Interview with Eugene Fama

Well, economists are arrogant people.  And because they can’t explain something, it becomes irrational.  The way I look at it, there were two crashes in the last century. One turned out to be too small.  The ’29 crash was too small; the market went down subsequently.  The ’87 crash turned out to be too big; the market went up afterwards.  So you have two cases: One was an underreaction; the other was an overreaction.  That’s exactly what you’d expect if the market’s efficient.

The word “bubble” drives me nuts. For example, people say “the Internet bubble.”  Well, if you go back to that time, most people were saying the Internet was going to revolutionize business, so companies that had a leg up on the Internet were going to become very successful.

I did a calculation.  Microsoft was an example of a corporation that came from the previous revolution, the computer revolution.  It was hugely profitable and successful.  How many Microsofts would it have taken to justify the whole set of Internet valuations?  I think I estimated it to be  something like 1.4.

Here it is, which is interesting throughout, hat tip to Mark Thoma.  I do think Fama is skippiing a bit too quickly from "the efficient markets hypothesis is hard to test," to "there is a presumption in favor of efficient markets."


Speaking of stock valuations with regard to the Internet, or rather, the Dot-Com bubble of the late 1990s, there really are two major phases encompassing the rapid increase in stock prices in this period. The first began in July 1991 and continued until January 1998, consistent with the growing level of productivity associated with the widespread introduction of computer technology in businesses throughout the period.

The second is the actual disruptive event of the bubble itself, which ran from January 1998 through June 2003 (see this chart roughly halfway down the post in the "Discovery" section - you'll know it when you see it.)

As for differences between 1929 and 1987, they're rather like night and day. Fama understates the magnitude of the crash of 1929, while overstating the crash of 1987, which really pales in comparison.

One crash too small and one too big is evidence of an efficient market? Looks like the opposite to me, but then I'm not an economist. Efficient markets theory says that markets react instantaneously to new information. But the problem, as the example shows, is that they don't necessarily react correctly.


I think you misunderstand Fama's point. Obviously there were massive overvaluations of individual companies. I suspect what he is saying is that if you had held a broad portfolio of those Internet companies it would have taken only 1.4 Microsoft style successes to generate a good return for the entire portfolio, even if most of the companies went under.

I don't know if that's true, or how exactly he did the calculation. Probably there are things involved one could argue with. But I very much doubt he made a silly mistake.

One reason to expect the market to tend toward rationality is that irrational elements in the market tend to lose influence. They make bad bets, and lose money. If they're irrational in the first place, they tend not to gain influence in the first place.

Rational stock prices are based upon expectations. My comment wasn't that CISCO's stock valuation turned out to be wrong. My comment was that the expectations required to rationally justify CISCO's stock price were essentially ludicrous. During the tech boom period, this wasn't a company specific phenomenon... it was systemic.

Near the height, about 25% of the market, ($4 trillion!) had valuations at an average of approximately 15 times sales and 87 times trailing earnings. However you look at it, these valuations imply rather fantastic expectations about earnings growth for a huge number of companies. How much would have to have gone right just for these stocks on average to NOT lose value? (Also, I don't see how 1.4 Microsofts would make this work... Microsoft's market cap now is around $330 billion?)

(1) If Fama thinks this is all rational, I think he is dead wrong (2) To even begin to convince me otherwise would require a lot more evidence than some throwaway line about Microsoft that (to me at least) doesn't seem to make much sense.

Ansel F: Strongly disagree. Arbitrageurs (or highly rational investors) will only wipe out irrationals under an unlikely set of assumptions - frictionless markets, unlimited or very large leverage, and very long time horizons. To the closed-end fund examples B. Rosser mentions above I would add the 'stub' examples of, e.g., Lamont and Thaler where for several months, all of 3Com's non-Palm business was valued at - (negative) $22B!

In general, I think Prof. Fama still cleaves to the notion that because a) it's nigh impossible to make money consistently without private information and b) the efficient markets hypothesis is hard to test, therefore c) we ought to assume that markets are efficient. C implies A and B, but the reverse implication emphatically does not hold - Robert Shiller called it "the most remarkable error in the history of economic thought".

The efficient markets hypothesis is junk. Why? Because value is subjective. Work it out for yourself from there.

The market will never be "rational" to most people, because other's actions are never rational to them. The real question is why don't these people who complain about market failures go into business and make some money off of them (markets in everything)?

Anyways, very few investors during the height of the dot-com boom actually expected long-term gains. At least, none of the investors I talked to did. They were flipping stocks, hoping to get still have a chair when the music stopped. I think the question we should be asking is what enabled the liquidity needed for this sort of flipping to occur.

I have great interest in Eugene Fama's work (Fama and French's) because I have to explain many of his ideas to my clients.

I also believe that most investors fail to believe that "markets are efficient" and that is one of the reasons many, if not most, fail to get market returns with their investments.

Everyone likes to think they can outsmart the stock market. We are designed to think we can. Unfortunately, we still can't determine if the person who does is 1. Lucky or 2. Skilled.

I have met Fama a couple times and he never fails to impress me. Fama is arrogant when talking about his research. I can handle arrogance.

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