Last week the Nobel committee awarded Eugene Fama, Robert Shiller and Lars Peter Hansen the Nobel Memorial Prize in Economic Science. At first, it would seem that Drs. Fama and Shiller make for a very odd couple. Dr. Fama believes in efficient markets while Dr. Shiller argued that the stock market in the late 1990’s and U.S. house prices in the early 2000’s were the result of “irrational exuberance.” Yet, there are valuable insights to learn from both Drs. Fama and Shiller.
Dr. Fama’s was that, because relevant information is quickly incorporated into asset prices, professional fund managers are unlikely to beat the market. His research followed that of another Nobel laureate, Paul Samuelson, who in his 1974 essay demanded “brute evidence” that active money managers could beat the market index. Such evidence has not been found. Dr. Fama’s work led to the development of the index-tracking industry. This allows investors to diversify their portfolios at low cost. Dr. Fama inspired the founding of Dimensional Fund Advisors (DFA), which follows an indexing strategy and exploiting market anomalies. Some DFA funds are used by DWM for portions of our equity and fixed income holdings.
Research of vast statistical evidence has shown that returns earned by active managers seldom outpace the S&P 500 index. Further analysis showed that the failure of active managers was the result of the costs they incurred. As John Bogle, founder of Vanguard puts it: “The average manager is only average, but only before these fund operating expenses, advisory fees, turnover fees and sales loads. After those costs, active management becomes a loser’s game (for equities).”
Dr. Shiller has always been a skeptic. His basic theory has been that financial assets are unlike consumer goods- when their prices rise, that creates more demand, not less. He believes that it is no use hoping that “rational” investors will drive prices back to fair value. Dr. Shiller is a professor of economics and Yale and his wife is Dr. Virginia Shiller, a clinical psychologist in private practice in New Haven. Back in the 1980s, Dr. Robert Shiller became the founder of the field of behavior finance, incorporating psychology into economics, particularly looking at bubbles in stock and real estate markets.
Dr. Shiller was one of the founders of the Case-Shiller Index, which measures real estate prices. He also developed “the Shiller P/E” which uses price and earnings to measure whether the stock market is overvalued. He predicted the dotcom bust due to a “Shiller P/E” of 44 as compared to a long-term average of 16. He predicted the housing bubble in 2006 citing the fact that house prices rose by 7% in real terms from 1890 to 1997 and then by 85% between 1997 and 2006.
Dr. Shiller’s work was used by DWM in early 2008, when we issued our “Bubble Bust Report” for clients and helped them reduce their equity positions and start to use alternative investments to better protect their portfolios. Like Dr. Shiller, we are cautiously optimistic at DWM.
The NYT interviewed Dr. Shiller last Sunday and asked him about his relationship with Dr. Fama. I thought he had a great response. He said, “Well, Gene and I have a lot in common, more than you might think. I use many of his theories. Not all of them, of course. But he’s a very good guy. It’s like having a good friend who is a devout believer in another religion. You can learn a lot from a friend like that, even if you don’t pray in his church.”