And The Nobel Prize Goes To… Asset Pricing

By Filipe R. Costa

Last Monday, the Nobel Foundation announced the winners of the Nobel Prize in Economics. This year the Foundation decided to split the prize between three American academics: Eugene Fama and Lars Hansen from the University of Chicago and Robert Shiller from Yale University. This illustrious group won the most prestigious prize in their field for their work on asset pricing.

Asset pricing has been one of the hottest topics in recent years, in the wake of the Financial Crisis. It is an extremely important area of study for anyone remotely interested in trading the markets. But what does the work of this year’s winners have to teach us?

Eugene Fama is one of the most famous names in economics. His specialism is in the field of financial research and he is widely regarded as the father of the efficient market hypothesis. Fama’s work on asset prices began with his Ph.D. dissertation, in which he asserted that stock prices are unpredictable in the short term. His research gave rise to the random walk theory, which maintains that all information is incorporated into prices. Were this not the case, so Fama would have us believe, then markets couldn’t be efficient.

Of course try telling this to a technical analyst and we’re sure he or she would have something to say about that!

Meanwhile Fama’s colleague at Chicago, Lars Hansen, specialised in statistics and econometrics. He developed a statistical model to test rational theories of asset pricing. Although not necessarily that relevant to the average trader his research was still interesting.

However, it was the work of Robert Shiller that probably has the most relevance to traders. Regular readers of SpreadBet Magazine will be familiar with some of Shiller’s insights in that we often reference the Shiller PE ratio. Published in Shiller’s book Irrational Exuberance, this ratio is widely regarded as being a better barometer of stock health than the standard PE. The simple rule to apply to this ratio is the higher it rises and the lower it falls above or below the mean, the greater the chance of a reversal. This mean reversion process affords traders opportunities to exploit medium to long term price discrepancies.

In making their award this year the Nobel Foundation has highlighted the weakness in financial markets concerning asset pricing. Specifically they have tried to encourage a more rational approach towards risk and investment. Shiller’s work, in particular, plays a key role in helping us understand why stock prices cannot rise forever, unless earnings and dividends follow the same trajectory. At any given time, if prices grow faster than earnings then a mean reversion event has to occur. If P/E or P/Div ratios are too high this usually indicates a bubble has formed and the mean reversion event is generally a crash.

The lesson is simple. Buying just because everyone else appears to be buying is not necessarily a winning strategy in the long run.