The 2013 Nobel Prize for economics oddly went to two men with opposing views on how stock markets work.
Eugene Fama argued that markets are ‘efficient’ – they price in all known information more or less perfectly because investors are rational and are able, all together, to price information correctly.
Co-winner, Robert Shiller, in a now famous 1981 paper, asked: ‘Do stock markets move around too much to be justified by subsequent changes in dividends?’ He proceeded to show that, based on the S&P 500, stock prices fluctuated more than the eventual dividends that they were supposed to have forecast.
Shiller concluded that erratic price movements are a product of investor psychology: greed, fear, you name it. From this study emerged a school of behavioural economics, which argues that social, cognitive and emotional factors influence investor choices. In other words, people are NOT rational, hence neither are markets.
Fama, the efficient market champion, explained odd price movements as a symptom of cyclical factors (the natural ups and downs of economies). To which Shiller responded rhetorically: ‘Have you ever heard of a rational stock market bubble?’
There is a world of difference between these two camps, a point illustrated by an oft-used analogy called the random walk.
Supposing you went for a stroll and found a $10 bill lying on the pavement. Would you pick it up? Or would you regard it with disbelief thinking it can’t be real because someone else would have picked it up first? Of course, pavements are not strewn with $10 bills, but markets are much like pavements – occasionally unexpected rewards turn up.
How can we learn to identify those moments when markets stop being rational and throw up value? Warren Buffett counsels investors to be ‘fearful when others are greedy and greedy when others are fearful’. In other words, take advantage of others’ seeming irrationality. Which is easier said than done, of course. When markets are expensive, there is always a reason for saying they are worth what the market says. When markets fall, it’s easy to believe the end of the world is just around the corner.
Since the global financial crisis, the S&P 500 has almost trebled from its lowest point (as at 26 August 2015).
However, while US corporate cashflow has been strong, it has arguably been driven by tight cost management and not by an increase in sales.
US companies, for the most part, haven’t been investing. Consumer sentiment remains weak and even though unemployment has come down, the recovery hasn’t benefited the many people in part-time work. For years the Federal Reserve has dithered over when to raise interest rates.
The picture in Europe is even less convincing. Structural problems persist and the region’s peripheral members are in economic limbo. As for Japan, stimulus policies seem to have achieved little more than making the country a cheaper place for foreigners to go on holiday.
So did global stock markets break new ground for sound reasons or because money is free and this encouraged asset speculation?
We shall soon find out because this extraordinary era of low cost borrowing appears to be ending soon. Investors have already shifted money out of so-called ‘riskier’ assets and back into those denominated in dollars in anticipation of higher US interest rates.
Emerging markets in particular have suffered heavy capital outflows, falling asset prices and weaker local currencies. However, this new ‘risk-off’ mentality may be just as irrational as what it replaces. Indiscriminate selling is as bad as indiscriminate buying. Markets can overshoot on the downside as well as the upside.
These gyrations lead us to conclude that Fama and Shiller are both right.
Liquidity and sentiment tend to affect markets over the short-term, and, in an absolute sense, distortions can persist for quite a while.
But eventually, prices have to reflect something more fundamental, namely business performance and prospects. Until then, we find there is always work to be done researching individual companies.
This is the investment equivalent of looking for those stray $10 bills.
Hugh Young is the managing director at Aberdeen Asset Management Asia.
