04 Sep 2014

Clarification on Fama vs. Shiller

Efficient Markets Hypothesis, Eugene Fama 20 Comments

In the comments here at Free Advice, regarding my Mises CA post on Fama, J Mann was bringing up some good points. In response to one of his comments I wrote the following clarification, which may help some of you:

J Mann wrote:

If I’m being as charitable as I can to Fama, then if Shiller claims there’s a bubble in equities, and equities somewhat underperform other assets over the next 5 years,.

Here’s what I think happened:

(1) Shiller claimed a tech bubble.
(2) A few years later, tech stocks crashed hard.
(3) People said, “Shiller called it, he’s a prophet.”
(4) Fama pointed out, “Wait a second, tech stocks went way up after Shiller called bubble. So we need to see what the crash looked like, compared to when he first called bubble, not compared to the peak.”

If the above (4) steps were all Fama/Sumner had done, then they would be great. I would congratulate them on their caution before rewarding people with kudos for calling “bubble.”

However, Fama went further:

(5) He looked at the market bottom, saw that it was higher than the price when Shiller first called bubble, and concluded that Shiller had in fact been an idiot.

So that’s what I was objecting to.

Further, the stuff with housing was just complete nonsense. With perfect certainty and a static equilibrium, you would expect house prices to be flat at a price that capitalized the annual rental equivalent at the market rate of interest. If your house price went down 6.7% or whatever over a 9-year stretch, you wouldn’t say, “Oh that’s OK, I got to live in my house for free.” Fama totally ignored the opportunity cost of the funds you invested in your house in 2003. He stated something matter-of-factly about the preferences of the home buyers that only makes sense if you ignore interest over 9 years. That’s kind of a big deal, especially in a Nobel acceptance speech pertaining to the subject matter for the award.

20 Responses to “Clarification on Fama vs. Shiller”

  1. Kevin Erdmann says:

    So, Shiller makes two calls. In the decade after each call, the risk adjusted price of the markets he called spent roughly half the time above his call and half the time below his call. And this is a knock on EMH?

    I’ve got a newsletter I’d like to sell you…..

    • Bob Murphy says:

      Kevin Erdmann, so just to be clear, you think that the EMH says that ex ante, when I buy an asset the expectation of its price in either 7 or 9 years in the future, is the current spot price?

    • Bob Murphy says:

      And where did you get “risk adjusted” price?

      • Kevin Erdmann says:

        I thought that was your point in the article. That an investor would expect the price to appreciate, so that the spot price is not the correct comparison for a future price.

        You are right – you should compare the spot price at time zero to the risk adjusted price in the future.

        My point is that, while Fama might have been a little sloppy with his critique, even using your adjustment, you are assuming that someone following Shiller’s advice would have covered their short position at the exact bottom of the market. But, if you had taken the opposite position of his calls, and sold at the exact top of the market, you probably would have had even better returns, especially accounting for the holding period, in both instances. Practically any market call looks good if you assume the speculator unwinds the position at the perfect time, because prices are usually going to move in both directions.

        • Bob Murphy says:

          Kevin, now you’re totally changing your argument. Here’s what you originally wrote:

          So, Shiller makes two calls. In the decade after each call, the risk adjusted price of the markets he called spent roughly half the time above his call and half the time below his call. And this is a knock on EMH?
          I’ve got a newsletter I’d like to sell you…..

          That makes it sound like you think the EMH says, “Ex ante, the expected price of this security at any point for the next ten years is the current spot price. Of course in reality it will go above or below, but we can’t know that right now. If we did, then the current spot price would already reflect that belief.”

          Is that what you think?

          • Kevin Erdmann says:

            By risk adjusted price, I meant that an investor at time 0 would expect some level of returns over time, so I’m agreeing with your point that the spot price isn’t the appropriate comparison over time.

  2. Ken B says:

    Fama criticized the claim made 3 Dec 1996 that prices were already irrationally high. Then they went higher, lots higher, finally settling back above the price of 3 Dec 1996. They have not ever dropped as low as 3Dec 1996. Fama notes that they can only be reasonably said to have been irrationally high if they are also said to be so “now” ( when he spoke). This seems incontestable if irrationally high has its usual meaning.

    Murphy’s counter is that if sold at the later minimum the stock would have proven a sub par investment. Probably so. But not an irrationally optimistic one surely? Rational investors expect variation in performance and would only say ” wow did I ever crazily over value that” if its value seriously tanked.

    What if Shiller had predicted tech stocks should expect low growth but would hold their value back on 3 Dec 1996. Would Murphy look at the later minimum and claim vindication for Shiller?

    • Ken B says:

      Misspoke, never as of the time of Fama’s speech.

  3. skylien says:

    I am not really sure anymore what this discussion is about. Is it about specific calls by Shiller, or is it about the EMH?

    I mean clearly we can find people who made calls for the bubble when the market price was clearly higher than the market bottom of the following crash.. Can’t we?

    • Bob Murphy says:

      Right skylien but Fama/Sumner are picking on Shiller because he is so famous, and so many people high-five him for “calling” the tech and housing bubbles. So by taking him down, they think they are really showing people to stop being so liberal with the showering of kudos.

      • Major.Freedom says:

        “Don’t shower him…shower me.”

  4. MG says:

    Fama’s “free rent” comment was extreme, but directionally defensible and sheds an interesting light on the “value” of Shiller’s presccience. A home’s occupancy value (which may or may not be the same as its equivalent rent) could be quite a significant percentage of the purchase price of a home. In the US it is now between 9% to 10%. per annum. In effect, this is the minimum “return” that owning your home gives you per year. (I say minimum because I assume you prefer your home more than most rentals and because the market does not really offer long-term guaranteed occupancy.) If and when after nine years of occupancy you do not end up renting for free will have lot more to do with your ownership expenses (taxes, maintenace, insrance) and your cost of capital than the amortization of the “Shiller’s loss” of 6.7% over nine years (~ 0.75% per annum). Shiller’s “prescience” would have helped you avoid a drag of 0.75% on a “return” of 9% – 10%. Rather than listening to Schiller the average homeowner could have just lived in a low prop taxes state, watched DIY shows, and shopped around for the best mortgage and insurance rates. I thnk these savings could have added up to more than 0.75% per annum.

    • Bob Murphy says:

      OK MG then I’ll just use the same argument on you that I used on Fama: You seem to be arguing here that all things considered, the people buying houses in 2003 should have no regrets, because even though the houses fell in price 6.7% over a 9-year stretch, there were all these offsetting benefits of buying the house.

      If that’s true, then don’t you have to conclude that the market typically undervalues houses by a massive amount? Your argument seems to imply that if houses started at a huge value in the year 1900, and then on average fell 0.5% per year throughout the 20th century, that that would’ve been a stable equilibrium. You don’t think that, right?

      • Major.Freedom says:

        “If that’s true, then don’t you have to conclude that the market typically undervalues houses by a massive amount?”

        Good point.

        Fama is really just attacking the price system in housing as not reflecting the “true Fama values” of housing, which of course contradicts his own thesis about prices.

        • Kevin Erdmann says:

          Investors buy and sell bonds all the time that have coupon rates that are different than the yield, so that they expect the face value of the bond to decline over the holding period, which is countered by the higher coupon payments.

          Likewise, futures prices can be in normal backwardation or contango. The nominal rise or fall of a security doesn’t necessarily say anything about its value to the holder.

          • Major.Freedom says:

            But those are securities invested in to earn a cash flow. A positive rate of nominal return.

            Fama is talking about the non-cash flow “value” of home ownership.

  5. J Mann says:

    Thanks – FWIW, I think you’re right.

    IMHO, Fama starts with a good point – that Shiller’s bubble calls get rounded up to much more dramatically correct calls than they probably were, but the final answer isn’t that Shiller didn’t get the call right, just that it wasn’t as dramatic as people remember.

    If after Shiller made his irrational exuberance call, tech stocks had underperformed the rest of the market for several years, ending up at the same place, Fama is right that people wouldn’t remember it as well, but you’re right that he still would have made the right call.

    Actually, come to think of it, I’m not sure why Fama doesn’t give Shiller credit for the run-up in tech stocks that happened AFTER his call. If “bubble theory” is right, Shiller was basically saying that the market had entered an irrational phase, and was chasing dumb money investors instead of chasing value. I’m not a big fan of that theory, but if Shiller were right, then a continuing steep run-up followed by a crash is pretty much what you would expect.

  6. Robert says:

    When is the right time to “call” a bubble? If you call it early, then critics say the bubble hadn’t formed fully so you were premature. If you call it late, then critics say that by that stage it was too late to do anything about it so your prediction was useless. When is the right moment to shout ‘things have gone too far!’?

    Predicting bubbles is a bit like watching a drunk drive home from the pub. You’ve seen the warning signs so you can make a pretty confident prediction he’ll crash, but its impossible to know at which turn in the road he’ll crash at.

  7. Lio says:

    Dear Mr Murphy,

    I don’t like when you talk about fama and the EMH because you totally misrepresent both (too long to explain and I am tired to read you about those topics). You do not seem to understand that the EMH concerns and has implications for portfolio management and that, in this context, the key issue is timing. Compare the return of an investor who manages his portfolio using the cape shiller ratio with another who buys and holds a well diversiified portfolio. I prefer when you talk about economics not quantitative finance.

    • Major.Freedom says:

      What a helpful, informed comment.

      Perhaps you should have waited for when you are not tired so that you can enlighten everyone.

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