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The Nobel Prize Is No Crystal Ball

The Nobel Prize Is No Crystal Ball

Posted by on Oct 21, 2013 in Blog, Columns |

By Jason Zweig | 6:20 pm ET  Oct. 18, 2013
Image Credit: Wikipedia Creative Commons

For investors, the main lesson from this week’s announcement of the Nobel Prize in economics should be humility about anyone’s market-forecasting ability—especially your own.

 This past Monday, the economics prize went to three researchers whose work seems to have little in common: Eugene Fama, a leading advocate of the theory that stock prices are efficient; Lars Peter Hansen, who probes predictive models for statistical weaknesses; and Robert Shiller, who argues that markets are more irrational than efficient. The Nobel committee said these economists’ findings show that “it is quite possible to foresee the broad course of [stock and bond] prices over…the next three to five years.”

If only it were that simple.

Prof. Fama, a finance professor at the University of Chicago’s Booth School of Business, was unavailable for comment this week. He has argued for nearly five decades that markets are efficient—meaning that you can’t reliably predict, using publicly available information, which securities will have higher or lower returns than expected.

On the other hand, with his longtime research partner, Kenneth French of the Tuck School of Business at Dartmouth College, Prof. Fama has identified several factors that appear to beat the market over long periods.

Small stocks, “value” stocks (priced at low multiples of their net worth), “momentum” stocks (with recently rising prices) and “quality” (or highly profitable) stocks all have earned higher-than-average returns over the decades, according to Profs. Fama and French. Why these stocks tend to outperform isn’t yet fully understood.

But you should be wary of stock-pickers who claim to be able to beat the market buying such companies. Approximately 97% of fund managers haven’t demonstrated enough skill even to cover the expenses they charge, Prof. Fama has argued—making low-cost index funds, which don’t even try to beat the market, the best bet.

“It will always be challenging to get sharp predictions as to what will happen in the future,” Prof. Hansen, an economist at the University of Chicago, told me this week. “There’s a tremendous amount of uncertainty [in financial data], and if there are predictable patterns in there, they are modest and very subtle.”

Prof. Hansen has spent his career building complex mathematical models to measure economic variables. He has learned much about what works, but even more about what doesn’t work.

“There’s a danger if you turn over policy and regulatory design to models that we don’t yet have full confidence in,” he says. “There’s a big danger in pretending that we have a new set of knowledge that we can use in fine-tuning policies and markets.”

Prof. Shiller, an economist at Yale University, is best known for his book Irrational Exuberance. The first edition, in March 2000, warned that the U.S. stock market was dangerously overvalued. Over the next 2½ years, stocks fell 44%. The second edition, published in early 2005, warned that the U.S. housing market was dangerously overvalued. He was right again.

Still, Prof. Shiller doesn’t believe that if you roll up enough data, it will turn into a crystal ball.

For years he has calculated what has become known as “the Shiller CAPE,” or cyclically adjusted price/earnings ratio. That measure is the price of the S&P 500-stock index, divided by the average of its past 10 years of earnings, adjusted for inflation. The resulting number has averaged 16.5 since 1871. By the end of 1999, it was flashing furiously at 44.2, the highest level ever recorded.

Today, Prof. Shiller says, CAPE is “a plausible strategy” for getting a rough sense of whether markets are fairly priced. “It appears to work over the very long term,” he says, “but I don’t think you can know that it’s going to [work] tomorrow or even over the next few years.” (At 23.5, the recent CAPE for the U.S. stock market is well above the historical average.)

One lesson I’ve learned from Prof. Shiller comes not from his work but his life. In college, he went on such long contemplative walks that he stress-fractured a bone in his foot. He told me years ago that the collective enthusiasm of fans at sporting events is alien to him. He still recalls, with a shudder, reading Aldous Huxley’s novel Brave New World as a teenager. In Huxley’s dystopia, babies are brainwashed with “hypnopaedia” and adults are doped into conformity with a drug called “soma.” “I never wanted to get socialized like that,” he told me.

In 2003, Prof. Shiller said in an interview that he has kept a diary “continually since I turned 12 years old.” He added that “talking in it to oneself creates a more idiosyncratic view.”

Such deliberate detachment from the crowd may be the best way to avoid getting swept up in the next bubble.


Source: The Wall Street Journal


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