Monday, October 14, 2013

Nobel Prize for Economics - Fama, Shiller and Hansen

The Nobel prize in Economics was announced today and it goes to Gene Fama, Lars Hansen and Robert Shiller. From a finance perspective this is very big news.  But personally - both Fama and Shiller have had a profound impact on my academic career.
Let me talk about Gene Fama (of U. Chicago) first.
Fama is sometimes called the "father of market efficiency".   The efficient market theory is one of the most important concepts in finance.   Simply stated, it says that all public information is instantly incorporated into stock (or asset) prices.  This means that you can't use public information (balance sheets, sales forecasts etc) to forecast stock prices.  In essence, if you believe markets are efficient, then you believe that anyone who beats the market is just lucky.   Not surprisingly, money managers don't like this.
So, are markets efficient (I am referring to major financial markets)?  The answer is a resounding YES.   That is why most finance professors are indexers - we don't try to beat the market.  We know that chasing abnormal performance is a fool's errand.
I have never met Fama, although I've seen him talk.  But in the seven degrees of separation in finance, I know quite a few academics who had Fama as their dissertation chair.  Fama's book "Foundation of Finance" is still required reading in many top PhD programs.  I still have my copy on my shelf.
Robert Shiller is being pegged as the opposite to Fama by much of the media.  This isn't true.   What Shiller shows in his research is that markets can deviate from fundamentals - for example - the housing bubble of 2000-2007 and the tech boom of the 1990s.   His arguments are brilliantly laid out in the book "Irrational Exuberance".   Shiller's work is sometimes called "behavioral finance".
My PhD dissertation at the University of Florida looked at how investors fail to take account of inflation when they value stocks.  I showed (with Jay Ritter) that a decline in inflation can lead to a bull market.  In 1997 we showed that the market was horribly overvalued (it crashed in 2000).   Shiller cited my work in his book "Irrational Exuberance" - I made it into a footnote!  I've met Shiller and had dinner with him on a couple of occasions - he's a quiet, mild mannered guy.  I am sure that he doesn't disagree with the bulk of Fama's work - but his work shows that while Fama is correct in the short run, in the long run things can get out of line.