The blind men and an elephant

Long back, in India, originated a story of the blind men and an elephant, which provided insight into the ineffable nature of truth and precision. This story is known to accommodate differences, even contradictions at one place. In modern times too, this story has not lost its sheen. When three Americans, Eugene Fama (74), Lars Peter Hansen (60), and Robert Shiller (67), were awarded the Nobel Prize in economics, the age-old story take a fresh breath of life.

These scholars spent their academic careers to probe that how the value of assets, such as stocks and bonds, varies over time. After a life long research, they have come up to fundamentally different conclusions and strangely, they have empirical evidences to prove their own particular point of view.  These economists worked independently, walking in opposite directions for years, but their mutual interest in understanding the predictability of asset prices, unify them. So, leading proponents of divergent views were grouped together in an amazing union, as winners of the Nobel in Economics.

Robert Solow, winner of the Nobel economics prize in 1987 says the winners represent a very interesting collection because Fama is the founder of the efficient-market theory and Shiller at least is one of the critics of it.

The Royal Swedish Academy of Sciences says, understanding how mis-pricing of assets emerges and when and why financial markets do not efficiently reflects available information, is one of the most important tasks for future research. ….. no doubt, extremely valuable for policymakers as well as practitioners. This dispute has important implications for investment strategy, economic policy and regulation.

Fama (University of Chicago) said that it’s difficult to predict price movements in the short run. This conclusive statement leads to the theory of financial market efficiency and made way for the development of indexed funds. Shiller (Yale University) focused on longer-run price movements and the extent to which they could be explained by such fundamental features as dividend payouts on stocks and the risk appetite of investors. Shiller further applied his work to create the monthly Case-Shiller index (with economist Karl Case), which many asset managers now follow across the US.

Hansen (University of Chicago) developed statistical methods, using these methods; theories of asset pricing can be tested empirically. He is known as the developer of a statistical technique called the Generalized Method of Moments.

The choice of having Hansen complements the two extremes of efficient markets and inefficient markets is the perfect balance between the two, said Prof. Andrew Lo of MIT’s Sloan School of Management.

On the academic side, one fact fascinates researchers that, predictability of asset prices and market functioning is closely linked. Prices cannot be predicted with accuracy, if market functions well.

But even in a well-functioning market, prices some how follow a predictable pattern. For these patterns, a key factor is risk.

Theoretically, a risky asset is expected to deliver a higher return because risky assets are less attractive to investors. A higher return for a risky asset means that it rises faster than relatively safer assets, so its price can be predictable. To detect market malfunctioning, one need to have an idea about reasonable compensation of risk. The issue of predictability of stock and the issue of normal returns that possibly could compensate for risk are interrelated.

Fama has worked lifetime for the efficient market hypothesis but Shiller emphasized investor psychology and inefficient markets, whereas Hansen make use of high-tech econometric techniques to attain the answer of the same question. Shiller concluded that models based on rationality of the stock market are erroneous.  Stock sometime prices fail to reflect rational expectations of future payouts. Shiller could find some predictability in stock and bond prices over the longer term. In his view, due to risk tolerance and behavioral biases. But his proposition didn’t explain how market bubbles are created.

Shiller showed there’s a strong herd effect on financial markets, said Nariman Behravesh, chief economist at consulting firm IHS.

Hansen built on Shiller’s work by using new statistical methods to test what exactly was driving all that stock price and related volatility. Hansen’s work reiterated the idea that the mis-pricings had to do much with the appetite for risk people had. When times are good, more investors are willing to pay high prices for assets, investors become more cautious in bad times.

 

In fact, in 1980s Shiller added complexity to Fama’s initial work; He confirmed Fama’s findings by showing that stock prices fluctuate more than underlying fundamentals like dividend yield.

Previous thinking was that stock valuation should be a relative of expected future dividend payout. But over the long term, prices tend to fall if the price to dividend ratio is high and vice-versa.

Shiller’s work raises questions about investor rationality, pricing and discounting.  Hansen took steps toward answering these questions with his Generalized Method of Moments. His model incorporates asset prices, savings and risk. His model disproves popular asset pricing ideas and further corroborated Shiller’s findings.

The forethought of these three and other economists led to disbelief on the active management of multi-trillion dollar mutual fund industry. If Fama’s insights are correct, then the fees are wasted money

Fama pronounced that the market investment is essentially a zero-sum game, and if some fund managers outperform for the time being, their less-lucky rivals earn less, but the overall gains are reduced by fees and other expenses.  As discussed, Fama’s ideas may not appeal to all, actively managed mutual funds accounts for more money than the passive index funds.

Keeping in view the precariousness during and after the recent global financial crises, Shiller’s premise seems to be more logical and reasoned, but Fama’s view can not be ruled out.

Shiller’s work has particular significance for home prices. He held that the rise in prices beyond relative traditional levels was driven by excessive optimism about future prices. He envisages the period of uncommonly low returns after the phase of high prices.

Once blended, Fama, Hansen and Shiller propose that in short term stock prices behave randomly, but for longer periods markets may carry mispriced securities. Mispricing is due to fluctuations in risk and its outlook and partly due to behavioral biases due to investor psychology.

The Nobel committee attempted to unite and coalesce competing schools of thought into a unified premise to make out what economists now understand about what determines the prices of an asset. The prize committee said these findings showed that markets were moved by a mix of rational calculus and irrational behavior.

Academy too articulated that we do not yet fully understands how asset prices are determined; the research of the Laureates has revealed a number of important regularities that are helping us to arrive at better explanations.