Explaining Asset Prices : Nobel Prize in Economics 2013

By Dr. Paramita Mukherjee

The study of the movement of asset prices in the past few decades has seen different
approaches and led to the development of new methodologies. These range from the ‘efficient
market hypothesis’ to ‘irrational exuberance’ on part of the investor leading to asset ‘bubbles’.
But the attempt to find out what determines the prices of an asset, whether a stock, a bond or
a house, remains to be the greatest contribution to the modern finance literature and this has
been honoured by this year’s Nobel Prize in Economic Sciences. This merits special attention as
the implication of the works can be directly used by investors to improve their outcomes. There
are ‘competing’ theories proposed by Eugene Fama and Robert Shiller, but both have tried to
study asset prices and to apply their theory in the real world. Lars Hansen also contributes to
this by developing an econometric method used to study prices in the financial markets.

Why Study Asset Prices?

The financial sector of an economy plays an important role in channelizing surplus funds to
deficit units for use of productive purpose. The financial assets, viz. stocks, bonds, bank
deposits etc. are the tools or instruments through which this function is performed. Now,
different asset prices may or may not move in the same direction and/or to the same extent. As
a fund manager, knowing the relationships of the asset prices can provide significant insight as
she can combine different assets in the manner that provides her client maximum return given
the level of risk the client is willing to accept. But, the behaviour of asset prices is not only
relevant for professional investors, but also for common people at large, when one wants to
choose how to save through cash, bank deposits or a house. Apart from investors, asset prices
also provide important information about some key variables relevant for macroeconomic
decision making like consumption and investment. Having information on possible bubbles1 can
help financial sector and the economy prevent a crisis.

The Theories on Asset Price Movements

One important aspect of studying asset prices is its predictability. If one could predict with
certainty how price of an asset would go up compared to another asset, there would have been

1
When the prices of securities or other assets rise very sharply for some period of time, such that they exceed
valuations justified by fundamentals, it is mentioned as the formation of a ‘bubble’. This is because this high rate
cannot sustain for long and makes a sudden collapse with heavy sell-off of the asset and at that point the bubble
"bursts".
scope for making profit by the investors. However, it is learnt quickly by others implying no one
can make abnormal profits in the asset market. But, in reality it is possible to get high return on
an average from a particular trading strategy and there are reasons why prices might be
predictable. For example, higher returns can be justified by risk. The contribution of Nobel
winners lies in analyzing these issues.

Fama’s Work

Fama tries to assess predictability by examining whether prices have incorporated all publicly
available information. His ‘efficient market hypothesis’ states that prices of securities in
financial markets fully reflect all available information. What remains is an unpredictable price
pattern with random movements which are the reflection of the arrival of news. In his seminal
paper in 1965, he showed that such movement of asset price is a ‘random walk’ in which ,given
today’s price, the future price is as likely to rise as to fall based on the new information related
to the firm. This information is immediately incorporated into the asset’s price. This insight led
to skepticism on the ability of fund managers. This implies that the fund managers’ claim to
have special ability to pick stocks is not true and their fees are nothing but a waste; This, in
turn, resulted in the growth of passively managed index funds having lower fees. Fama’s later
findings suggest that there is a tendency for certain types of stocks, small-cap stocks in
particular and stocks with a low price-to-book-ratio, to outperform the market over longer
periods like several years.

Another empirical finding by Fama had a profound impact on the academic literature as well as
on market practices. The event study from 1969 and many other subsequent studies by Fama
and his colleagues indicated that the amount of short-run predictability in stock markets is very
limited. Hence looking at historical prices does not yield a good prediction of prices in the
immediate future.

Shiller’s Work

One seemingly natural conclusion following the limited predictability of short run prices is that
it is more difficult to predict prices over longer time horizons. But empirical research by Robert
Shiller shows that this belief is not correct. In his 1981 paper, he found that stock prices are
much more volatile than that suggested by the underlying trends in the dividends should
suggest2. This excessive swings imply that an increase in prices relative to dividends in a year

2
The theory states that a stock’s value should be equal to the expected value of future dividends.
will be followed by a fall in prices relative to dividends in some other year and one can infer a
predictable pattern in the longer run.

Thus, Shiller’s findings contradicted the efficient market hypothesis of Fama. Shiller extended
his research from stock to bond market and the real estate market. He also suggested that the
rapid rise in the market (Nasdaq in late nineties, in particular) might reflect trend-following on
part of the investors rather than a rational appraisal of future prospects and thus, indicated a
speculative bubble in the market. Subsequently in March 2000, the bubble in technology stocks
did burst, the market collapsed and his theory of ‘irrational exuberance’ caught attention.

This points to the rejection of the notion of ‘rational’ investors. Mistaken expectations may lead
to over or underestimate of future payment streams; thus, psychological mechanisms may
explain why asset prices deviate from fundamental values. This ‘behavioural finance’approach
is now an established strand in the finance literature. Even more rational investors cannot
nullify the effects of swings created by irrational investors as they may face constraints or
limitations preventing them from going against the market.

Shiller’s significant contribution also lies in the housing market. He predicted the collapse of the
housing price bubble in the recent past. His work has shown that housing prices in US and other
countries that rose to the levels far above traditional valuations, was actually driven by
excessive optimism about future prices. The Case-Shiller housing price index was developed to
help investors track the price movements and trends.

Hansen’s Work

An asset’s value is based on the future payment stream. But these should be discounted as the
payments in the distant future carry less weight than immediate future payments. Shiller
considered constant discount factor. But, actually discount rates may vary over time and then,
even stable dividend streams may lead to significant variation in stock prices. Why discount
rates vary could be explained by a theoretical model, viz. the Consumption Capital Asset Pricing
Model (CCAPM) that connects the asset prices to the savings and risk-taking decisions by
rational individuals. In the longer run, compensation for risk should play a more important role
for returns.

CCAPM was not testable for many years till Hansen developed an econometric method, the
Generalized Method of Moments (GMM) in 1982, particularly suited for dealing with the
peculiar properties of asset-price data. Hansen made fundamental contributions also by
applying it in a sequence of studies. His findings showed that the standard version of CCAPM is
not valid and broadly supported Shiller’s preliminary conclusions that asset prices fluctuate too
much even with time-varying discount rates. Hansen's work established more strongly the idea
that the mispricings identified by Shiller had to do with fluctuations in people’s appetite for risk,
e.g. when times are bad, investors become more cautious, and when times are good more
investors are willing to pay high prices for assets. This result has generated a large wave of new
theory in asset pricing both with rationality assumption as well as in the areas of behavioural
finance.

Beyond Theory

The empirical findings of Fama, Shiller and Hansen have important practical implications for
investors.

First, efficient market hypothesis implies that an investor cannot earn an abnormally high
return and fund advisor claiming to predict the stock prices well, also cannot provide
consistently high returns. It has been observed that having performed well in the past does not
imply that the advisor or the mutual fund will do so in future as well. Second, future stock prices
are unpredictable as stock prices quickly reflect all public information. That is why stocks
prescribed on the basis of ‘technical analysis’ also cannot outperform the market. Third, the
evidence against the efficient market hypothesis shows some anomalies which an investor can
keep in mind while investing. It is found that small firms have earned abnormally high returns
over long periods that cannot be fully justified by risk. Fourth, stock prices may overreact to
news and the pricing errors are corrected only slowly giving scope for making higher returns
(e.g. by buying immediately after a poor earnings announcement and selling it after a few
weeks when price gets back to normal levels). Fifth, sometimes prices do not adjust to the news
announcement immediately; it takes time to adjust, yielding scope for higher returns. The
debate will continue, but an investor may play safe by buying stocks and then holding it for long
periods. It is also sensible to go for the funds charging low management fees.