Valuation-Informed Indexing #204

by Rob Bennett

The Economist’s View blog has collected comments made in reaction to the awarding of the Nobel prize to Yale Economics Professor Robert Shiller. Set forth below are a few of the comments and my observations regarding them:

1) The New York Times

“In jointly honoring the work of Mr. Fama and Mr. Shiller, the committee also highlighted how far the economics profession remains from agreeing on the answer to a basic and consequential question: How do markets work?”

It’s an important question. We need to hear a national debate on it. For that to happen, the Buy-and-Holders need to dial back the dogmatism about 15 notches.

Do stocks pay higher returns because they are more risky? Buy-and-Holders think so. But Shiller’s research suggests otherwise. Does long-term timing always work? Buy-and-Holders say “no” but Shiller’s research says “yes.” Do investors who consider valuations when setting their allocations thereby reduce the risk of stock investing dramatically? Buy-and-Holders laugh at the idea but Shiller’s research indicates that this is a very real possibility.

We all need to learn the answers to these questions. it is only the dogmatism of the Buy-and-Holders that stands in our way today.

2) Justin Wolfers, University of Michigan Economist

“We have big important questions that remain largely open and we have giants bringing evidence to bear. And the answer turns out to be more complicated than markets are efficient — or markets are inefficient.”

Yes. The toughie is — How can both Fama and Shiller be right? My take is that Fama is right that the market longs to be efficient and would be efficient if only investors had access to the information and tools needed for them to exercise price discipline when buying stocks (as they do when buying all the other goods and services offered in every type of market other than the stock market). Fama’s tragic mistake was jumping to the conclusion that the reason why short-term timing doesn’t work is that prices are set rationally — The real reason is that it is investor emotion that determines prices in the short term and emotion is unpredictable stuff.

Add Shiller’s insight (that prices are determined by emotion in the short term) to Fama’s (that the market must get the price right eventually because that is what markets do) and you’ve really got something. We don’t need to reject Fama’s insights, we need to look at them in a new light informed by Shiller’s insights. Both “sides” have something powerful to contribute.

If only the Buy-and-Holders could calm down enough to see that acceptance of Shiller’s contribution brings them to the place that deep in their hearts they really want to be.

3) Stumbling and Mumbling Blog

“Their work is actually compatible because they are talking about different things. Fama’s work is primarily about individual socks…. Shiller’s work, by contrast, has focused more upon the aggregate market.”

Long-term timing always works. But only for those who purchase broad index funds. The introduction of index funds opened up entirely new options for investors because the market as a whole does not operate in the same manner as individual stocks. Rules that apply in one context do not apply in the other. This is a point that is missed over and over again.

4) Paul Krugman

“Fama’s work on efficient markets was essential in setting up the benchmark against which alternatives had to be tested; Shiller did more than anyone else to codify the ways the efficient market hypothesis fails in practice.”

That’s a nice summation of the historical realities.

5) Marginal Revolution Blog

“The initial finding was that returns were not forecastable and that is true for short durations but it is now clear that returns can be forecastable over longer horizons!”

Indeed. It is a national scandal that millions of middle-class investors do not know about this critically important reality because The Stock-Selling Industry has devoted considerable energies and resources to keeping it hushed up.

6) Marginal Revolution Blog

“What is most impressive to me, however, is that most people who think that markets can be inefficient are anti-market. Shiller’s solution to market problems, however, is more markets!”

That makes all the sense in the world to these journalist ears. The solution to bad speech is more speech.

7) Yanis Varourfakis Blog

“One that can only be bested by awarding the Physics Nobel to Gaileo and to the Inquisitor who condemned him.”

Too many people try to paper over the differences between Shiller and Fama out of some mixed-up idea that this is the only way to show them both respect and gratitude for their contributions. I have learned much from both men. But I would be insulting them both to suggest that their ideas can be reconciled or that there is some reasonable case for taking a middle-ground position. If Fama is right, Shiller is wrong. And, if Shiller is right, Fama is wrong. And as a nation of people we very, very much need to know which it is. Sand is running through the hourglass.

8) New Yorker

“From Adam Smith to Knut Wicksell to Hyman Minsky, many great economists have appreciated the perils of rampant credit growth and unhinged finance generally. During the past few decades, though, all too many economists overlooked these dangers, or purposely sought to downplay them. Over time, these omissions helped to produce an intellectual climate in which policymakers from both parties could pursue policies that proved disastrous. One of the reasons for this failure in the market for economic analysis was the hegemony of the efficient-market hypothesis, and the sunny view of finance it embodied. In choosing to honor Shiller and Fama at the same time, the Nobel committee has, wittingly or unwittingly, obfuscated this history. To prevent another policy disaster in the future, it needs telling and retelling.”

If Shiller is right, the relentless promotion of Buy-and-Hold strategies has ruined the retirement hopes of millions of people. That’s a public policy question that should be the subject of a far-ranging national debate.

9) Underbelly Blog

“The trouble is that there are two Famas: manic, loony, ideological Fama as set forth above and the younger, soberer twin. The latter doesn’t know anything about how markets move and takes pride in his ignorance. The former knows (or knew): look, investing is insanely competitive. At its best it takes extraordinary skill and hard work (not to say luck).”

These words describe precisely how I feel about my many Buy-and-Hold friends. They started with some very deep and important insights and then went sort of nuts when they came to believe that those insights had taught them all there was to know about the subject of investing. The Buy-and-Holders are smart. Unfortunately, we are living through a time-period in which they cancel out their intelligence with their out-of-control dogmatism. Let’s hope that changes before they cause too much more financial wreckage.

Rob Bennett has recorded a podcast titled Dumb Is Smart, “I Don’t Know” Is Powerful. His bio is here.