Month: October 2013

As an undergraduate Fama worked for a stock forecasting service and he was tasked with coming up with rules to make money in the market. Time and time again he would find profitable rules only to find that they didn’t work in new data or out of sample. In graduate school he started talking to Merton Miller, Lester Telser, and Benoît Mandelbrot and finally hit on the idea that in an efficient market price changes would not be forecastable. The rest is history.

Fama’s dissertation and famous 1970 review article, Efficient Capital Markets: A Review of Theory and Empirical Work made efficient markets a touchstone for modern economists and finance theorists but practitioners hated and still hate the idea. Nevertheless, test after test showed that very few mutual fund managers beat the market and those that beat the market this year are not more likely to beat the market the next year. Chance and perhaps a few, very rare, geniuses explain the data. Eventually, hundreds of billions of dollars began to flow into index funds and today index funds manage over $7 trillion dollars worth of assets worldwide, making Fama the 7 trillion dollar man. Fama’s ideas have made an enormous contribution to how people invest, saving them billions in fees which generated beautiful homes for fortunate mutual fund managers but less than nothing for their customers.

The no free lunch principle is the most robust of the findings of the early Fama/efficient markets school. Other early findings such as non-forecastability of returns have been revised. The initial finding was that returns were not forecastable and that is true for short durations but it is now clear that returns can be forecastable over longer horizons! In particular, variables such as the dividend/price ratio can predict stock return variation years in advance! (Robert Shiller pioneered many of these kinds of studies as did Campbell and Cochrane).  Fama, however, contrary to how he is sometimes represented did not reject these findings. Indeed, the less well known part of the story is that Fama working with French (e.g. Fama and French (1988a,1988b, 1993) has been among the pioneers in documenting and explaining these findings. What Fama’s later work has shown is that many of the anomalies such as time varying returns and the higher return to so-called value firms are real but they are not anomalies they are better explained as variations in risk premia tied to changes in the business cycle.

The CAPM (for which Markowtiz and Sharpe won the Nobel) suggested that the only source of true (priced) risk was risk that varied with the market return. That is one important source of risk but it’s not the only one, other types of macro risk which appear to vary with the business cycle are also priced and they are correlated with markers like the dividend/price ratio and the prospects for value and small-cap stocks. Thus, Fama showed that many of the seemingly anomalies (not all, however!) of the early efficient market tests can be better explained by a market model that incorporates more sources of risk. All of this work has really been a tour de force. It’s not often that the same person creates the theory and then participates in the first revolution overturning (some of) that theory.

Fama also pioneered the first event study! Fama, Fisher, Jensen, and Roll (1969) studied something a bit prosaic, stock splits, but the methodology, looking at how the stock market reacts to unexpected events, has seen been used to study what happens when Senators die unexpectedly (firms they support fall), what happens in close elections, which part was responsible for the Challenger space shuttle crash and many other events.

Fama has been long-deserving for some time now.  He won basically for his empirical work on asset prices.

Here is Fama on Wikipedia.  Here is Fama on scholar.google.com.

Fama teaches at the Booth School of Business at the University of Chicago and he is very much in the classic mold of a Chicago School economist.  I feared that with the financial crisis Fama would be too unpopular a pick, because many people misinterpret “efficient markets theory,” so this was a prize which valued the economic impact of the research over the trendiness.  That said, giving the prize to Shiller as well is a nod in the direction of behavioral finance and inefficient markets theory, so the committee covered all the bases.

Fama’s first key piece dates from 1965, and then through the 1970s he laid down the foundations for tests of efficient markets theory.  The bottom line to these early tests is that publicly available information does not predict excess returns.  That does not mean market prices have to reflect fundamental values of stocks (though Fama sometimes flirts with that claim too), but it does suggest that stock-picking, in the absence of information, will not on average outperform diversification plus random stock purchases.  The variables which earlier theorists thought might predict excess returns turn out not to.  Here is a good survey article, with Burt Malkiel, on where the efficient markets hypothesis stood circa 1970.

The remarkable thing about Fama — and a point which critics often neglect — is that Fama, working with Ken French, also has provided some of the best evidence against the efficient markets hypothesis.  See for instance this 1992 piece.  And see this piece too, with French from 1993.  Contrary to the earlier Fama work, it turns out there are some empirical predictors of excess returns, if you look hard enough for them.  The most notable of these are firm size and book to market value.  To put that more concretely, small firms, when they sink in market valuation relative to their book values, appear to yield excess returns in the future periods.  In this regard Fama’s later work is closely in tune with some of the later research by Robert Shiller.  One possible way of reading this empirical result (which I believe by the way Fama has never endorsed) is that the share prices of small firms show some mean-reversion upwards after they are hit by bad news; that could result for instance from imperfect liquidity in those share markets, combined with some measure of contagious investor sentiment.

The 1992 and 1993 pieces with French are landmarks in empirical finance and they set off a much longer literature trying to find predictors of excess returns on stocks.  Note that Fama holds open the possibility that real rates of return are changing in the economy, or risk premia are changing, and thus he does not automatically identify these empirical results with market inefficiency, as he had defined that concept in his articles from the 1960s.

Perhaps surprisingly, many of Fama’s best cited pieces are on organizations, control, and property rights, in the vein of Ronald Coase.  These pieces are not what won him the prize, but he provided an early and very insightful typology and analysis of different organizational forms, such as limited liability, non-profits, publicly vs. privately-held firms, and so on.  With Jensen he wrote a seminal piece on the separation of ownership and control, and why transactions costs might give rise to such organizational forms.  I am a big fan of his 1980 piece “Agency Problems and the Theory of the Firm.”  One contribution of this article is to show how the market for managers can boost firm efficiency, even when takeovers and other ways of disciplining managers are working imperfectly.  Also see his “Agency Problems and Residual Claims,” again with Jensen.  Fama’s work on organizational forms tends to suggest that observed market structures work relatively well, for reasons related to the work of Ronald Coase and transactions costs.

Fama has many other contributions.  He wrote an insightful piece asking what is special about banks.  It could be that deposit-taking banks have special information about the businesses they are dealing with.  This was a very important piece about inflation and stock returns.  Finally, one of Fama’s 1980 papers suggested that control of currency would suffice to pin down the price level and also control aggregate demand.  This piece continues to exert a strong influence on our own Scott Sumner, who argues that currency will suffice to achieve a nominal gdp target, even when credit markets are not operating very well (I don’t agree with that claim, by the way).

It is remarkable how many top flight, empirically important, and conceptually sharp pieces Fama contributed from 1965 through the mid 1990s, pretty much a thirty year period.  And after that he hardly fell apart in terms of research.  This is a very well deserved Nobel Prize.

Here is a fun New Yorker interview with Fama.  Here is Fama’s home page.  He is also an avid golfer.

I’ll be revising this post regularly over the next hour or so, so get out of your RSS feed and visit MR by hand.

Great picks!