An Easy and Convincing Way to Reconcile the Ideas of Shiller and Fama

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Valuation-Informed Indexing #205

by Rob Bennett

I reported here last week on the reactions of a number of economists to the awarding of this year’s Nobel prize in Economics to Robert Shiller and Eugene Fama. two figures with opposite takes on the fundamental rules of how the stock market works. The common theme in a good number of the comments was that both Shiller and Fama made important contributions, even though the implications of their findings take us in very different directions.

I share the feeling that animates these comments. Fama has been proven wrong. That’s my assessment. A good number of people say publicly that they do not agree. But it was clear in the comments that I reported on last week that this is the consensus view. Several of the economists went so far as to ridicule Fama for many of his recent observations. Fama has repeatedly dismissed the idea that such a thing as a bubble could ever exist (a position consistent with and required by his belief in an efficient market). Most people, ordinary investors and experts alike, find this position laughable. More and more all the time Fama is coming off as a doofus.

That said, he is a giant. Most of the people who mock him also say that. And they say it with good reason. His research is top-quality stuff. His insights changed our understanding of how stock investing works in a fundamental way. All of the research that has followed owes a debt to his pioneering endeavors. If Fama is a doofus, he is a very unlikely doofus, a doofus who sees things that nobody else sees and who is capable of awe-inspiring breakthroughs.

I believe that I understand what is going on.

Fama came up with a truly powerful insight when he discovered that short-term timing does not work (this was in 1965). Had Shiller came forward with his finding that long-term timing always works and in fact is required for any investor hoping to have a realistic chance of achieving long-term success within the next year or two, there never would have been any problem. All of the economic troubles we are enduring today have their origins in the unfortunate reality that Shiller did not come forward with his own “revolutionary” (his word) findings until 1981.

Fama was right in his finding that short-term timing does not work. The finding was the product of his research efforts, which were top quality stuff.

Where Fama went off on the wrong track was in his explanation of those research findings. There is zero research backing his explanation. Thus, there is no conflict in saying both that Fama produces the highest quality research possible while also coming forward with some truly doofus ideas (the ideas that are rooted in his mistaken explanation of his research findings are wildly off the mark).

There are two possible explanations for why short-term timing does not work.

One is the one that Fama advanced. It could be that the market is efficient. That is, that all information bits affecting price are immediately incorporated into market prices. If this were so, all of the principles of the Buy-and-Hold Model (the model for understanding how stock investing works built on Fama’s research) would follow.

The other possible explanation is that the market is in the short term the farthest thing from efficient that is possible. If it were investor emotions that determine prices in the short term rather than economic realities and if economic realities became the dominant influence on prices only in the long term, short-term timing would not work. Emotions are irrational. Things that are irrational are unpredictable.

There’s a way to determine which of the two explanations is the right one. If the reason why short-term timing doesn’t work is that the market is efficient, long-term timing would not work either. But if the reason why short-term timing does not work is that it is investor emotions that determine short-term prices, then long-term timing would work.

The market must get the price right eventually. That’s what markets do. But if the market is not efficient, it could take some time for it to get the price right. If investor emotions are the primary determinant of short-term prices, the only way that prices can be set right is through a price crash. Prices cannot crash until they first rise to insanely high levels. It could take 10 years or even a bit longer for that to happen. If the reason why short-term timing does not work is that it is investor emotion that determines prices in the short term, the data should show that prices always move in the direction of fair value over the long term but that this process can take as long as 10 years to play out.

That is of course precisely what Shiller’s research shows. There has never been any evidence that the market is efficient. It was not research findings that suggested that, it was a reckless and mistaken interpretation of very powerful and correct research findings.

The mystery here is why 33 years have passed since Shiller pointed us to the obviously correct reconciliation of his and Fama’s views without lots of good and smart people coming forward and pointing to this as the obvious reconciliation.

Our mistake has been to become so deferential to Fama because of his genuine breakthroughs to become reluctant to point out the obvious mistake for which he also bears responsibility. If the mistake had been corrected in 1981, it would have been no big deal. All pioneers make mistakes. So what???The trouble is that the mistake has gone uncorrected for so many years that it has been permitted to destroy millions of portfolios and even to bring on an economic criss. I think it would be fair to say at this point that we are doing no favor to Fama or to the Buy-and-Holders by pretending that we do not see that he made an important mistake while generating his breakthrough insights.

The longer the game goes on, the harder it is to bring it to an end. It’s not the mistake itself that is embarrassing at this point. it is the 33-year cover-up of the mistake. And in another 12 months, it will be 34 years of cover-up. And in yet another 12 months after that, it will be 35 years of cover-up.

It’s sad stuff.

Fama truly is a giant. So is Shiller. We are lucky investors to be living in a day when the powerful insights of both giants can be put to use to make stock investing a far more safe and profitable game than it has ever been in the past.

But how do we get from the dark place where we all are today to the bright and wonderful and life-affirming place where we all (Eugene Fama above all!) long to be tomorrow. How do we as a society work up the courage to acknowledge the perfectly understandable mistake that we have been covering up for over three decades now?

Rob Bennett has recorded a podcast titled You Won’t Believe the Truth About Stock Investing Until You’ve Heard It 5,000 Times. His bio is here.

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