Fama vs Shiller: Are markets efficient or driven by emotion?

hi I'm Josh Brown we are live from the compound for a very special edition I've got Barry Ritholtz with me here today Michael batt Nick and our friend Alison Schrager allison is an economist and wrote the smash hit book can we call it that sure the smash hit book an economist walks into a brothel I wrote a really great intro so I'm gonna read it right off my shade in 2013 professor Eugene fama of the University of Chicago and professor Robert J Schiller of Yale University shared the Nobel Memorial Prize in Economic Sciences into the movement of asset prices like stocks bonds real estate where their contributions to the the science I suppose were enormous but they had diametrically opposed in views we're gonna talk about how that's possible and how two people could so radically disagree with what moves asset prices up and down and then yet share the same Nobel Prize stick around let's see what everyone thinks [Music] all right so first of all let me just give you a better introduction Allison not only are you an economist and you've worked at investment firms and and you've done a lot of other things but you spent part of your career working directly for Eugene fama I did for about two years I had a biweekly meeting with him and Ken French and Robert Merton we debated the future of long term interest rates and what was the result of that debate you know in the beginning it was to calibrate a model I was working on in the end I think they just were enjoying it okay which is why we just kept doing it because no one knows where they're going okay so let's let's get directly into the this this idea that two people could disagree and share the same prize I'm fine with it because my own attitude is markets are somewhat efficient but also driven by emotion is that cop is that to you is that like controversial or is that what most people believe I think that's what most people believe I think the divide between behavioralists and market efficiency issue they regular people I guess in economics isn't everyone agrees people are irrational and that sometimes that impacts how people behave in markets but I think the debate is whether or not that actually impacts prices soda prices so is so some trader might be extra rationally but does someone else go in and bid prices back to where they should be quick enough so that the market stays efficient yeah like take the flash crash not that that was behavioral but that was something that happened that shouldn't have happened it may May 2010 the stock market dropped by like 10% all t algorithm right by the end of the day it was back to where it should be but it doesn't have to be faulty algorithms could be faulty humans so when the Cuban news hit with Obama maybe in 2012 or something like that there was a closed-end fund with the ticker see you BA that spiked big time and Thaler and faunal were having a debate about this on a video a few years ago yeah oh so it's a closed-end fund that everyone said all we're gonna normalize relationship with Cuba I need to be invested in Cuba and they found that ticker and they just bought it and nothing to deal with with actually Cuba so I don't know if that was algorithms it could have been and then maybe humans piled on who knows right so not only it's not an ETF so when it spiked up its it's a price was worth more than the actual assets that yes I think there was a significant premium to NAV how long did it last I think it day or two yeah so Jean would be like well eventually everyone caught on and bit it back to where it should be okay so so let's get into it let's get into what each of them are saying so tell me if I have this right or elaborate on this Eugene fama is basically saying that as information is disseminated to the public the public very quickly or quickly enough takes that information and enacts whatever buys and sells they might do on an assets price let's just say the stock market okay and so in that world there's enough efficiency where it would be really hard to be smarter than the market on a regular basis and the takeaway or the implication of that is most people should be in some sort of an index and and not spend their whole time trying to outguess or out think the market is that like in a nutshell what he's saying that's excellent that's a very good summary of it and what would you say is Barry what would you say is Robert sellers counterpoint to that so that markets are efficient and they follow a whole set of circumstances for a while but then when you look at things like the fluctuation in prices of dividend yielding stocks you know what the dividend is you know what's gonna be and yet the range and the volatility in these are so far in excess of what's remotely rational you have to think people are just not being reasonable that's before we get to all the work he's done on bubbles which fama has never really done a good job explaining bubbles within the context of EMH and and that seems to be the tension between how the two of them won a prize together so so Mike you you pointed out that one of the things that Shiller did that was cited I guess by the committee was looking at dividends and saying there's so much less volatility in things like dividends and earnings than there is in the price of the stocks themselves so how do you not point to that and say there's a lot of emotion involved in the movement of prices well if people are discounting future cash flows what our cash flows are there actually discounting its dividends and to Barry's point and to Sheila's point the price fluctuates so much greater than the actual dividends do so how could that be anything other than irrational participants but quickly also so so Pharma was cited as people's inability to protect short-term market movements and Schiller on the other hand somewhat predictability to forecast long-term market movements and with things like the kaepa ratio so he was saying if you take the cyclically adjusted price earnings ratio of the market and you look over the long term it turns out that returns for stocks are higher when you buy into the lower cape even if you have to wait ten years for that to materialize so he was able to say like how does that translate into markets a wildly inefficient or markets or emotional so correct me if I'm wrong but I think that farmer thinks that all of the available information is reflected pretty immediately in the stock price he wouldn't say that the stock price is always correct he would probably say that you don't know when it's incorrect and you can't consistently profit off of these times yeah I think that's it it's just I mean this is why it's efficient market is infuriatingly simple and I think this is where a lot of people go wrong because he doesn't believe in bubbles cuz he doesn't think there's a definition of a bubble he thinks if it's a bubble you should be able to predict when it's gonna pop but why I don't because it could be rational if you think something's overpriced you know if you think the stock market's overpriced right now could continue to go up for another five years he told the New York Times farmer I don't even know what a bubble means these words have become popular I don't think they have any meaning he said that in 2010 which took a lot of guts to say given what had gone on in the previous two years I don't think he thinks Park prices don't get out of whack I think it's just hard to predict you know when and how they're gonna change but don't you think that he is such an empiricist that maybe bubbles can't be quantified and can't be profited off of consistently with it with an algorithm doesn't mean they don't exist though well how do you define bubble when stuff becomes so wildly unhinged from a fundamental so he was asked about that question Cassidy wrote at The New Yorker did like a did an interview and went to him with all those questions and he said this is Pharma now after the fact you always find people who said before the fact that prices are too high people are always saying that prices are too high when they turn out to be we anoint them when they turn out to be wrong we ignore them they are typically right and wrong about half the time so in other words you can always find someone who's saying that such-and-such asset class real estate bonds stocks are too high and maybe they'll get it right and and you'll say look how smart but like a lot of people just always say that all the time here's the pushback to that and I'll have a lot of respect for what he's accomplished and everything behind EMH but here's where I think he slightly loses the the thread look at the 82 - mm bold market no the 75% of the market gains over that period wasn't due to an increase in earnings it was due to an increase in stock market multiples meaning the sentiment hadn't gone from I'm gonna pay X for a dollar of earnings to 4x for a dollar of earnings that's pure cinnamon and EMH is not picking that up as reflecting information what they're picking up is a what the markets picking up is the change in sentiment and that's where Schiller's irrational exuberance eventually kicks in at the end of that run it so in 1982 the stock market's selling at a multiple of ten times earnings 7/7 yeah if you go right in the heart of nobody nobody nobody wants stocks and by 32 it by the end of that period it's 32 for the S&P it's 90 for the Nasdaq it's 50 for the Dow like people people change their mind on the whole asset class because they kept making more money each year they'd willing to pay more meaning it's not oh look all our information about earnings are reflected it's no I am now willing to pay much more for the exact same dollar Vernon what's the farmer answer to that so I mean I don't want to speak for him but no it's okay we couldn't get him so you can I'm sure he'll be thrilled that you know is information just earnings orchid sentiment be like I have this sentiment be part of information does it have to be so well it's certainly informational but it's it's the human emotion as as reflected in stock prices so I think it's a stretch to say it's information no gene doesn't believe in momentum as a factor but in spite all the quantitative data about you know to defend everything he thinks but um but you could argue with the sentiment thing that there was momentum involved and therefore that would have been rational I would argue definitely there was momentum don't you think that people are too extreme investors here either in one camp or another where there's a lot that you can learn from both of these gentlemen and I think that but I do think that if you had to pick a side I think most people are much better off acting as if markets are perfectly efficient even if we know that they're not absolutely and also a lot of Schiller's work is super valuable because we all definitely do all these behaviors they said that to do this and we could not only do better as a market as a whole but do better known to individual behavior as if we study these things and understand them better this is Schiller's quote he says the assertion stock prices were rational was one of the most remarkable errors in the history of economic thought and then he goes on say mass psychology may well be the dominant cause of movements in the price of the aggregate stock market so maybe there's room to say that stock prices one stock versus another maybe there's a lot of efficiency there with all the stock picking and all the research that goes into that and how quickly people react but maybe in the aggregate like taking an absolute view of the stock market maybe that's where the irrationality and the inefficiency of the overall level somebody said that markets are micro efficient and macro inefficient but how many like world famous macro funds are there I mean it is remarkably hard to do this consistently what to say when the absolute level is too high or too low high or too low yeah and you would know that this better than I am our markets getting more efficient with more algorithmic trading theoretically I mean no no I think so again internally or on the overall value how can there be an efficient overall level for the market to sell at I mean all these sort of especially hedge fund guys are saying it's so much harder to make money as reflected in their performance yeah so the market has become efficient for expensive or or manipulated a lot of them would say that's alright so that's an interesting question because then you can hear from people who say it's less efficient than ever because 40 son of the market is now held by index funds and these are people that are buying the fund and then the fund is allocating to the stocks and they're not making any judgment call on the value of each stock they're just buying the basket in the increments that they currently sell out like in the waiting's that they currently sell out so there are people that say that's inefficient and therefore it should be easier for the other 60% of the market to find opportunity which we know hasn't materialized but that other sixty forty percent now zalgar algos and you know they're not allegedly although you could argue biases are built into ever built the algo not prone to our behavioral foibles or the purchases of indexers indexing purchases of specific stocks isn't that completely predictable why wouldn't the algos or the macro traders be able to game that you know what the proportions are you know what the proportions are you know the money flows are that shouldn't be why they're underperforming they're actually the market makers for those transactions those are the those are the those are the participants in the market that actually formed those baskets and sell them back to the to the fund so answer so 40% of the stock that's being traded is being traded in a very foreseeable predictable way why would that make markets less efficient if anything it would make him more efficient so the reputation of Robert Schiller's forecasts so he does a lot of media and he will point out things that are excessive which a lot of us could do and then he'll say but I own index funds anyway but he did become very well known for quote-unquote predicting the dot-com meltdown in 2000 and then he did it again with home prices but I think in both cases in one case he was four years early and then in the home the home in 2005 was when he was really raising the alarm about the the home bubble if you want to call it a bubble or the credit bubble or whatever you want to say but back to Shiller is point farmers point isn't it easy to always do that no like two years ago he said the stock market was overvalued or four-year right yes stay stay with the Shiller prediction thing him and Richard Thaler were co-presidents of the behavioral economics group of the American economist Association and Thaler has very specifically slag Schiller in terms of how bad his forecasts are he just makes them over and over again very nicely until he's eventually right 96 I know the speech was 96 I think the book was was I think they took the name of the book from Greenspan's Greenspan said in Rush now Greenspan said that in 96 and it was four years to the top right and I think Greenspan pulled the term from a presentation that Schiller had given the Fed so one of the other things that always happens when market people are chattering and the land and somebody says markets are inefficient it's almost an affront to their career and their way of life so they ridicule it and they they and I'm one of them but but we pile up all these examples that we can break out like a trump card like oh yeah market oriented markets are efficient you're happy on me or till Iran no even like in in 1999 three calm was this networking company that owned Palm Pilot that's right a palm ink and they they spun it off and for like a considerable period of time before the spin out no they spun they did like 10% of pomazan IPO and then they were gonna distribute the other 90% to 3com shareholders I was involved in that like we were pitching that to retail clients by 3.com because you're gonna get Palme spun off explaining the valuation so what happened was for a period of time Palme was trading by itself 10% of it and that 10% became worth more than all of 3com even though 3.com owned the other 90% I'm not saying that went on for six months but it might have been three months like it's no here's here's the take and that's one example of like 700 that people have yeah but that's availability bias like you remember those but it's also a tangible example of a huge inefficiency that if we were so efficient it would have been wrung out before it could so here's the takeaway markets aren't perfectly efficient they're mostly kind of sorta eventually where's your Nobel Prize for that that was a blog post I just got a few page views on it but that's that if if if this were a spectrum and Schiller's at this end and he doesn't give an inch by the way which is what I love about him like he doesn't do nuance he's like there was no such thing as a bubble right Alfama excuse me like he basically said he said there was a recession that caused the financial crisis not the price of assets so what would he say about tokyo real estate wasn't it the imperial palace was worth more than all the real estate in the united states that won't that Schiller said that no but what would Pharma say to that was that not a what's that how is that not a bubble well I said he doesn't mean that the prices are right it just means that there's no way to predict when they're gonna be wrong so there's no difference between expensive and Ben Carlson did a post on how much different the Japanese bubble of the 80s was relative to the Nasdaq bubble it was like 5x the Nasdaq bubble and it was people say how we were turning into Japan no you have to understand how insane and unhinged their prices were for real estate for stocks bonds everything had Patrick L Shaughnessy give a greatest up honest buck about it plus it's context if somebody to kid had a lemonade stand and they were doing like $50 an annual profits the company would be worth five million dollars it was something like that something so outrageous so all right so there's a spectrum and at one end is Schiller markets are driven by emotion bubbles happen all the time and then at the other end is Pharma basically saying now people are paying what they think something's worth at that moment and then that changes and that's why prices change like which nd you closer to closer to fama but not entirely there I would say if it's here I'm like here you're 60% of the way to fama 60 to 70 depending on the day do you remember when we were in Austin and we we were there for DFA presentation I know exactly and so it's a roomful of financial advisers and it's like 2014 or if and like the Fed is like the biggest story in the markets and somebody asked a question about the Fed or where interest rates gonna go and his response was so pharma was on a big screen from Chicago he wasn't there in person but he was taking Q&A and he go and he bit his statement was I forget the exact words but he goes the Fed doesn't decide interest rates he literally laughs anything started laughing like you know that laugh that he does he makes himself he's big something in his head and then he starts laughing yeah he laughs to himself and I spent was it two years debating which traits are going with him which interest rates we debated by the way long into the curve which is driven by the bond market not by the Federal Reserve so he's right yeah so although I remember at one point I was getting my my calibrations weren't converging and I was like it's because of QE these aren't market prices and then he shut down that conversation he's like you're wrong was his answer to the QE and how that affected he said I was wrong but anyone on CNBC a couple weeks later and said that QE was messing with crisis so he doesn't accept that there was a bubble that caused the financial crisis and what he's basically saying is that there was government policy that forced fannie and freddie to get very involved in making it so that buying a home was easier more affordable and that that changed the dynamic of the market and then he he says it's not that prices for assets started to fall and then we had a recession he's saying there was a recession so people stopped paying mortgages and then prices fell you know a lot of what he said has been debunked the housing boom and bust was global look at Europe looking around the world that it wasn't Fannie and Freddie that it was Fannie Fannie Freddie I'm gonna affect Ireland or Iceland home prices but that's his point he said the big surprise and what made that recession different was that it was global and you never had a housing a globally coordinated housing boom and bust before therefore it had to be driven by ultra low interest rates and easy availability of credit primarily from the private mortgage underwriters and the entire securitization industry his I guess when he's saying it's not the bubble that causes it it's people stopped paying their mortgages which forces all these bonds that were based on mortgages to fall in value which then triggers markets to sell off but that's caused by something people don't wake up one morning and say we're not gonna pay our mortgage today there's an economic issue that forces them well one rate when interest rates go from talking they do it actually he's got it backwards because house peaked in Oh 506 and started rolling over the stock market didn't peak till October oh seven in the recession did begin till December Oh session housing was already deep why to the peak why did it peak why did people one day say that million dollar house you know what I'm gonna pay nine hundred ninety thousand for it instead and then the seller accepts it what is the process by which the people twenty eight mortgages that reset the Circa a five Oh 607 batch of mortgages were resetting in oh seven oh eight oh nine and when they began to reset and win from these low teaser rates to these bigger rates especially in non-recourse states where you can walk away without penalty people walked away and that's why the defaults started the defaults preceded the market peak and the recession so the recession did not cause the defaults no it's backwards this was a backwards real estate driven economy they took the markets up post bubble in 911 and it took him back down remember home builders were crashing in oh five the banks and the mortgage underwriters were in trouble in oh six by the time you got into oh seven the money center banks and the brokers we're running into trouble else to fama scale I'm alright hold on this one but Andrade Holtz would be where Shiller is essentially there were emotional home buying purchase people wanted to trade up give people free money and guess what they're gonna take it my favorite scene in the big short is he's talking to the stripper about the home that she bought and he said that is my favorite scene because she says to her the Steve Carell character says you bought a home on a variable mortgage with no money down and she says a home I have seven of them and that's when the light bulb goes off and hey this whole thing is gonna collapse what's your take on on the crisis and the causes I think there's a lot of them I mean oh that sounds like a cop-out no I think we all agree yeah I think you know there there was a combination of too easy money that was a company that was a combination of bad judgment coming to interference I think it was just a witch's brew of everything went wrong search for like what's the one reason for why there's a stock market bubble or a real estate crash or what it like it's probably never one answer exactly I mean it's I you know why if interest rates been trending low for so long so why our interest why are interest rates trending low for so long so so here's an example of like you would say that you would say that there's a motion involved because people just want safety at any cost and in Germany they're willing to give up a quarter of a point to own government debt rather than risk it well is that a rational I mean people if people crave safety they want safety or you have like all these large sovereign funds who want government to save government bonds for whatever reason they need liquidity yeah is there a shortage of quality sovereign bonds it seems if there were more of them REITs wouldn't be as low as they owned over just shortage but it's made them very expensive 55 trillion in sovereign bonds 20 trillion is negative yielding so double that and you'll get rid of the negative yielding bonds that seems irrational to me it well that doesn't that doesn't seem efficient to me we went through a long another 5 years we were a long period of time where we weren't deficit spending we were running moderate budgets and now that's starting to end I understand there were macroeconomic reasons I'm just referring to whether or not it's rational or or it's efficient yeah I mean isn't it obvious that they have been what did it farmers say that sometimes people overpay but I guess again it's just like can you identify when they're overpaying and can profit off it and probably the answer is no you cannot they're waiting for bond yields to go up for like what like 15 years now they were in a bubble in 2011 alright so it seems like we've solved this markets are mostly efficient but periodically prone to emotional actions by market participants and so there is a rational exuberance - thanks for uh thanks for tuning in let us know what your thoughts are our markets efficient or do human emotions dominate the ups and downs of asset prices let us know what you think we'd love your feedback go ahead and smash that like button for us subscribe to the channel if you are not already subscribed and we will talk to you soon [Music]

Channel: The Compound

Views: 18,417

Rating: 4.8581562 out of 5

Keywords: Stocks, Stock Market, Make Money, Wealth, How To Invest, Investing, Money, Trading, Retirement Investing, Financial Advice, Investment Advisor, Josh Brown, Michael Batnick, Eugene Fama, Nobel Prize, Economics, Efficient Markets, Robert Shiller, Irrational Exuberance, the compound, downtown josh brown, an economist walks into a brothel, barry ritholtz, behavioral finance, allison shrager, finance, women in finance, female authors

Id: KrhaOyhZDZk

Length: 25min 44sec (1544 seconds)

Published: Mon Jul 01 2019