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Interview with Eugene Fama
Well, economists are arrogant people. And because they can’t explain something, it becomes irrational. The way I look at it, there were two crashes in the last century. One turned out to be too small. The ’29 crash was too small; the market went down subsequently. The ’87 crash turned out to be too big; the market went up afterwards. So you have two cases: One was an underreaction; the other was an overreaction. That’s exactly what you’d expect if the market’s efficient.
The word “bubble” drives me nuts. For example, people say “the Internet bubble.” Well, if you go back to that time, most people were saying the Internet was going to revolutionize business, so companies that had a leg up on the Internet were going to become very successful.
I did a calculation. Microsoft was an example of a corporation that came from the previous revolution, the computer revolution. It was hugely profitable and successful. How many Microsofts would it have taken to justify the whole set of Internet valuations? I think I estimated it to be something like 1.4.
Here it is, which is interesting throughout, hat tip to Mark Thoma. I do think Fama is skippiing a bit too quickly from "the efficient markets hypothesis is hard to test," to "there is a presumption in favor of efficient markets."
Posted by Tyler Cowen on December 15, 2007 at 07:20 AM in Economics | Permalink
Comments
Speaking of stock valuations with regard to the Internet, or rather, the Dot-Com bubble of the late 1990s, there really are two major phases encompassing the rapid increase in stock prices in this period. The first began in July 1991 and continued until January 1998, consistent with the growing level of productivity associated with the widespread introduction of computer technology in businesses throughout the period.
The second is the actual disruptive event of the bubble itself, which ran from January 1998 through June 2003 (see this chart roughly halfway down the post in the "Discovery" section - you'll know it when you see it.)
As for differences between 1929 and 1987, they're rather like night and day. Fama understates the magnitude of the crash of 1929, while overstating the crash of 1987, which really pales in comparison.
Posted by: Ironman at Dec 15, 2007 9:12:48 AM
I've always been more comfortable with an unpredictable rather than rational description of the market. Fama's once over once under comment is evidence for an unpredictable market. The idea that some new information rationally cut stock values by 25% in one day seems hard to stomach.
Tom
Posted by: Tom G. at Dec 15, 2007 12:14:43 PM
One crash too small and one too big is evidence of an efficient market? Looks like the opposite to me, but then I'm not an economist. Efficient markets theory says that markets react instantaneously to new information. But the problem, as the example shows, is that they don't necessarily react correctly.
Posted by: Dennis Mangan at Dec 15, 2007 12:31:00 PM
I'd like to know how he did that Microsoft calculation because that sounds a bit wacko to me. Quoting Steve Balmer back in 99, "There is such an overvaluation of technology stocks that it is absurd. I would include our stock in that category. It is bad for the long-term worth of the economy,"
Take CISCO for example back in 2000 and ask WHAT HAD TO HAVE GONE RIGHT for it to be fairly valued at $77 a share in 2000 (how much earnings growth, revenue growth etc... would it had to to have over 5-10 year period for it to have a semi-normal P/E ratio etc... at the end of the period.) The expected earnings growth was absolutely staggering. Every lottery ticket was being priced as if it had already won.
Posted by: mgunn at Dec 15, 2007 2:57:02 PM
mgunn,
I think you misunderstand Fama's point. Obviously there were massive overvaluations of individual companies. I suspect what he is saying is that if you had held a broad portfolio of those Internet companies it would have taken only 1.4 Microsoft style successes to generate a good return for the entire portfolio, even if most of the companies went under.
I don't know if that's true, or how exactly he did the calculation. Probably there are things involved one could argue with. But I very much doubt he made a silly mistake.
Posted by: Bernard Yomtov at Dec 15, 2007 3:06:06 PM
One of those so-basic-I'm-embarrassed-to-ask-it questions?
Why on earth would anyone *expect* the market's reactions to anything to be rational?
If I can anthropomorphize for a sex: Are your reactions to most things "rational"? Mine certainly aren't. They are what they are. I overreact to some things and barely register other things at all. I might like a movie on a Thursday that I'd dislike had I watched in on Tuesday.
And where does "liking (or disliking) something" come from anyway? I've done some movie and book reviewing, and it's one of the trade secrets: You enjoy a movie, then you come up with a bunch of reasons why -- but the "reasons why" are largely bullshit. You're pretending to make a case for the movie while basically just rhapsodizing. Which is OK, of course, and no harm so long as everyone knows what's going on: "Oh, he really got a kick out of that movie, and he's carrying on about it." Maybe I'm carrying on in an entertaining and insightful way. But what I'm offering as reasonable-seeming "reasons" why I enjoyed the movie aren't really reasons at all. The fact simply is that I got a kick out of the movie. There's no real way to rationally explain why.
But organisms don't generally react "rationally" to stimuli, do they? A mosquito (or a splintre) can really, really annoy -- yet is either one of much "objective" importance? Besides, the nervous system that brings us news of what's going on in the world seems to be wired in such a way that it ignores some things and overdramatizes others. It's up to us -- up to some faculty up in the brain somewhere -- to evaluate and make sense and set in perspective the info the nervous system brings us.
But that "evaluating" function isn't -- or at least isn't always -- part of the "reacting" process. The "reacting" process is mainly irrational, primitive, hard-wired, reptile-brain stuff.
So, once again: Why should anyone expect the market's "reactions" to anything to be rational? Honestly, me, I'd *expect* the market to swing around in all kinds of crazy ways, some of which get corrected, but some which fly out of control. I mean, that's the way life works, right?
Posted by: Michael Blowhard at Dec 15, 2007 3:10:06 PM
One reason to expect the market to tend toward rationality is that irrational elements in the market tend to lose influence. They make bad bets, and lose money. If they're irrational in the first place, they tend not to gain influence in the first place.
Posted by: Ansel F at Dec 15, 2007 3:27:11 PM
'29 had a Fed that strenuously tightened the money supply, '87 had a Fed that pumped liquidity into the market.
Posted by: lee at Dec 15, 2007 3:27:22 PM
Rational stock prices are based upon expectations. My comment wasn't that CISCO's stock valuation turned out to be wrong. My comment was that the expectations required to rationally justify CISCO's stock price were essentially ludicrous. During the tech boom period, this wasn't a company specific phenomenon... it was systemic.
Near the height, about 25% of the market, ($4 trillion!) had valuations at an average of approximately 15 times sales and 87 times trailing earnings. However you look at it, these valuations imply rather fantastic expectations about earnings growth for a huge number of companies. How much would have to have gone right just for these stocks on average to NOT lose value? (Also, I don't see how 1.4 Microsofts would make this work... Microsoft's market cap now is around $330 billion?)
(1) If Fama thinks this is all rational, I think he is dead wrong (2) To even begin to convince me otherwise would require a lot more evidence than some throwaway line about Microsoft that (to me at least) doesn't seem to make much sense.
Posted by: mgunn at Dec 15, 2007 3:46:58 PM
Fama's statement is nonsense, although arguably defensible.
The problem in identifying bubbles is the misspecified fundamental
problem, that there is usually, even for 1929 and 1987, an
explanation that amounts to these being tail events out of a
skewed distribution, with the mean of the a priori distribution
being very different from the exp post outcome, but not irrational
to have bet on the mean. In short, what we saw may well have been
a "rational fundamental."
However, there are cases where we know what the fundamental is, or
something close to it. These involve closed-end funds, where the
fundamental is the net asset value of the fund, plus or minus some
transactions costs and tax issues. So, when we see large premia
appear on such funds, they are bubbles, pure and simple. We have
seen such occur on several occasions in the 20th century, including
on closed end funds in 1929, and very dramatically on closed end
country funds in late 1989 and early 1990, the latter crashing hard
in Feb. 1990. So, we have seen other bubbles than the ones mentioned
by Fama.
Posted by: Barkley Rosser at Dec 15, 2007 4:03:24 PM
Ansel F: Strongly disagree. Arbitrageurs (or highly rational investors) will only wipe out irrationals under an unlikely set of assumptions - frictionless markets, unlimited or very large leverage, and very long time horizons. To the closed-end fund examples B. Rosser mentions above I would add the 'stub' examples of, e.g., Lamont and Thaler where for several months, all of 3Com's non-Palm business was valued at - (negative) $22B!
In general, I think Prof. Fama still cleaves to the notion that because a) it's nigh impossible to make money consistently without private information and b) the efficient markets hypothesis is hard to test, therefore c) we ought to assume that markets are efficient. C implies A and B, but the reverse implication emphatically does not hold - Robert Shiller called it "the most remarkable error in the history of economic thought".
Posted by: Anon at Dec 15, 2007 4:27:41 PM
Regarding Professor Fama's remark about Microsoft, according to my calculations, based on the page for MSFT on Google Finance, from the early 80s to the 2000 peak, Microsoft shares increased by more than 65,000%, or a 650-fold gain. So probably what Fama meant was that if you held 1.4 companies that did that well, you would have come out ahead. Needless to say, I doubt anyone did.
Posted by: Dennis Mangan at Dec 15, 2007 4:54:09 PM
The efficient markets hypothesis is junk. Why? Because value is subjective. Work it out for yourself from there.
Posted by: Russell Nelson at Dec 16, 2007 2:45:58 AM
What is rational in the stock market anyway? Some people buy or sell some stock because its price crossed a moving average of some abritrarily chosen number of days. Is that rational? Some people say you should use a stock's beta to determine its risk premium. Beta is the slope of a linear fit to a cloud of points that would get you laughed out of a 9th grade science lab. Is that rational? It's not all that hard to find stocks that have a 52-week low 50% of the 52-week high, without any major change in business fundamentals. Is that rational--or efficient?
Fama used the phrase, "most people were saying..." Isn't that what the market is? And since when has that ever been rational?
Posted by: David at Dec 16, 2007 10:40:37 PM
The market will never be "rational" to most people, because other's actions are never rational to them. The real question is why don't these people who complain about market failures go into business and make some money off of them (markets in everything)?
Anyways, very few investors during the height of the dot-com boom actually expected long-term gains. At least, none of the investors I talked to did. They were flipping stocks, hoping to get still have a chair when the music stopped. I think the question we should be asking is what enabled the liquidity needed for this sort of flipping to occur.
Posted by: G at Dec 17, 2007 10:38:48 AM
So you have two cases: One was an underreaction; the other was an overreaction. That’s exactly what you’d expect if the market’s efficient.
Sample size???
Posted by: Anderson at Dec 17, 2007 10:49:48 AM
I have great interest in Eugene Fama's work (Fama and French's) because I have to explain many of his ideas to my clients.
I also believe that most investors fail to believe that "markets are efficient" and that is one of the reasons many, if not most, fail to get market returns with their investments.
Everyone likes to think they can outsmart the stock market. We are designed to think we can. Unfortunately, we still can't determine if the person who does is 1. Lucky or 2. Skilled.
I have met Fama a couple times and he never fails to impress me. Fama is arrogant when talking about his research. I can handle arrogance.
Posted by: Chip H. at Dec 17, 2007 11:07:32 PM
It is not possible for everyone to outsmart everyone else, Chip. You don't even need to study finance to understand that.
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