Planet Money
4:45 am
Mon October 14, 2013

Economics Nobel: Nobody Knows What Stocks Are Going To Do Today

If you want to honor today's Nobel laureates in economics, turn off CNBC and ignore everyone who says they know what the stock market is going to do today, tomorrow, or next week.

The award went to three economists — Eugene F. Fama, Lars Peter Hansen and Robert J. Shiller — for their work studying asset prices.

One key finding in Fama's research is that nobody knows whether the stock market is going to go up or down in the short run. Shiller found that, over the long run (years), the stock market as a whole does tend to follow a predictable pattern.

A fun detail about today's award: Fama and Shiller have a long-running debate over bubbles. Shiller is perhaps the most famous contemporary chronicler of bubles (he wrote a book called Irrational Exuberance). Fama thinks the term bubble is used too often and too sloppily.

In a 2010 interview with the New Yorker, Fama brought up Shiller, suggesting he was always saying things were bubbly:

New Yorker: There were some people out there saying this was an unsustainable bubble...

Fama: Right. For example, (Robert) Shiller was saying that since 1996.

New Yorker: Yes, but he also said in 2004 and 2005 that this was a housing bubble.

Fama: O.K., right. Here's a question to turn it around. Can you have a bubble in all asset markets at the same time? Does that make any sense at all? Maybe it does in somebody's view of the world, but I have a real problem with that. Maybe you can convince me there can be bubbles in individual securities. It's a tougher story to tell me there's a bubble in a whole sector of the market, if there isn't something artificial going on. When you start telling me there's a bubble in all markets, I don't even know what that means. Now we are talking about saving equals investment. You are basically telling me people are saving too much, and I don't know what to make of that.

Shiller cited that Q&A with Fama in a column he wrote earlier this year:

Maybe the word bubble is used too carelessly.

Eugene Fama certainly thinks so. Fama, the most important proponent of the "efficient markets hypothesis," denies that bubbles exist. As he put it in a 2010 interview with John Cassidy for The New Yorker, "I don't even know what a bubble means. These words have become popular. I don't think they have any meaning."

In the second edition of my book Irrational Exuberance, I tried to give a better definition of a bubble. A "speculative bubble," I wrote then, is "a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increase." This attracts "a larger and larger class of investors, who, despite doubts about the real value of the investment, are drawn to it partly through envy of others' successes and partly through a gambler's excitement."

That seems to be the core of the meaning of the word as it is most consistently used. Implicit in this definition is a suggestion about why it is so difficult for "smart money" to profit by betting against bubbles: the psychological contagion promotes a mindset that justifies the price increases, so that participation in the bubble might be called almost rational. But it is not rational.

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