The Nobel Prize Winning Asset Price Theories
Thursday, October 17, 2013
Charles Rotblut, CFA
AAII Journal Editor

AAII Resources

Is the Stock Market Efficient?
Beating the indexes is not an easy task.

Valuations, Inflation and Real Returns
Robert Shiller on market valuations

AAII Discussion Boards
What do you think about this year’s Nobel Prize in Economics?

Most Popular AAII Articles

  1. “Social Security Basics”
  2. “The Cash Flow Statement: Tracing the Sources and Uses of Cash”
  3. “My Investment Letter: Words of Advice for My Grandchildren”

Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 46.3%, up 4.9 points
  Neutral: 28.8%, up 3.7 points
  Bearish: 24.9%, down 8.7 points

Long-term averages:
  Bullish: 39.0%
  Neutral: 30.5%
  Bearish: 30.5%

Take the AAII Sentiment Survey »

The predictability of asset price movements was the theme of this year’s Nobel Prize in Economic Sciences. By awarding it to Eugene Fama, Robert Shiller and Lars Peter Hansen, the committee acknowledged the debate as to whether security prices are efficiently priced. It also recognized two men often viewed as being at different sides of the debate about market efficiency: Fama and Shiller. Most importantly, the lessons behind this year’s award have practical applications for individual investors.

University of Chicago Professor Eugene Fama created the efficient market hypothesis (EMH). This theory holds that new information is quickly priced into the asset prices. It is the foundation for the random walk school of thought, which views stock price movements as random and unpredictable. Under the EMH model, a stock’s price reflects all known information and there is no advantage to be gained from analyzing a stock or a bond.

Yale University professor Robert Shiller concluded price movements have some predictability over the long run. His researched showed that when asset valuations rise too high, prices tend to fall; conversely, when valuations become too low, prices to tend to rise. His cyclically adjusted price-earnings (CAPE) ratio has become a widely followed measure. (Shiller will discuss his valuation methodologies at our upcoming Investor Conference.)

Who is right? The Nobel Prize committee said both men have valid points. Stock price movements are very difficult to predict. The inability of security analysis to give a consistent advantage explains why active fund managers have had such a difficult time consistently beating their benchmarks. At the same time, high valuations lead to lower price returns and low valuations lead to higher price returns, on average. This finding by Fama corresponds with Shiller’s work. Shiller shares common ground with Fama by suggesting investors look at long-term valuation trends and not the day-to-day movements of stock prices.

Lars Peter Hansen’s work is akin to a bridge between Fama’s and Shiller’s work. His mathematical method, the generalized method of moments (GMM), enabled the testing of asset price theories. His work, and additional research based on his method, found that applying modifications to financial theory helps to explain price movements.

The Nobel Prize website has a paper explaining their reasoning for giving the award to all three men. It’s a bit theoretical, though interesting.

From the standpoint of real-world investing, there are a few lessons to keep in mind. The first is that we individual investors are at an informational disadvantage. Particularly in today’s environment of high-speed computers, a significant part of important new information is priced in before we can place an order with our broker. The second is that valuation and size matter; going smaller in size and lower in valuation lead to better long-term performance. Third, and most importantly, Warren Buffett was right when he said “buy fear and sell greed.” Asset prices can and do reach irrational levels from time to time. Realizing when valuations are out of whack and acting accordingly is a very profitable strategy for those with the emotional tolerance and the patience to use it.

Model Portfolios Updated

The Model Fund Portfolio was due for review this month, but no transactions were made. No transactions were made in the Model Shadow Stock Portfolio, either.

For August, the Model Shadow Stock Portfolio gained 10.5%, outperforming the Vanguard Small Cap Index fund (NAESX), which rose 5.7%, and beating the DFA US Micro Cap Index fund (DFSCX), which was up 7.1%. Year-to-date, the Model Shadow Stock Portfolio has now gained 47.6%, well ahead of the Vanguard Small Cap Index fund, which has gained 26.5%, and the DFA US Micro Cap Index fund, which is up 30.4%. The Model Shadow Stock Portfolio has a compound annual return of 18.0% from its inception in 1993, while the Vanguard Total Stock Market Index fund (VTSMX) has gained 8.9% annually over the same period.

The Model Fund Portfolio was up 4.2% for September and the Conservative Portfolio (75% Model Fund Portfolio and 25% iShares Barclays 1-3 Year Treasury Bond ETF) was up 3.2%. This compares to a 3.7% gain for the Vanguard Total Stock Market Index fund (VTSMX). Year-to-date, the Model Fund Portfolio has now gained 17.4% and the Conservative Portfolio is up 13.0%, compared to 21.2% for the Vanguard Total Stock Market Index fund. The Model Fund Portfolio has a compound annual return of 9.0% from its inception in June of 2003, while the Vanguard Total Stock Market Index fund has gained 8.4% annually over the same time period.

More on

The Week Ahead

Approximately 150 members of the S&P 500 will report earnings next week. Included in this group are many Dow components: McDonald’s Corp. (MCD) on Monday; Du Pont (DD), Travelers Companies (TRV) and United Technologies Corp. (UTX) on Tuesday; AT&T (T), The Boeing Company (BA) and Caterpillar (CAT) on Wednesday; 3M (MMM) and Microsoft Corp. (MSFT) on Thursday; and The Procter & Gamble Company (PG) on Friday.

September existing home sales and the final October University of Michigan confidence survey will be released on Monday and Friday, respectively. September new home sales and September durable goods orders are scheduled for release on Thursday and Friday, but because of the government shutdown, it is unclear when we will actually see them. The release dates for other economic reports delayed by the shutdown is also unknown as of this afternoon.

The Treasury Department will auction $7 billion of 30-year inflation-adjusted securities (TIPS) on Thursday.

Chicago Federal Reserve Chairman Charles Evans will give an interview on CNBC on Monday morning.

AAII Sentiment Survey

Optimism rose to a three-month high in the latest AAII Sentiment Survey, despite the fiscal standoff in Washington, D.C. Pessimism, meanwhile, fell to its lowest level in a month.

Bullish sentiment, expectations that stock prices will rise over the next six months, jumped 4.9 percentage points to 46.3%. This is the highest level of optimism registered by our survey since July 11, 2013. It is also the fourth time in the past six weeks bullish sentiment is above its historical average of 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged, rose 3.7 percentage points to 28.8%. This is the fourth time in the past six weeks neutral sentiment is below its historical average of 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, plunged 8.7 percentage points to 24.9%. The drop puts pessimism at a five-week low. Bearish sentiment is also below its historical average of 30.5% for the fourth time in six weeks.

Both bullish and bearish sentiment remain within their typical historical ranges.

Short-term optimism rose among AAII members despite the government shutdown and the threat of the federal government defaulting on its debt. Part of the reason for the bullish stance was expectation of a resolution being found. (The survey period runs from Thursday through Wednesday.) The rising stock market was another reason. Better-than-forecast third-quarter earnings are also helping. Concerns about slow economic growth, stock valuations and the lack of a long-term fiscal solution have not gone away, however, and remain front and center for some individual investors.

This week’s special question asked AAII members for their opinion of Janet Yellen’s nomination to be the next Federal Reserve chairman. Approximately 43% of respondents were pleased with her getting the nod. Several members thought Yellen would continue the current monetary policies, others liked her background and some liked the fact that a women was nominated. Nearly 15% disagreed with the choice, primarily because they thought Yellen would continue current Federal Reserve policies or viewed her as a supply-side economist. More than 16% of respondents simply said Yellen represents a continuation of current Federal Reserve policy. Some respondents (13%) said they were withholding judgment, did not know enough about her or otherwise were unsure. Though we did not ask about Larry Summers, who was discussed as a potential nominee for the position, 5% of respondents thought Yellen was the better choice.
Here is a sampling of the responses:

  • “I think she is an excellent choice and has been with the Fed long enough to be a stable, astute leader.”
  • “I am pleased—She is not only extremely well qualified, but she is also a woman. It is time for a woman in this role.”
  • “A great choice who will work in the Bernanke manner.”
  • “I fear that she will flood the market with too much money, even longer than the current Fed Chairman Ben Bernanke.”
  • “I know little about her. I’m simply overjoyed that we didn’t reward Larry Summers.”

» Take the sentiment survey