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.
