Three Nobel Prize-winning truths

 

Earlier this week, it was announced that three American economists, Eugene Fama, Lars Hansen and Robert Shiller, had won the Nobel Prize in economics for their empirical analysis of asset prices. The work for which they won goes as far back as the 1960's, so the news comes as no surprise to anyone who is deeply involved with the market. It does, however, raise the level of public awareness of their work, which is a good thing, as it may mean, at last, the demise of some trading myths that do a great deal of damage to those who believe them.

The Laureates are not being honored for any joint work, but each for his individual contributions—contributions which seem, at turns, obvious or impossible, compatible or contradictory. If you dig a bit into their theories, you will find that when taken together, they offer powerful, useful insight into the market of the sort that will prove useful nearly every time you trade.

Starting with a truth I have long lived by…

Technical analysis / charting has absolutely no predictive value

It sometimes seems that nearly every article written with regard to the price of stock devotes a certain amount of space to technical analysis. Yet Fama demonstrated convincingly, way back in the 1960's paper, that there is no correlation between a stock's past prices and its future fluctuations. Note that all forms of technical analysis ultimately rely on the assumption of such a correlation. In recent years, this analysis most frequently examines a stock's moving averages, describing the lines as levels of “support” or “resistance.” This is fiction. When moving averages cross, chartists call it an “indicator,” though it indicates nothing—repeat, nothing. Again, this is according to the work of Fama.

For market writers, this is awful, as all but the most lazy among us will have to stop passing off the faux-wisdom of charting as serious analysis. For investors, this is good news, as the quality of most market analysis will surely rise as the news spreads far and wide that charting is dead. When it comes to predicting fluctuations in asset prices, you are served just as well by tea-leaves, falling sparrows, Ouija boards and Voodoo dolls.

Consider the chart of Facebook (FB). The 50-day moving average (blue) crosses the 200 day moving average twice. In the most recent case, in early August, the shorter-term trend crosses and rises above longer-term trend, and indeed, the stock has since moved higher from there, as charting would predict. But look at the case in late June, where the shorter-term trend crosses and falls below the longer-term trend. Charting predicts the stock will fall, but it rises. In fact, it rises far more sharply between the two cross-over points than at any other time. If you were going by the chart, you would have sold FB in late June then bought it back in early August, having lost out on a spectacular gain.


Chart courtesy of www.stockcharts.com.

Asset prices are determined by the most knowledgeable investors, not by the pack

In 1969, Fama, Fisher, Jensen and Roll made a wildly counter-intuitive discovery. They set up a mock stock-market, and told their subjects to make as much money as they could trading stocks. Unbeknownst to most students, a handful of students were given what amounted to inside information, each on a particular stock. These students knew for certain that a particular event would cause a stock to trade at a particular price on a particular day. The researchers then waited to see if the existence of the inside information would push the price of a stock in the direction that the insider alone knew.

Not only did the stock move toward the revealed future price, but it moved directly to the revealed future price almost immediately. Somehow, the knowledgeable traders had a far greater impact on the market than simple math could explain. The reason, as the team later explained, has to do with the nature of volatility. In the absence of knowledge, all trades are equally ignorant, so those on the high side and those on the low canceled each other out. The inside traders were, in effect, the only real price determiners.

The initial conclusion was that in a free and fair market, all knowledge held by any and all investors is immediately (read “already”) factored into the price of the stock. This is the basis of Perfect Market theory, which, in effect, declares it impossible to effectively beat the market as a stock picker in the long run. You know what you know, but the market knows everything, so every time you think you see an advantage, you are simply falling prey to your own ignorance, or so the theory goes.

The theory changes the way investors should look at valuations in stocks. Rather than conclude that a stock is overpriced because its PE is high compared to its peers, one should conclude, rather, that there are rational reasons why the stock's price appears to be too high. The most frequent criticism of the theory is that it legitimizes market hype. I'm certain that both sides of this argument ultimately make decent points which only seem contradictory. To put it another way, I find the understanding of perfect market theory invaluable, but I'm still not going to buy Tesla (TSLA) at its current price.


Chart courtesy of www.stockcharts.com.

Short term irrationality gives way to long-term predictability

Our second laureate, Shiller, has done groundbreaking research on volatility. In a 1981 study, he compared the price of a stock to its calculated value based on its dividend stream. What he found was that prices fluctuated far more wildly than reason could account for. Consider this three-year graph of Linn Energy (LINE) as an example—there is no rational explanation for its sharp peaks and troughs, because they are based on inherently irrational human behavior. Still, many researchers have attempted to create models to account for these wild fluctuations, and many have become quite popular. (It was our third laureate, Hansen, who convincingly discredited the most well accepted of these.)


Chart courtesy of www.stockcharts.com.

Having established that there is no way of knowing at any given point whether a stock's next move will be up or down, Shiller then went on to prove that there was, nonetheless, a correlation between the price of the stock and its calculated value based on its dividend stream. In other words, prices, no matter how irrationally they move, remain in or near a rational zone, relative to the calculable value of a stock. This means, in seeming contradiction to common sense, that it becomes easier and easier to forecast the price of a stock as one looks further and further into the future.

And to be fair, you probably guessed that something like this was coming. After all, there could be no possible justification for putting our money in stocks if we did not have some reasonable and rational belief that prices would generally go up over time.

Julian Close has been a professional business writer since the first day of the twenty-first century, having written for PRA International and the United Nations Department of Peacekeeping. He graduated from Davidson College in 1993 and received a Masters of Arts in Teaching from Mary Baldwin College in 2011. He became a stockbroker in 1993, but now works for Fresh Brewed Media and uses his powers only for good. You can see closing trades for all Julian's long and short positions and track his long term performance via twitter: @JulianClose_MIC.

Julian Close

Julian Close

Julian Close became a stockbroker in 1995. In his 20 years of market experience, he has seen all market conditions and written about every aspect of investing. Julian has also written extensively on corporate best practices and even written reports for the United Nations. He graduated from Davidson College in 1993 and received a Master of Arts in Teaching from Mary Baldwin College in 2011. You can see closing trades for all Julian's long and short positions and track his long term performance via twitter: @JulianClose_MIC.

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