|WACO, October 16 - Believe it or not, the prices of assets such as stocks and bonds are somewhat predictable when you look over a period of years.
Three men who helped to develop the methods we use to project asset prices were awarded the 2013 Nobel Prize in Economics (formally “The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel”). The three (all Americans) are Eugene Fama, Lars Peter Hansen, and Robert Shiller.
The Nobel Prize in Economics was instituted in 1968 by the central bank of Sweden and is given by the Royal Swedish Academy of Sciences. Every year, the almost $1.5 million awards are given for important work in economics; areas of study include general equilibrium theory, traditional micro and macroeconomics, bargaining theory, and economic history. In addition, economists and a few others who have found and explained linkages between economics and other arenas (political science, psychology, sociology, law, and others) have been recognized.
The Royal Swedish Academy of Sciences makes selection decisions based on the originality of the contribution, its scientific and practical importance, and its impact on scientific progress. The effects of the work on society and public policy may also factor into the process. Clearly, the ability to predict asset prices is extremely practical and important.
Eugene Fama began to demonstrate as far back as the 1960s that new information is quickly incorporated into stock prices, and that they are very hard to predict in the short run. Such new information for a company might include being awarded a patent, winning or losing litigation, hiring or firing a CEO, and much more. It also involves factors influencing the entire industry (or even market) such as a weather event or a change in price of a needed input. By showing that information is rapidly reflected in stock prices, Dr. Fama changed the way we look at stock prices, and an entire new spectrum of products (index funds) is one outcome.
Much of the emerging information Dr. Fama was looking at is intrinsically hard to predict. How can we know, for example, that a CEO will announce an early retirement? Stock prices can move on such events, but there’s often little sign that they will occur. In the short run (like days or weeks), therefore, it’s virtually impossible to predict stock prices. A few years ago, several scholars were recognized for their work in this arena, and I felt at the time that Dr. Fama was a glaring mission. I am pleased to see his vital work acknowledged.
Robert Shiller (some of you may recognize his name from the Case-Shiller housing price index) took these ideas to the next level in the early 1980s, exploring the question of whether it is possible to predict prices over a longer period of time. The answer to that question is a somewhat surprising ‘yes.’ Dr. Shiller looked at the ratio of prices to dividends. He found that when the ratio is high, it tends to fall; when the ratio is low, it tends to rise. This dictum holds true for both stocks and bonds. Since dividends fluctuate far less than prices, looking at how prices and dividends currently compare yields some power to predict how prices will shift over a period of three to five years.
Lars Peter Hansen took another step in looking at responses of investors, specifically rational investors. If future prices are unpredictable, investors must be compensated via returns. High returns are needed for risky investments or uncertain times, for example. Mr. Hansen developed a statistical model which is useful for looking at the relationship between risk and return, and new areas of research have opened up (such as behavioral finance). While Fama’s work is sometimes viewed as conflicting with that of Shiller and Hansen, I have always viewed them as complementary elements of a complex and important story.
The research, analysis, and ideas of these three gentlemen (two now at the University of Chicago and one at Yale) changed the way we look at the prices of assets. While it’s virtually impossible to tell what’s going to happen over a period of a few days or weeks, there are relationships which can help predict future price trends through a longer timeframe (unless, of course, something strange changes the whole market). That these awards, which remind of rational pricing fundamentals, were given during a particularly dysfunctional time in financial markets (due to recent irrational events in Washington) is especially fitting.
Dr. M. Ray Perryman is President and Chief Executive Officer of The Perryman Group (www.perrymangroup.com). He also serves as Institute Distinguished Professor of Economic Theory and Method at the International Institute for Advanced Studies.