Monday, 14 October 2013

Nobel Prize in Economics 2013: What Fama and Shiller Don't Explain

Today, Eugene F. Fama, Lars Peter Hansen and Robert J. Shiller were awarded the Prize in Economic Sciences in Memory of Alfred Nobel "for their empirical analysis of asset prices",
There is no way to predict the price of stocks and bonds over the next few days or weeks. But it is quite possible to foresee the broad course of these prices over longer periods, such as the next three to five years. These findings, which might seem both surprising and contradictory, were made and analyzed by this year’s Laureates, Eugene Fama, Lars Peter Hansen and Robert Shiller.
Fama and Hansen are both professors at the University of Chicago while Shiller is a professor at Yale. Though I am not familiar with Hansen's work, I've read the majority of Fama's academic articles especially up to 2002. In general, his articles are heavily geared toward rigorous statistical analysis and testing using various quantitative models as one perhaps would expect from research coming out of the Chicago school. When I wrote my dissertation in financial economics in 2001, I applied one of Fama (and French's) models to test for mean reversion in equity prices. In fact, Fama was one of my favourite finance professors at the time, primarily as he published academic articles on a subject I was interested in as I was trying to figure out ways to beat and predict the stock market. I also remembered he was highly regarded from my studies in finance at a university not too distant from Chicago in the early 1990s.

Anyway, back in 2001, I remember thinking that Fama had probably never been awarded the Nobel Prize as his articles were mere econometric analyses as he never, in my opinion, offered any viable or underlying reasons for his findings. As a more recent example, in his paper with French from December 2008 titled "Average Returns, B/M, and Share Issues" (subscribers only, a draft is available herethey explain in the concluding part,
"Finally, there is an issue on which our results are silent: whether the cross section of expected stock returns is the result of rational or irrational pricing".
Similar conclusions can be found in earlier papers. But why are people acting irrationally? And how can they act rationally if by doing so make them underperform? These were the type of questions where Fama's work left me out in the cold with the illusive "equity risk premium", irrational or not, ultimately being the driver of short/medium term stock market returns.

After completing my masters degree I contemplated pursuing a PhD in finance to do further research on the stock market and asset pricing. I remember e-mailing my professor explaining I thought the financial economics profession had went down a path (the statistical one) I did not think was very fruitful and that future research in finance should lie in the behavioural arena. As I was more of a numbers guy back then, this was not something I was particularly keen on pursuing. And I'm glad I did not (which becomes apparent below).

I first heard about Shiller back in 1996 when Greenspan popularised Shiller's phrase "irrational exuberance" (following a presentation by Shiller and Campbell to the Fed) and read his book with the same name a few years later with great interest. I had by then read Graham and Dodd's book Security Analysis and have since on a regular basis visited Shiller's website to check the latest cyclically adjusted P/E ratio (CAPE) numbers based on Graham's work. Shiller publishes the data series religiously on a monthly basis and based on the data I prepare a report published on this website every month (here's the most recent one). In contrast to Fama, the father of the efficient market hypothesis, Shiller freely uses the word irrational and is influenced by behavioural finance. He has also showed on numerous occasions that asset prices frequently depart from fundamentals. Yet, I did not get a complete answer from Shiller's work either: if investors were irrational, then why? And why were they more irrational during some periods than other? Was it just old-fashioned hype that lead the stock market herd of speculators forwards, and upwards and far beyond a reasonable assessment of fundamentals?

Since then, for lack of answers to my questions, I have not read much of either professor, though I do listen to Shiller's views on asset prices and valuations. I stand corrected if they since have offered more fundamental explanations to the underlying reasons for "mispricings". The Scientific Background paper issued by the committee does not mention what I am looking for however. I discuss this below.

Years later I worked in London and saw first hand (from my office window) that some high street retailers, financed by Icelandic banks, went bust following the Lehman collapse. The bottom fell out of the stock market, credit came to a standstill and having skimmed through Extraordinary Delusions and the Madness of Crowds a few months earlier, I could at least imagine what the last guy to buy a Viceroy (a tulip bulb) during tulip mania in March 1637 could have felt. I did not have much spare time back then, so it was not until later on I had the time to do some serious digging into the economic causes of the crisis beyond the standard explanations: the weakness of free markets, animal spirits, herd behaviour, hedge funds and speculation and of course, lack of regulation.

But then one day I watched a video on Youtube (can't remember which one) with a link to a website dedicated to something called "Austrian Economics". Though I had heard about Hayek and read some of Schumpeter's work on the role of the entrepreneur, I had never heard about this school of economics before. With Friedman and Keynes making up the bulk of my economics knowledge, it took no more than a few hours of reading before it became apparent to me that the notion "an economist is one who explains why, something he was unable to see coming, happened" was utterly wrong. Suddenly, economics started making sense. And most importantly, I finally found what I had been looking for. I had discovered a fundamental reason assets sometimes are priced "irrationally" (in both directions) and why we have booms and busts in both the economy and in the stock market. And the answer was not just cheap credit: it was fiat money, fractional reserve banking and the whole Federal Reserve system. Or more precisely, credit granted without being 100% backed by savings. In short, credit and money growth and contraction fuel optimism and pessimism, booms and busts and hence offered the fundamental explanation I was looking for to the behaviour of asset prices and the illusive equity risk premium (medium to long term, short term is anyone's guess) both Fama and Shiller document, but fail to explain the underlying and fundamental causes for.

Though I am grateful for all what I've learned through studying both Fama's and Shiller's publications, my advice to any student of the stock market and financial economics (student and professional alike) not familiar with the Austrian school is as follows: become familiar with some of Fama's work and do read some of Shiller's papers, especially his work and comments on stock market valuations. But don't spend too much time doing so. Rather, if you want to get to the bottom of the underlying and fundamental drivers affecting asset prices and risk premiums, the fundamental reason behind broader booms and busts which affect asset and stock prices - you need to understand the theory of the business cycle (the Austrian version that is). The work by economists long forgotten by the mainstream, Ludwig von Mises, Friedrich A. Hayek (and others, including their predecessors), offer answers to these questions. And they do so through deductive reasoning and a thorough understanding of economics second to none and thus provide crucial knowledge anyone wishing to become an expert in so-called financial economics need. Today's Nobel Prize winners' work on the other hand do not as they do not incorporate the business cycle caused by fluctuations in money and credit (not backed by a commensurate amount of savings), which is again caused by fractional reserve banking and the Fed, in their analysis, reasoning and conclusions. If they did, they probably wouldn't have been awarded the prize. Jörg Guido Hülsmann explains why,
Unsurprisingly, the economics prize has always been heavily biased against economists who oppose the fiat-money foundation of the welfare state and of the warfare state. 
The prize is, after all, based on a donation in 1968 from Sveriges Riksbank - Sweden's central bank.

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