Eugene Fama, Nobel laureate and Professor of Finance at the University of Chicago, doesn’t believe in a stock market bubble. But he is worried about the high levels of government debt. He warns that investors could stop perceiving government bonds as risk-free. A conversation with the «father of modern finance».
Few economists have had a greater influence on the financial markets than Eugene Fama. According to his Efficient Market Theory, competition among investors is so intense that all information and expectations are immediately and correctly priced in. Therefore, it’s impossible to beat the market in the long-term.Never shy of making pointed statements, the Professor of Finance at the University of Chicago doubts the power of the central banks. «The business of central banks is like pornography: In essence, it’s just entertainment and it doesn’t have any real effects», he says. In contrast, he warns that investors could begin to question the credit worthiness of governments because of the high national debt levels.In this in-depth interview with The Market/NZZ, which has been edited and condensed for clarity, Prof. Fama explains why he welcomes the boom in passive investing and why he sees no problem in the high capital concentration at tech giants like Apple, Amazon or Microsoft. In his view, absurd price swings such as negative oil prices are no reason to doubt the rational behavior of markets.Professor Fama, the efficient market hypothesis has revolutionized the way people invest. What goes through your mind when you look at the wild swings the stock market made this year?The market seems pretty good. It held up even though the economy is deep in the bucket. This is a good example of how forward looking the market really is: It’s looking past what we are going through now, and it’s saying that the future doesn’t look that bad.Do you think that’s the correct assumption?If I could forecast, I wouldn’t be a professor.Still, since the crash in February/March, we basically went from 1929 to 1999 in just a few months. What are the chances stocks are in a bubble?Bubbles are things people see in hindsight. They don’t identify them in advance. Sure, you can look at the behavior of prices, and you may be able to identify cases where they are too high. But if you only look back and say: «Oh, stocks went down a lot, so that was a bubble», then that’s 20/20 hindsight. At the time, there was no evidence that there was a bubble.On the other hand, sometimes there are obvious signs of excess. Let’s take the final stage of the great dotcom bull market of the late nineties as an example.Let’s go back to that period before the crash. Alan Greenspan, the head of the Federal Reserve, made his famous «irrational exuberance» speech about the market being too high in early December 1996. But even after the crash, the market never went back to the level when he made that speech. So what do you think of that forecast?Is there really no way to spot a bubble?Here’s another example: In the fifties, there was a famous professor at Stanford who was an agricultural economist. He brought plots of agricultural prices into the faculty lounge and asked people to identify bubbles. Of course, they saw the ups and downs, and all of them identified bubbles. Afterwards, he told them that these were just numbers he had randomly generated. That tells you how good people are with identifying bubbles.Against that backdrop, what do you make of the growing discipleship of behavioral finance which focuses on the influence of psychology on investment decisions and questions the efficiency of markets?What I say is that we agree on the facts but we disagree on the interpretation. In my view, there is no such thing as behavioral finance. Essentially, it’s just a criticism of efficient markets. They don’t have a theory of their own. Hence, that makes me the most important person in behavioral finance. Without me, they don’t have anybody to disagree with. So I think behavioral finance is just a branch of efficient markets.But what about factors like emotions, herd mentality or cycles? Aren't they important at all?Tastes and behavior are important in economics. Nobody denies that. But you have to translate these things into something testable, so we can take the data and test it, looking forward and not looking backward. That’s my response to all that stuff. It never works out.Yet, we also know that investors regularly mix up similar-looking stock tickers or company names and thereby cause absurd movements in stock prices. How is this rational behavior?It isn’t. You can identify mistakes like that. It’s common that names confuse investors and as a result, you can get temporary price movements. But they are usually tiny and go away quickly. I don’t say markets are completely efficient, but they’re efficient for most questions that I address. Models are never a 100% true. If they were, we would call them reality, not models. But for almost all purposes, market efficiency is a very good approximation. I’ll go even further: Almost all investors should regard markets as efficient for their own investment decisions. If they do that, they will be better off in the long-term....
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HT: Alhambra Investments, "Fama 2: No Inflation For Old Central Banks"
