by Rob Bennett
I don’t buy the conventional explanations of the economic crisis. Anti-government conservatives just happened to see the cause as government programs. Anti-wealth liberals just happened to see the cause as wealthy bankers. These explanations are too ideologically convenient and don’t offer convincing descriptions of how we came to see trillions of dollars of wealth disappear overnight.
It’s far easier for me to believe that it was the insane bull market of the late 1990s that brought things down. Even Buy-and-Holders acknowledge that stock prices always revert to the mean within 10 years or so. Stocks were overpriced by $12 trillion in January 2000. So price reversion would mean that $12 trillion of spending power would be leaving the economy by 2010 or so. It’s hard to imagine that our economy could lose that much spending power and not go into cardiac arrest.
So I blame Buy-and-Hold and the experts in The Stock-Selling Industry who pushed it so hard and for so many years. Investors’ common sense told them that stocks were dangerous when they were priced at three times fair value and the academic research confirmed what their common sense told them by reporting that we have seen an economic crisis on all earlier occasions (and on no other occasions) in which stocks have become insanely overpriced.
However, I don’t think it is fair to place all the blame on The Stock-Selling Industry. Millions of middle-class investors went along with the industry’s self-serving claims that it is okay to stay at the same stock allocation when prices rise to dangerously overvalued levels. So we all played a role in causing the crisis that inevitably followed our irresponsible behavior.
Moreover, there’s one sense in which The Stock-Selling Industry behaved responsibly. The Buy-and-Hold concept is not something that was cooked up solely by the marketing departments of the big mutual funds. Buy-and-Hold is rooted in the Efficient Market Hypothesis, which is the product of real academic research performed by respected economics professors. Eugene Fama deserves a big part of the blame for this economic crisis. What was he thinking?
I have two views about Fama. One is that his idea that stock prices always reflect all available information is truly out-there stuff. If this were so, there would be no such thing as overvaluation or undervaluation. A price that reflects all available information is a proper price. Did Fama understand that when he put forward his hypothesis he was essentially declaring that overvaluation and undervaluation do not exist?
Did he really believe that? Did he understand the implications of his claim? Did none of the many smart people with whom he was associated think to bring the matter to his attention?
It’s hard to understand.
My other take on Fama is that he really did come close to expressing an important truth while failing to hit the mark in a very important way. Stock prices obviously do not reflect all available information at times when significant amounts of overvaluation or undervaluation are present. But I know of no reason to think that the market price as adjusted for overvaluation or undervaluation does not do this.
The market price cannot be right at times when overvaluation or undervaluation is present because the humans are obviously refusing to take into consideration some factors at such times. If all factors were taken into account, there would be no overvaluation or undervaluation. So the nominal market price cannot be right.
But I see no reason why we cannot know the efficient price just by making the adjustment required by the amount of overvaluation or undervaluation present at the time (for example, we need to divide the nominal market price by two to know the proper price at a time when the P/E10 level is two times the fair value P/E10 level).
So Fama made a huge and painfully obvious mistake. But he also made an observation that has the potential to help us mine many powerful insights once we reach the point where we are willing to make the changes in his hypothesis needed to make it conform to the realities of a world in which both overvaluation and undervaluation are clearly important and real factors.
It’s not fair to place all the blame at Fama’s feet either, of course. Like all of us, Fama is trapped by the beliefs he has come to acquire over the course of a lifetime of investigation of the world around him. Fama is an economist of the Chicago school, He has come to believe the things that economists of the Chicago school believe.
Economists of the Chicago School believe in Rational Man. They believe that people act in their own best interests when making money decisions. They have never shown this to be so. They have assumed it to be so.
They have developed complex economic theories based on this assumption. All that Fama did was to apply an idea that had become popular in the economic world in the stock investing world. What we are seeing today is what happens when a half-baked idea is given enough influence to do lots of people lots of harm.
When the Rational Man concept was only something people talked about in economics textbooks, it could only cause so much trouble. Today, it is an idea that influences how millions of people invest their retirement money. That’s a very different thing and a much more dangerous thing.
We all are to blame for the economic crisis. The Stock-Selling Industry is more to blame than the rest of us. Fama in particular is to blame. And it is the economists who came up with the Rational Man concept to whom should be attributed the greatest blame of all.
The good news is that, as we fix the Buy-and-Hold mess, we will be forced to come up with new and more realistic understandings of how economics works as well. There is no such thing as a Rational Man. It’s a myth. It doesn’t exist.