The Smartest Guys In The Room
By David Feinman
Sir Isaac Newton showing an optical experiment to an audience. Woodcut by Martin after C. Laverie
Some of the greatest minds in history have tried with varying success to divine the future direction of markets. MIT mathematician Edward Thorp, regarded as the father of modern quantitative hedge fund trading, started his investing career by counting cards at blackjack tables in Las Vegas. Later, after being banned from the casinos, he accumulated vast wealth by applying his deep understanding of probability to trading a niche market in convertible securities. On the other side of the ledger, Sir Isaac Newton, not an intellectual slouch by any measure, went bankrupt in 1720 when his shares in The South Sea Company crashed following one of the biggest stock bubbles of all time. Futurists have looked at everything from sunspot activity to the outcome of the Super Bowl in search of a reliable predictor. The challenge remains unanswered.
The 2013 Nobel Prize in economics was shared by Eugene Fama, Robert Shiller, and Lars Peter Hansen, but the prize-winning research was not a concerted effort. In fact, for years, Fama and Shiller have sparred publicly, expressing adversarial views about how markets work. Fama’s “Efficient Markets Hypothesis” holds that asset prices reflect all available information. The implication is that markets operate with a high level of rationality, making it difficult for individuals to outperform the total market with any consistency. In contrast, Shiller and other behavioral economists contend that asset prices are driven by emotion instead of rational calculation, suggesting that price inefficiencies can be exploited to capture gains in excess of average market returns. Hansen’s highly statistical view lands somewhere in between the other two. In recognizing three divergent perspectives simultaneously, the Nobel committee seems to have acknowledged that no single model can explain the mystery of market behavior.
I have attended lectures and Q&A sessions with both Fama and Shiller (separately) where I have heard them criticize each other’s work. Fama discounts Shiller and most behavioral economists as weak statisticians doing what he wryly calls “the devil’s work.” [1] Shiller says Fama treats data the way a Catholic priest considers the existence of God – i.e., as more of a belief system than rigorous science. [2] Ecumenical differences notwithstanding, they are both tenured professors of economics at elite institutions — Fama at the University of Chicago and Shiller at Yale — and outside of the classroom, they are both consultants to mutual fund companies.
The rivalry between Fama and Shiller and their competing world-views is less significant than the extent to which they agree. Ask either of them what the markets will do next and you are likely to hear the same answer: Who knows? More specifically, both scholars concede the limitations of statistical modeling when it comes to predicting markets and the economy. In the physical sciences, hypotheses are scrutinized with laboratory testing to ensure reproducible results. But in economics, there is no laboratory, only mathematical extrapolations from the past. And the data is noisy, incomplete, and difficult to interpret. It therefore comes as no surprise that every piece of advertising produced by the investment industry closes with the oft-quoted admonition: “past performance does not necessarily predict future results.”
In February of this year, as spread of the novel coronavirus escalated into a global tragedy, the financial media forecasted a violent sell-off in risk assets. Less frequently predicted was an equally dramatic recovery. And yet, as of this writing, despite a rising rate of infections and soaring unemployment, the S&P 500 index sits only 10% below where it opened at the start of 2020 and the NASDAQ index is slightly positive year to date. Bulls say the recent advance of US stocks foreshadows a V-shaped march back to recent highs while pundits warn of a bear market reminiscent of the Great Depression that will end in tears. During a Dimensional Funds webinar earlier this week, Fama remarked how it is impossible to know what the economic landscape will look like in the aftermath of the COVID-19 pandemic. The world is at an inflection point and we will just have to wait and see what happens next.
It is tempting to think of current market volatility as a harbinger of things to come. But historically, short-term market returns are just as likely to be higher as lower. The following graph showing daily US large-cap stock returns going back 30 years is almost evenly split between up-days and down-days, slightly favoring gains. Research has shown that current volatility does not predict future market performance. Attempting to time the markets with tactical entrances and exits usually results in underperformance compared to a passively held index fund. Markets are driven by news and news is random.
How can one invest in the face of an unknowable future, given imperfect information? The markets suggest an answer. Each business day, markets trade securities worth billions of dollars. This financial activity represents our collective will to innovate and prosper, through times good and bad. The net result has been a long-term positive return on invested capital that has compensated investors for the risks, as shown below in a graph of S&P 500 index historical closing prices. The smartest guys in the room may not be able to predict the future. But with the benefit of hindsight plus a dash of wisdom, it is reasonable to expect that sooner or later, the world will get it right.
Source: https://www.google.com/finance/quote/.INX:INDEXSP
[1].https://www.forbes.com/sites/hershshefrin/2013/10/17/my-behavioral-take-on-the-2013-economics-nobel/#14376e259db3
[2].https://www.theguardian.com/business/2013/dec/10/nobel-prize-economists-robert-shiller-eugene-fama
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