Nobel Prize honours conflicting theories

Eugene Fama, Lars Peter Hansen and Robert Shiller have earned the highest career distinction an economist can hope for. However, their theories are fundamentally at odds.

“This would never happen in the natural sciences,” Yves Gingras, expert in the history and sociology of science at Université du Québec à Montréal (UQAM), points out with a smile. “When two theories contradict each other in physics and chemistry, it means neither has been validated, and an experiment establishing which one is accurate will be required before a Nobel Prize can be awarded to the originator.”

According to Gingras, the fact that the Nobel Prize in Economics is sometimes awarded to advocates of conflicting theories proves that the scientific quality of economics is entirely relative.

Friedrich Hayek and Gunnar Myrdal have topped the list of contradicting theorists until now, but may very well be unseated by the 2013 laureates.

A rational market

Eugene Fama, U.S. economist at the University of Chicago and scholar of the highly liberal Chicago School of Economics, laid the theoretical foundations of market efficiency in the 1960s and 1970s.

“Mr. Fama teaches us that there is no point in struggling to compare different assets from all kinds of angles,” explains Richard Guay, director of the UQAM School of Management’s Financial Services MBA program. “If you buy RBC, BMO and National Bank shares without conducting exhaustive research, you’ll end up with about the same return as someone who has analyzed all the data.”

Why is that? “Because the market is so efficient that it incorporates price changes too quickly for you to benefit by anticipating short-term price changes,” explains Philippe Grégoire, associate professor in the Finance, Insurance and Real Estate Department at Université Laval.

In other words, all available information—whether it’s a chart indicating share price and volume changes, financial statements or analyst reports—is already incorporated in the price, which therefore reflects the share’s real value.

Even inside information, such as corporate CEO-level data, can only be so useful, because even the CEO cannot predict how the market will handle the impact of the information once it is revealed.

This vision of the market has been a strong driver of index fund growth, for example. According to Guay, “These funds accurately reflect the market, limit risks and reduce management fees.”

Irrational investors

In the 1980s, Robert Shiller, economist at Yale, broke away from Fama’s theories. Even though he agrees that changes in short-term prices can’t be predicted, he believes that it is possible to establish trends over several years.

“For him, the series of successive crises and extreme volatility of share prices, which are not justified by returns or corporate dividends, clearly demonstrate that the forces at play are not necessarily rational,” says Grégoire.

According to Shiller, finance must take human behaviour into account. This is commonly referred to as behavioural finance. “When investors are optimistic, they shift to excessively confident mode and buy too much, at prices that are too high; whereas when they’re feeling pessimistic, they panic and sell at prices that are too low,” says Guay. It’s as if investors were a herd of bipolar sheep.

Shiller’s theories gained a lot of ground when he predicted the collapse of the U.S. real estate market. Without providing a specific date, he long held that prices were excessive vis-à-vis household income, and that the prevailing unsustainable pace would end up bursting the property bubble.

For Guay, Shiller’s theories indicate that people could gain a great deal by making their own decisions, without considering market conditions. “This is the approach favoured by Warren Buffett, who sometimes acquires unexpected assets at their lowest value, like Goldman Sachs shares in 2008, while many people were worried about the American investment banks that were reeling from the crisis,” says Guay. He does acknowledge, nonetheless, that it’s not always easy to resist when panic sets in, and to move in the opposite direction of what seems to be logical.

Complementary visions

Alfred Lee, a portfolio manager at BMO Asset Management Inc., regards the work of Fama and Shiller as complementary. But the 2008 recession tipped the scales in favour of the latter’s ideas, which maintain that the market is not always guided by rational forces. “We used to say that the large number of investors in the market made it rational, and that the critical factors of publicly traded companies were what truly mattered,” he says. “But the crisis of 2008 demonstrated the opposite—that investors are not always rational, that they fear risk and that they’re overly influenced by headlines.”

He adds that the theories of Fama and Shiller have a negligible impact on the everyday activities of those who design financial products such as mutual funds and ETFs. He feels that the resulting models, like the Fama-French three-factor model, are quite innovative, but complex.

“These theories are likely to play a role in the future development of the financial sector, but industry players are still fairly conventional and don’t take much stock in new theories,” he claims. The Capital Asset Pricing Model, which is still the one most commonly used, only takes a single variable into account—the security’s sensitivity to market risks (beta). Fama and French’s model contends that crucial variables (size, book-to-market ratio, etc.) play important roles to explain the profitability of an asset.

This model uses three factors—beta, HML (High Minus Low) and SMB (Small Minus Big). HML and SMB measure historic excess returns of small caps over big caps, and of value stocks over growth stocks.

Lee can see the impact of these theories, especially on ETFs. “Some funds are exposed to the three factors of Fama and French’s model, so you can build an ETF portfolio based on that, but no financial product has been built based specifically on this model as of yet.” Shiller’s theories are more recent and lesser known in the financial sector. There is one financial product, the Barclays ETN+ Shiller CAPE ETN, that’s linked with the CAPE (cyclically adjusted price-to-earnings) ratio, created by Shiller and John Campbell in 1988. The ETN+ Shiller CAPE ETN is traded on the U.S. market, but at $13 million, it is still relatively undercapitalized.

“Few people truly understand Shiller’s theories, which partially explains why the product is not meeting with much success,” maintains Lee. “What’s more, it’s based on exchange traded notes, which are much more difficult to understand than ETFs. This doesn’t discredit his research; it only shows that he is a pioneer whose work is ahead of his time.”

Market or models?

Fama’s critics claim that markets do not always reflect the real value of assets. He often responds that their mathematical models are the problem, not the market. That’s the issue addressed by the third laureate, Lars Peter Hansen, also from the University of Chicago. Hansen is not as well-known as the other two (some are already calling him the forgotten Nobel winner), but he has nonetheless made essential contributions to econometrics.

Like Fama, Hansen supports the concepts of efficient markets and rational investors. He developed statistical models that are intended to be more effective for testing rational theories of asset pricing. They track price fluctuations in relation to changes in certain macroeconomic data such as spending, savings and investment. Since it is very difficult to create a model that compiles credible data representing a collection of data as extensive as global spending, for example, Hansen’s models can be used to study such collections by using finite data. This is what he calls the “generalized method of moments.”

“Econometric software programs generally have functions that he directly helped create, which indicates the extent of his influence,” Grégoire points out.

Hansen’s work addresses a kind of economics that can be compared with natural science, in terms of the methods used. In a recent interview with a journalist from Time magazine, he stated that to claim economics had solved public policy debates was “a little bit extreme.”

What is important, according to Hansen, is that economics brings new understanding, which enables governments to make more informed decisions. He adds, however, that events like the recent global financial crisis show that there are still knowledge gaps in economics, giving experts in his field some interesting challenges. That means there’s still plenty left to do.

what’s next for equities?

Equities had a great year in 2013. But this was at the expense of fixed income, and that trend is just getting started, says a report by NEI Investments.

Last year, the U.S. market had a return of 41.37%, while Japan had a return of 35.83% and Europe returned 34.67%, the report notes. It’s a turning point, and now the shift away from bonds and into equities is beginning in earnest. The good time for equities will keep on rolling in the medium term, the firm predicts, despite the initial retraction in 2014. NEI Investments expects lower commodity prices in Canada to persist for some time, putting significant pressure on Canadian exports and overall growth.

Consumer spending is also expected to slow, given record debt-to-income levels and the Bank of Canada’s cautious tone. Home prices appear to be peaking and the housing sector could be at risk should interest rates move even modestly higher, says the firm. Improving U.S. fundamentals should provide some support for the economy, as should a lower Canadian dollar. Key findings include:

• most indicators suggest equities are still stronger than traditional fixed income;
• Canadian equity portfolios performed well in 2013 in absolute terms, but were dragged down by softer commodity prices;
• Europe, Asia Pacific and select emerging markets represent some of the best opportunities; and
• investors will benefit from active investment management.

Jean-François Venne is a Montreal-based freelance journalist.