Back to School: Fama, French Discuss Their Work; The top proponents of the efficient-market theory on stocks, behavioralists, and bubbles

SATURDAY, JANUARY 4, 2014

Back to School: Fama, French Discuss Their Work

By BEVERLY GOODMAN | MORE ARTICLES BY AUTHOR

The top proponents of the efficient-market theory on stocks, behavioralists, and bubbles.

Eugene Fama and Kenneth French have the easy banter of two brilliant minds that have collaborated and challenged each other for three decades. Fama, 74, teaches at the University of Chicago’s Booth School of Business. He just won the Nobel Prize for his theory of market efficiency, which, in 1965, argued that all available information was immediately incorporated into stock prices. In 1985, he teamed up with Ken French, who at the time also taught at Chicago, but is now a professor at Dartmouth College’s Tuck School of Business. Since then, “Fama and French” has been a catchphrase, shorthand for efficient markets and the model for investing that grew out of that theory.They’re best known for the Fama-French three-factor model, the 1992 paper that built on the capital-asset pricing model, incorporating two other crucial observations: Small stocks and value stocks tended to outperform. Since then, they’ve revised that model to include two other factors (momentum and profitability). Dimensional Fund Advisors was founded on Fama’s early work, and has modified its strategy under Fama and French’s ongoing work and guidance. Both serve on Dimensional’s board; French is the firm’s director of investment strategy.

Though they mostly agree—and work together when they do — the fun part is watching them reach that agreement. They’ve collaborated consistently for nearly 30 years now and, in the course of their conversation with Barron’s, might have hit upon the topic for their next paper.

Barron’s: The Nobel Prize for economics puzzled a lot of people. You won, Gene, for your efficient-markets theory. Robert Shiller won for his work in behavioral finance — a school of thought diametrically opposed to yours. Is it odd to find yourself in that company?

Fama: I have a stock answer. We agree on the facts; we disagree on their interpretation.

French: That’s a very nice way to say it.

Fama: Everybody understands that there is some predictability in stocks. That is the reward you get for bearing the risk of whatever security you own. That risk varies from time, and there are reasons for that. The difference between the efficient-market types and the behavioralists is that we think the variation in expected returns has rational sources to it, and they think it doesn’t.

The basics of market efficiency are often misunderstood. Some say that if factors such as a stock’s value, size, trading momentum, and profitability — all of which are part of your multifactor model — indicate outperformance, then the market isn’t really efficient.

Fama: That’s a misconception. I’ve talked to maybe 15 journalists, and they say “You changed your mind; you came out with this three-factor model.” My response is “you’re mixing models of market equilibrium with market efficiency.”

Can you explain that?

Fama: Market efficiency says that prices embed all available information. Models of marketing equilibrium tell you how the prices get set.

French: This is where we agree on the facts [with the behavioralists], and we disagree on the interpretation. We agree there is a value effect. But some folks say: “See, that must be mispricing.” If I tell you interest rates went up, you know that bond prices went down. You didn’t need to ask, “Why did interest rates go up?”

So using behavioral finance to explain the “why” behind any of these relationships is irrelevant?

French: No, no, there are really interesting questions to be asked as to why there are differences in expected returns. But observing a relationship between book-to-market and expected returns doesn’t help you distinguish between mispricing and risk.

It’s also been said that your work ignores the notion of bubbles.

Fama: It doesn’t ignore it; it says you can’t document that they’re there. The word bubble makes me mad because you can’t predict an end. Stock-price returns are unpredictable in the short term and more predictable in the long term. But there is nothing in the long term that isn’t already built into the short term.

French: I’ll clarify what Gene says in terms of the persistence of expected return. Let’s say I ask you to calculate the average return of a stock. If I give you one day versus 100 years, your estimate after 100 years is going to be more accurate. But if I want you to tell me what the price of this stock is going to be, would you rather guess tomorrow’s price or the price 100 years from now? You’d rather guess tomorrow’s price.

Critics also point to the financial crisis and market crash as evidence of inefficient markets.

Fama: That’s another big misunderstanding of what efficient markets is all about. It is a characteristic of stock returns that they get much more volatile in bad times. Volatility is a characteristic of an efficient market, especially in an uncertain environment. We had a huge recession; nobody knew how it was going to turn out.

French: It’s even more than that. The big hallmark of the crisis was….

Fama: Well, let’s be clear. The behavioral people did not fall into this trap. It was only the media and practitioners who don’t like the idea of efficient markets to begin with.

French: But what was key in the financial crisis was what people call “modern bank runs.” There were all sorts of instabilities in the system. And, as Gene says, normally we have lots of volatility during bad times. Well, in the crisis, we had enormous volatility because of this feedback—the bank runs—in the process.

Fama: Mmm…I don’t think you can say that.

French: I think we can say that confidently.

Fama: No, you can’t document it.

French: What, that we had bank runs?

Fama: No, there were bank runs. But that stock returns got volatile because of bank runs? That’s a belief.

French: OK, I firmly believe it.

Fama: I don’t think you can tell.

French: I have one foot in the behavioral camp. We’ll wind up writing a paper on this.

I’d like to read that paper.

French: We have to agree on something first.

Fama:I don’t think you can draw conclusions from one event.

French: Here’s my argument: So banks are financing 25% to 30% of their capital every day in the overnight market. The uncertainty about whether they are going to be able to raise capital or not creates volatility. If you give me that financial institutions are a key part of the economy, and they get blown away, you lose infrastructure.

Fama: Well it was predictable that they wouldn’t get blown away.

French: No, it wasn’t.

Fama: Sure it was; they were either going to get bailed out or they were going to get nationalized.

French: Lehman Brothers went down. Bear [Stearns] essentially went down. So you come to the market each day not knowing whether everybody else would show up. If they did show up, that was good news, that means the economy is better than we thought. That’s huge positive feedback. On the day they didn’t show up, that really bad news came with a big negative feedback.

Fama: OK, but what you are saying is that investors are responding to what they perceive is news about real events.

French: Yeah, but the bank-run problem exacerbated, magnified the impact.

Fama: All right, we’ll explore.

Thanks, gentlemen.