If the nation hadn't been in the midst of a government shutdown and debt ceiling debate, last year's Nobel Prize winners in economics probably would have received more attention and commentary. Two of the three winners--Eugene Fama of the University of Chicago and Yale's Robert Shiller--are as different as Tea Party Republicans and Democrats in their theories about the rise and fall of stock prices and other assets. Investors can learn a lot from both.
To Fama, markets are efficient systems where relevant information is immediately and rationally reflected in stock prices. So, for the most widely researched portions of the market, such as domestic U.S. large cap stocks, that means active management is nearly impossible.
Numerous studies show just how difficult it is for active managers to consistently outperform the market when operating in the most efficient and liquid asset classes, since thousands of other individuals are able to simultaneously adjust to each bit of information just as quickly. This inability to gain an edge amid a well-informed crowd has helped popularize such investment vehicles as index and exchange traded funds (ETFs).
In Shiller's behavioral finance theory, markets and prices are considered as emotional and irrational as the people making the investments--a version of the "fight or flight" response that allows people to survive danger.
After 30 years on the front lines of the investment business, my experience aligns more closely with Shiller's. I can cite hundreds of examples.
Take U.S. equity markets. As we closed out 2012, the sequestration cuts, budget impasse, and increases in payroll and marginal tax rates seemingly would have led you to believe that U.S. equity markets would swoon in late 2012 and into 2013. Remember that the tax and budget deal didn't get signed until early January. However, the opposite happened. The S&P 500 actually rallied more than 10 percent by the end of first quarter and ended the year more than 30 percent higher!
Last summer, when the Fed said the U.S. economy seemed to be recovering well enough to be taken off monetary life support (quantitative easing), the markets plunged, instead of rising to applaud an economy healthy enough to stand on its own.
Now, some investors are cheering the notion that the Fed is moving slowly in retracting its monetary stimulus. It is likely that the Fed will not raise short-term interest rates until well into 2015 or beyond, given the still tenuous state of developed economy fundamentals and balance sheets. Longer term, flooding the globe with cheap dollars is bound to have consequences. I discuss much more on this topic in "The End of the Bond Bull," a white paper you can read on abbotdowning.com.
Think this applies just to the stock market? What about in 2011 when Standard & Poor's downgraded the AAA credit rating of U.S. government debt? U.S. Treasury securities actually rallied on the day of the downgrade! Global equity markets in general were roiled as investors prized the perceived security of treasuries more than the effects of the downgrade.
Fundamentals and feelings can co-exist. Both schools of Nobel Prize-winning thought can complement each other in a well-thought-out portfolio or investment program. For example, investors who want participation in the many corners of the markets that are increasingly well covered and efficient would theoretically look for investment vehicles that allow broad and cheap participation (ETFs, for example).
Those wanting to invest in parts of the globe or in asset classes that are less efficient (fewer analysts covering, fewer investment choices, less market depth, etc.), should be willing to pay a premium price to active managers with strong track records in those segments.
Meanwhile, behavioral finance reminds us to consciously and actively seek to test the implied wisdom of current market prices against a solid evaluation of intrinsic value. Some of the best long-term tactical opportunities often come when the herd is running hard in one direction, but fundamentals indicate a different course.
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