Last week, the Nobel Foundation announced the winners for the Nobel Prize in economics. This year, they decided to split the prize among three American academics: Eugene Fama and Lars Hansen of Chicago University, and Robert Shiller of the University of Yale. All three of the men have conducted their research on asset prices and behavioral finance. Their work helps us to understand how asset prices behave, how the latest financial crisis was formed, and, perhaps, how to avoid further financial crisis in the future.
Fama’s work is probably the most important inside of academia. It gave rise to the efficient markets hypothesis in 1970. Hansen’s background is in mathematics and statistics, which stimulated him to dedicate himself to econometric models, in particular the Generalized Method of Moments. Finally, Shiller’s work is of key importance for investors, as it highlights the importance of looking at fundamentals before purchasing any asset.
Eugene Fama is known as the father of the efficient markets hypothesis, a theory stating that if markets are efficient, all information should quickly be incorporated into asset prices. Hence, there aren’t many short-term investment opportunities and stock prices that should follow a random walk. It basically means that technical analysis is as good as guesswork when trying to identify short-term opportunities. However, markets aren’t always efficient, which gives rise to both information asymmetry and speculation opportunities.
The two asset bubbles that were experienced in the United States in less than 10 years shows how dangerous it is to invest in a market that is already out of sync with the real economy. During the late 1990s, tech stocks were experiencing price appreciation at exponential rates without accompanying gains in earnings growth. This made them far too expensive by historical means. In 2000, it became obvious that earnings expectations were unrealistic. Companies that were trading at P/E multiples above 200x saw their market caps sink abruptly. The market crashed and financial assets became in sync with the real economy. Before 2007, the same thing happened within the housing sector. Prices rose too much and a bubble was created. A crash was due again.
Shiller published several research articles about asset prices, but it was on “Irrational Exuberance” that he better explained why stock prices couldn’t grow forever without accompanying gains in dividends and earnings. The Yale professor believes we should look at historical values before engaging in any buying frenzy, especially those characterized by the tech and housing bubbles. When prices grow faster than dividends or earnings, P/E and P/Div multiples deviate from the mean. The market is then overvalued, and it will have to catch up with fundamentals sooner or later. Investors should avoid those assets.
Tradespoon’s valuation model includes measures that look at a stock’s deviation from mean valuation multiples as a way of screening the best investment opportunities.
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