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.”
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.
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