I’m Paul Kaplan, research director at Morningstar Canada.
Eugene Fama and Robert Shiller, and a third economist, shared the 2013 Nobel Prize in Economic Sciences. As I discussed in a previous Morningstar minute, Fama’s share of the prize was in recognition of his development of the Efficient Markets Hypothesis which implies that changes in stock prices are nearly impossible to predict. Shiller’s share of the prize was for demonstrating something seemingly quite the opposite; namely, that over the long term, stock prices are somewhat predictable. As the Nobel committee note in their press release announcing the winners of the 2013 prize:
“If prices are nearly impossible to predict over days or weeks, then shouldn’t they be even harder to predict over several years? The answer is no, as Robert Shiller discovered in the early 1980s. He found that stock prices fluctuate much more than corporate dividends, and that the ratio of prices to dividends tends to fall when it is high, and to increase when it is low. This pattern holds not only for stocks, but also for bonds and other assets.”
The work that the Nobel committee was referring to in its press release dates back to an article that Shiller published in 1981 that compares the volatility of actual stock performance to the volatility of performance that could be explained by fluctuations in expected dividends. Shiller based his analysis on the dividend discount model, in which the value of stock is equal to the present discounted value of expected future dividends. He compared the volatility of the performance of the U.S. stock market since the 1920s to the volatility of performance that could be explained by the dividend discount model. He argued that the volatility of the stock market was greater than could be explained by rational expectations of future dividends, thus challenging Fama’s Efficient Market Hypothesis.
In addition to his empirical research, Shiller conducted surveys to find out why investors and stock traders trade. The results reinforced the views that he shares with members of the behavioral school of finance such as 2002 Nobel laureate Daniel Kahneman (whom I discussed in a previous Morningstar Minute) and 2017 Nobel laureate Richard Thaler (whom I will discuss in a future Morningstar Minute); namely, that trading decisions are often based on emotion rather than reason.
In addition to his research on stock markets, Shiller is the co-developer of what has become one of the most important measures of real estate market performance, the Case-Shiller Index. He also has written about bubbles in the stock and real estate markets in which rapid price rises are followed by crashes. His best-known work on bubbles is his book, Irrational Exuberance, now in its third edition.
In giving the Nobel Prize jointly to the leader of the efficient markets school and a leading proponent of the views of the behavioral school, perhaps they were saying that can be truth in apparently opposing positions.
