Tuesday, 15 October 2013

Fama, Hansen, and Shiller winners of the 2013 Nobel prize in economics

The 2013 Sveriges Riksbanks Prize in Economic Sciences in Memory of Alfred Nobel has been awarded to three recipients for their empirical analysis of asset prices: Eugene Fama, University of Chicago; Lars Peter Hansen, University of Chicago; and Robert Shiller, Yale University. 

"There is no way to predict whether the price of stocks and bonds will go up or down over the next few days or weeks. But it is quite possible to foresee the broad course of the prices of these assets over longer time periods, such as, the next three to five years. These findings, which may seem both surprising and contradictory, were made and analyzed by this year’s Laureates, Eugene Fama, Lars Peter Hansen and Robert Shiller."
You can find a more detailed explanation in the official press release, in addition to an excellent technical note explaining asset price movements, provided by the Nobel committee. 

Also, around the blogosphere many notable economists and newspapers have weighted in and provided quick comments and congratulations. Mark Thoma lists them all in one place, but individually you can look at the New York TimesWSJThe EconomistFinancial TimesFT AlphavillePaul Krugman, Tyler Cowen and Alex Tabarrok each wrote a text on all three laureates (Eugene Fama, CowenFama, TabarrokRobert Shiller, CowenShiller, TabarrokLars Peter Hansen, CowenHansen, Tabarrok), John TaylorBrad DeLongJohn CochraneArnold Kling, a technical note on Hansen from Not Quite Noahpinion, and many, many more. 

So what makes the contribution of the three laureates so important? Predicting asset prices in the short run based on the price movements of the past few days or weeks is extremely difficult. This was first discovered by Eugene Fama back in the 60-ies, as he has shown that new information tends to be instantly incorporated into prices. But after the initial reaction to, say an announcement of dividends, the movement of a price is very hard to predict. Fama's crucial contribution is the so-called efficient market hypothesis (EMH) which claims that financial markets are always efficient information-wise and that one cannot constantly achieve returns above the average risk-adjusted market returns ("beat the index") if all information is available. Prices of assets are said to reflect all past available information and instantly adapt to it. To some controversial, the EMH became the focal point of empirical work in financial economics for more than 30 years. Whether one supports it or opposes it, the EMH undoubtedly had a crucial impact on research of asset prices. This is why many have argued that Fama's Nobel prize was long time coming.

The main criticism of this model came from behaviorists such as the second laureate Robert Shiller (among others like Daniel Kahneman, Amos Tversky or Richard Thaler), who tested the EMH by comparing the variance (volatility) of stock prices to the variance (volatility) of discounted dividends, and found that stock prices are much more volatile leading him to conclude that stock markets are inefficient (irrational), as financial markets tend to suffer from overconfidence, information bias, and various other human errors (behavioural economics). In his excellent book "Irrational Exuberance" Shiller compared the 20-year annualized returns with the 10 year price-earnings (P/E) ratio using almost a 100 years of data and concluded that long term investors did well when prices were low relative to earnings. When P/E is high, risks are high, so one should lower his or her exposure in the market, but get into it when P/E is low. Keep also in mind that Shiller was on of the economists often cited to have predicted the crisis, by predicting the housing bubble burst back in 2006. He co-created the S&P Case-Shiller index, a widely used tool to measure US housing market prices.

The link between the two opposing theorists is the following - in the short run one can only anticipate movements before the dividends get announced, while everything else is a random walk movement of prices. In the long run, prices can be predicted by looking at the ratio of volatile prices to smooth dividends (see graph below); if the ratio is high it tends to fall, so you should sell, but if the ratio is low, it tends to rise, so you should buy:

Lars Peter Hansen fits into this story by developing an econometric method called the Generalized Method of Moments (GMM) estimator, which is particularly useful in testing rational theories of asset pricing, or in other words, when one needs to test both the mean and the variance of stock market returns. Using the GMM he found it to be much more applicable to the unusual properties of asset price data than the most well-known Capital Asset Pricing Model (CAPM) model. His contribution is very technical and thus difficult to explain to a layman. However, Tabarrok at MarRev and Yang at Not Quite Noahopinion offer fairly easy explanations. In addition, here and here are some lecture notes for those more interested in the subject.

In conclusion, the Nobel committee states that the laureates have "laid the foundation for the current understanding of asset prices. It relies in part on fluctuations in risk and risk attitudes, and in part on behavioral biases and market frictions."

As far as the predictions, the Wall Street Journal was once again correct on declaring Hansen a shoo-in for this year (last year their favourite was the eventual winner Alvin Roth) and giving a big chance to Shiller in case behavioural economics becomes the focus, whereas Thomson Reuters, who usually base their predictions on research citations, was way off. Their main favourites were split between Angrist, Card and Krueger for empirical microeconomics, Henry, Pesaran, and Phillips for economic time-series and forecasting, and Peltzman and Posner for regulation. 

In the end, some suggested readings from each of the laureates:

Eugene Fama
Lars Peter Hansen
  • Hansen, Lars Peter (1982) "Large Sample Properties of Generalized Method of Moments Estimators" Econometrica Vol 50(4): 1029-1054. 
  • Lars Peter Hansen (2008), “Generalized method of moments estimation”, in S.N.Durlauf and L.E. Blume (eds.), The New Palgrave Dictionary of Economics, Second Edition.
Robert Shiller
  • Shiller, Robert J. (1981) "Do stock prices move too much to be justified by subsequent changes in dividends?" American Economic Review, Vol 71(3): 421-436. 
  • Shiller, Robert J. (2000), Irrational Exuberance, Princeton University Press.
  • Campbell, J.Y. and R.J. Shiller (2007), “Robert Shiller interviewed by John Campbell”, ch. 11 in P.A. Samuelson and W.A. Barnett, Inside the Economist’s Mind: Conversations with Eminent Economists, Blackwell/Wiley.
Congratulations to the winners! 

1 comment:

  1. I don't think it's at all strange that both Fama and Shiller have received the prize - one established the EHM, the other one completely disproved it.