Ersatz Nobel bets both ways in asset price prize


The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2013 (remember there is no actual Nobel Prize for economics) has gone to three men that share a theme: asset prices.

Eugene Fama, Lars Peter Hansen, and Robert Shiller have developed empirical methods and used these methods to reach important and lasting insights about the determination of asset prices. Their methods have shaped subsequent research in the field and their findings have been highly influential both academically and practically. The waves of research following the original contributions of the Laureates constitute a landmark example of highly fruitful interplay between theoretical and empirical work. We now know that asset prices are very hard to predict over short time horizons, but that they follow movements over longer horizons that, on average, can be forecasted. We also know more about the determinants of the cross-section of returns on different assets. New factors – in particular the book-to-market value and the price-earnings ratio – have been demonstrated to add significantly to the prior understanding of returns based on the standard CAPM. Building on these findings, subsequent research has further investigated how asset prices are fundamentally determined by risk and attitudes toward risk, as well as behavioral factors.

There is an immediate oddity here. Eugene Fama is considered the father of the “efficient market theory”, that line of thought that argues any asset price is always perfect because it incorporates all available information. On the other hand, Robert Shiller is considered the father of behavioural economics, which posits almost the exact opposite, that asset prices are influenced heavily by the irrationality of people and often have nothing whatsoever to do with any efficiency of value. Perhaps we can say that the ersatz Nobel is illustrating its own point, incorporating all available information then forming a judgement based upon an all-too-human act of arse-covering.

The contradiction eases somewhat in the rationale:

The behavior of asset prices is essential for many important decisions, not only for professional investors but also for most people in their daily life. The choice between saving in the form of cash, bank deposits or stocks, or perhaps a single-family house, depends on what one thinks of the risks and returns associated with these different forms of saving. Asset prices are also of fundamental importance for the macroeconomy because they provide crucial information for key economic decisions regarding physical investments and consumption.

While prices of financial assets often seem to reflect fundamental values, history provides striking examples to the contrary, in events commonly labeled bubbles and crashes. Mispricing of assets may contribute to financial crises and, as the recent recession illustrates, such crises can damage the overall economy. Given the fundamental role of asset prices in many decisions, what can be said about their determinants?

This year’s prize awards empirical work aimed at understanding how asset prices are determined. Eugene Fama, Lars Peter Hansen and Robert Shiller have developed methods toward this end and used these methods in their applied work. Although we do not yet have complete and generally accepted explanations for how financial markets function, the research of the Laureates has greatly improved our understanding of asset prices and revealed a number of important empirical regularities as well as plausible factors behind these regularities.

The question of whether asset prices are predictable is as central as it is old. If it is possible to predict with a high degree of certainty that one asset will increase more in value than another one, there is money to be made. More important, such a situation would reflect a rather basic malfunctioning of the market mechanism. In practice, however, investments in assets involve risk, and predictability becomes a statistical concept. A particular asset-trading strategy may give a high return on average, but is it possible to infer excess returns from a limited set of historical data? Furthermore, a high average return might come at the cost of high risk, so predictability need not be a sign of market malfunction at all, but instead just a fair compensation for risk-taking. Hence, studies of asset prices necessarily involve studying risk and its determinants.

Predictability can be approached in several ways. It may be investigated over different time horizons; arguably, compensation for risk may play less of a role over a short horizon, and thus looking at predictions days or weeks ahead simplifies the task. Another way to assess predictability is to examine whether prices have incorporated all publicly available information. In particular, researchers have studied instances when new information about assets becomes became known in the marketplace, i.e., so-called event studies. If new information is made public but asset prices react only slowly and sluggishly to the news, there is clearly predictability: even if the news itself was impossible to predict, any subsequent movements would be. In a seminal event study from 1969, and in many other studies, Fama and his colleagues studied short-term predictability from different angles. They found that the amount of short-run predictability in stock markets is very limited. This empirical result has had a profound impact on the academic literature as well as on market practices.

If prices are next to impossible to predict in the short run, would they not be even harder to predict over longer time horizons? Many believed so, but the empirical research would prove this conjecture incorrect. Shiller’s 1981 paper on stock-price volatility and his later studies on longer-term predictability provided the key insights: stock prices are excessively volatile in the short run, and at a horizon of a few years the overall market is quite predictable. On average, the market tends to move downward following periods when prices (normalized, say, by firm earnings) are high and upward when prices are low.

In the longer run, compensation for risk should play a more important role for returns, and predictability might reflect attitudes toward risk and variation in market risk over time. Consequently, interpretations of findings of predictability need to be based on theories of the relationship between risk and asset prices. Here, Hansen made fundamental contributions first by developing an econometric method – the Generalized Method of Moments (GMM), presented in a paper in 1982 – designed to make it possible to deal with the particular features of asset-price data, and then by applying it in a sequence of studies. His findings broadly supported Shiller’s preliminary conclusions: asset prices fluctuate too much to be reconciled with standard theory, as represented by the so-called Consumption Capital Asset Pricing Model (CCAPM). This result has generated a large wave of new theory in asset pricing. One strand extends the CCAPM in richer models that maintain the rational-investor assumption.

Another strand, commonly referred to as behavioral finance – a new field inspired by Shiller’s early writings – puts behavioral biases, market frictions, and mispricing at center stage. A related issue is how to understand differences in returns across assets. Here, the classical Capital Asset Pricing Model (CAPM) – for which the 1990 prize was given to William Sharpe – for a long time provided a basic framework. It asserts that assets that correlate more strongly with the market as a whole carry more risk and thus require a higher return in compensation.

In a large number of studies, researchers have attempted to test this proposition. Here, Fama provided seminal methodological insights and carried out a number of tests. It has been found that an extended model with three factors – adding a stock’s market value and its ratio of book value to market value – greatly improves the explanatory power relative to the single-factor CAPM model. Other factors have been found to play a role as well in explaining return differences across assets. As in the case of studying the market as a whole, the cross-sectional literature has examined both rational-investor–based theory extensions and behavioral ones to interpret the new findings.

So there you have it. Asset prices are unpredictable in the short term but more so in the long term and markets buy the dips and sell the tops. Profound stuff.

The only remaining question I have is why the ersatz Nobel didn’t go to an Australian. If you’re going to talk asset prices there is nobody – nobody – more equipped with information and irrationality than a randomly selected Aussie.

Houses and Holes
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  1. IMO Shiller has a point, stocks can move even without the tiniest bit of information.

    Market are quite ridiculous, you need luck to make your dough from the chaos.

    • You think Shiller has a point because it agrees with your view of the world. How convenient.

      What you disregard is the fact they move is a signal in and of itself. Aren’t you a great proponent of momentum following? Well the price and change in price is information. The biggest piece of info! And because there are so many that “trade” in this manner prices will be volatile and go past the efficient price both on the way up and down.

      By the way since you are so interested in the human factor in finance, you might be interested in these pieces of works:

      • which come first, egg or chicken ?

        Prices can be so disconnected from economic reality/risk ( i.e strong correlation between stocks/all financial vehicles (especially when shit hits the fan)/markets (correlation US market – ASX/ totally different economy)) that information has probably not that much of a bearing.

      • Prices can be so disconnected from economic reality/risk ( i.e strong correlation between stocks/all financial vehicles

        I am not and have never disputed this. I am a strong believer in human irrationality especially when it comes to financial decisions (you don’t have to look to far for this, many fine examples in comments here).

        what I take issue to is

        IMO Shiller has a point, stocks can move even without the tiniest bit of information.

        Firstly, it maybe hidden information (you might think t is moving for no reason) and secondly it can momentum following.

        This is not a chicken and egg scenario, treat it like one at your on financial peril.

        If I give you all the information about a company and only it’s current price, would you buy it? Would you buy it if the price has just started going up? Would you buy it if the price has just started going down?

        (correlation US market – ASX/ totally different economy)) that information has probably not that much of a bearing.

        Umhh stating the obvious much? We are living in a global and globally connected economy. Of course there will be correlations, strong ones. What that has to do with the argument you are trying to make, I have no idea.

      • Shiller has also had a few things to say about the Australian housing market that you may not agree with.

        KERRY O’BRIEN: Australia’s housing downturn was relatively short-lived and we’re now heating up again quite substantially in most cities. What’s your instinctive reaction to that?

        PROF. ROBERT SHILLER: I would imagine that it has bubble aspects to it. But, you know, maybe I shouldn’t say; I’m a foreigner, I’m not …

        I was recently in China and I got to talk to a lot of people. And I could smell and sniff a bubble there. What I mean by that is I could see that people’s judgments were influenced by rising prices, and the rising prices were amplifying for them optimistic stories, and that’s what happens in a bubble. We’ve seen this happen in the United States.

        I’ve been doing questionnaire surveys, and during the – in 2003, when our boom was going gangbusters, we were seeing 15 to 20 per cent expected returns for 10 years. People thought it’s gonna go on forever. I know because we’ve done questionnaires and asked them. And it was a wild expectation.

        It was generated out of excitement from the real estate price increase. And we know that the cities where prices were going up more, there were stronger long-term expectations. These expectations were ultimately violated because the prices came down, but – so I don’t think they were rational expectations; they were bubble expectations. And there’s an easy tendency for this to happen again.

        So when I hear that in Australia prices are going out rapidly, I’m inclined to suspect that something similar to what has happened in China is happening. And I think that the Australians may well be deceived, just as we were in the United States, by the sense that prices never fall here.

        That Australia hasn’t seen any significant drop of prices, that seems to mean, in a very intuitive way of thinking, that it can’t happen here. But that’s exactly what ultimately makes it happen.

  2. When Australia was colonized, the aristocracy, those free settlers with the hereditary links, expected Australia would be the sheep run of the planet. (large, granted holdings shepherded by free convict labour).
    The actual outcome has been a little different in that Australia has evolved to be very efficient at sheep shearing, especially of the punters, by the aristocracy.

    I agree “there is nobody – nobody – more equipped with information and irrationality than any randomly selected Aussie”, especially those who consider they understand any asset price because they have all available information. Information commonly garnered from taxi drivers, mates and the domestic press, for example.

    In the past the punters did not have the financial assets to really place themselves at risk of a financial upheaval. However over the last 20 years the community has been awash with bank funds looking for a higher return than bank interest and the punters have taken to those funds like the free settlers of old took to land grants.

    Aided and abetted by both governments and the banks the expectation was capital growth would continue forever, especially in housing pricing. The punters however have been blind to the rent seeking behaviour of the banks, and the banks have been siphoning off considerable quantities of the punters funds during this period.
    The emotion propping up this loop of continuous capital appreciation of asset prices, particularly housing, disregarded the detachment of housing prices to income.

    The Nobel prize for optimism should go to that group who think they can increase their wages the 2 or 3 fold necessary to bring housing values back to household financial perspective, without ruining their employer or the nation.

    The Nobel prize for endeavour should go to this nation if we can endure the forthcoming collapse in either housing prices or the economy, or probably both, without causing massive ruin for generations.

  3. migtronixMEMBER

    I call bullsh*t because these boozos are comparing apples to oranges: they talk about price determinism and rational decision for “saving” without ever acknowledging that the metric for “price”, i.e. fiat currency, is purely elastic!! You can’t even compare yesterdays dollar to todays let alone 50 years from now!

    Further humans don’t need to “save” they need to produce and store value, this has nothing to do with financial vehicles per se although of course these vehicles are a method of achieving that outcome — but they are not the end in it self.

    Crap like this from the economics academic establishment is just a smoke screen run/funded by bankers to keep their scam looking legitimate, like a science even, when in truth it is purely a confidence trick…

  4. It is interesting, how did they gather statistics about “free markets” to get to this conclusion of ever effective markets? The world doesn’t have free markets, especially financial ones, and it is already almost a century without having “free markets”. It is ridiculous and sad that Noble Prizes are going to people who doesn’t have any idea about reality. Their thoughts don’t reflect reality at all, which means they don’t do science.