Last week’s announcement of the Nobel Prize in Economics recognizes two seemingly opposing theories of The Market and how it works. Eugene Fama is recognized for his ‘efficient markets’ theory. Messrs Robert Schiller and Lars Hansen for their research on the impact of human psychology on markets.
Being an arm-chair economist myself, as are you and everyone else who makes decisions on a daily basis about allocating scarce resources to infinite wants (and sometimes needs when we get our priorities straight), I feel eminently qualified to weigh in on which argument is closer to the truth. My self-assurance is grounded on the comfort that I can be as correct on this question as any other economist or meteorologist. Meteorologist?
To the perception that the two theories of the nobelists are opposing, I would like to offer an alternative perspective:
Mr. Fama’s Efficient Market Hypothesis is a theory in search of reality. Messrs. Shiller and Hansen’s “Psychology Drives” premise is a reality in search of rationalization.
Mr. Fama’s work was introduced around 1970, and was a premise that may have had some imperfect grounding in the reality of that time, when the economy was simpler, information was less extensive but more reliable, historical trends were more predictive of future performance, and The Market, though smaller in quantitative terms, was more diverse and dispersed than now.
But that train has left the station. The Efficient Market Hypothesis may define how The Market ought to work, but not how it does work.
The concentration of wealth, and with it decision-making;
the rise of institutional investors as dominant players in the market;
the decline (or should we say rout) of mom-and-pop retail investors from the markets;
the retreat of capital from the public market behind the green private equity curtain;
the rise of high frequency automated trading;
the dubious quality and reliability of ‘public information’;
the escalation of risk, quantitatively and qualitatively, known and unknown…
…have all rendered the premise of the Efficient Market Theory suspect at best: that the market at any point in time reflects the best information available, broadly distributed and considered, in establishing a realistic asset price.
As a cynical auditor (yes, I will own that self-assessment) I have long found the premise of broadly held, reliable information to be somewhere between fairy tale and fantasy. After the events of the past twenty years, we should have stripped away any delusion of the pretense of ‘transparent markets’. But that was much less the case in the ’70s, at least in perception if not in fact.
As for Messrs. Shiller and Hansen, they speak to the conditions of our time, more than a theory of how The Market ought to work. The Market is less a system than a battleground. It’s workings are not by design, whether by The Invisible Hand or other deity, but by default of the net effects of asymmetric forces. We have become a society driven more by our ‘passions’ in reflexive action than by information and intellect applied through disciplined, rational processes.
I believe this judgment applies equally up and down the investment food chain. Exhibit A is the reaction of markets to every nuanced mention of quantitative easing coming out of the Fed. The Market acts more like a hormonal teen-ager, (correction: an unfair comparison with hormonal teenagers), or more appropriately a drug addict awaiting its next fix. The resultant fluctuations in market price can hardly be described as rational responses to organic changes in the economy.
Similarly, we read that more institutional investors are gravitating to higher yield / higher risk securities. Why? To augment the lousy performance of their portfolios during the Great Repression. Does it make sense to correct the consequences of past excesses in risk taking with yet greater risks, and in the awareness that the safeguards against prior failures are no greater today than before? Rational or desperate?
Anyone with remaining uncertainty about the relevance of the Efficient Market Theory to our current investment eco-system might benefit from an hour with Martin Wolf. His recent lecture on lessons learned from the Great Repression and the way forward should make clear that our current investment market valuations are only reasonable in our hyper-active imaginations. He pulls together the various threads of post-Repression economic trends and their implications for future productivity, and invites the audience to draw its own conclusions about the prospects for us to return to the heady days of our prior investment glory any time on the foreseeable horizon.
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It seems intuitively self-evident that the financial markets, the ‘sum of all things’, can be no more efficient and rational than the underlying markets that compose the ultimate cash flows of net present value. So if the real estate and labor and credit and energy and commodity and foreign exchange markets are individually either sclerotic or hyperactive beyond any credible organic justification, can the financial markets be any more rational than its irrational components?
To Mr. Fama, I say sincerely ‘thanks for the memories’ of what might have been, and what we might fervently wish for.
To Messrs Shiller and Hansen, I would suggest that there isn’t a cloud computer big enough or big data clear enough crunch our current reality into understanding and consensus to deliver us from our collective folly…
…but thank you for calling the situation as it is, and reminding us that to err is human, and we are most definitely human.