Directorate for Financial and Enterprise Affairs
Investors’ behaviour on stock markets has been likened to the irrationality described in Charles Mackay’s 1841 classic Extraordinary Popular Delusions and the Madness of Crowds. But there is also a more positive view of what crowds can achieve. In his 2005 book The Wisdom of Crowds, James Surowiecki argued that “diversity and independence are important because the best collective decisions are the product of disagreement and contest, not consensus or compromise.” Diversity and disagreement certainly characterise this year’s Nobel prize for economics, even if Eugene F. Fama, Lars Peter Hansen and Robert J. Shiller shared the award “for their empirical analysis of asset prices”.
Fama’s work is based on the idea that asset returns should be impossible to predict if asset prices reflect all relevant information. He tested empirically (and found new methods like event studies to do so) the efficient markets hypothesis (EMH), for which he and his followers found ample evidence. That is, in the very short run, like a day or a week, if all available information is incorporated in share prices, you cannot beat the market. While he accepts that there are factors like information or transaction costs that weaken the pure EMH, any anomalies – like the difference between value and growth stocks he analysed in a 1998 paper – are explained within the same rational investor framework, and risk factors would account for the differences. However, such anomalies (or “market imperfections”) may open up short-run arbitrage opportunities (that Fama himself exploits in his fund-management firm). Hedge funds and algorithmic traders in particular thrive on these imperfections.
Thus, Fama’s EMH is perhaps a great insight for theorists and algo-traders, but it is, in principle, tautological and often becomes useless in practice (yes, algo traders can also go bust) where market anomalies can go beyond rationality. While these anomalies still tend to leave markets unpredictable, the reasons underlying such unpredictability may be quite different from the agnostic view of market rationality, that deprives the researcher almost by definition from gaining better insights into the “true” functioning of markets and a better understanding of longer-term price movements, including bubbles.
Shiller thought outside the EMH box by exploring departures from Fama’s efficient market rationality using insights from behavioural finance (many of the ideas were developed by the 2002 Laureates Daniel Kahneman and Amos Tversky). Such departures, if they can be identified in asset prices, may open up arbitrage opportunities by rational investors to take advantage of misperceptions of irrational investors. While rational arbitrage trading would push prices back toward the levels predicted by non-behavioral theories, this is still not the world as described by Fama, where rational information is processed immediately. In Shiller’s framework, bubbles can not only exist, but there is also a possibility that they can be identified.
Hansen has tested many of these theories in his generalised method of moments (GMM) framework. If you cannot forecast stock prices, maybe you can find patterns in their volatility or other statistical moments that can be exploited. Hansen found, for example, that asset prices fluctuate too much for a rational expectations-based model to hold. This work has been carried forward in several ways, for example improving measures of risk and attitudes towards risk that may change depending on the economic situation. This is just one example of how this research can generate new insights about human behaviour more broadly.
Shiller showed the importance of social psychology for finance and economics using evidence from investor surveys. In the 2005 edition of his book Irrational exuberance, Shiller extended his analysis to real estate, arguing that the real estate market was irrationally overvalued, and he predicted large problems for financial institutions with the eventual burst of the real estate market “bubble”. But he was also aware of the problems a bursting stock market bubble would have on retirement income from pension plans that rely on equity investments, and he wondered about the “curious lack of public concern about this risk.” More generally, he also pointed out that the “tendency for speculative bubbles to grow and then contract can make for very uneven distribution of wealth” that may even make us “question the very viability of our capitalist and free market institutions”. He saw an important role for policy to address these issues.
The first line of policy defence against asset price bubbles is monetary policy, but bubbles are hard to identify and policy makers are reluctant to ‘prick’ a bubble. Robert Lucas, the 1995 Nobel Prize winner, noted that the main lesson from the efficient market hypothesis “for policymaking purposes is the futility of trying to deal with crises and recessions by finding central bankers and regulators who can identify and puncture bubbles. If these people exist, we will not be able to afford them.” (The Economist, Aug 6th 2009)
The Prize Committee in its decision seemed to want to reconcile a short-run and a long-run theory of asset prices, with Fama’s finding of that stock prices are unpredictable in the short run and Shiller showing that there is some predictability in the long run (Fama would not dispute that idea in principle as his own research found that stock returns become more predictable the longer the period considered).
But knowing that Fama as recently as January 2010) defiantly denied the existence of asset price bubbles because they cannot be identified and predicted, and Shiller (along with others) recognises bubbles and calls the EMH argument that stock prices reflect fundamentals “one of the most remarkable errors in the history of economic thought”, it will be interesting to see how the the three laureates interact on stage at the award ceremony in December in Stockholm.
Perhaps Hansen will have to play the role of a mediator with a humble remark like the one he made shortly after hearing about his award: “We are making a little bit of progress, but there’s a lot more to be done.”
OECD Journal Financial Market Trends