The Efficient Markets Hypothesis and Modern Finance with Nobel Prize Winner Eugene Fama

>> Jon Hartley: This is the Capitalism and Freedom in the 21st Century podcast, an official podcast of Hoover Institution Economic Policy Working Group where we talk about economics, markets and public policy. I'm Jon Hartley, your host today. My guest is Eugene Fonda, who is a professor of finance at the University of Chicago at Booth School of Business, is widely regarded as the father of modern finance, as his research has really, truly built the foundation of the field of financial economics as we know it today, for which he was awarded the Nobel Prize in economic sciences in 2013.

 

Welcome, Gene.

>> Eugene Fama: Thank you,

>> Jon Hartley: Gene. I want to first get into your early life. You were born in Boston, you grew up in the Boston area. All your grandparents were Italian immigrants from Italy, as I understand it. And my understanding is that you're actually named after one of the Pope Eugenes.

 

You are an athletic all star at the Malden Catholic High School, you're in their athletic hall of fame. And it's in the Boston area, that's Middlesex County. You study Romance Languages as an undergraduate at Tufts. How did you get interested in finance and decide to do an MBA and PhD at University of Chicago and arguably become the greatest financial economist ever?

 

 

>> Eugene Fama: Well, my initial intent was to be a sports coach and a French teacher. So I took Romance Languages there my first year, two years at Tufts, and I was getting bored with it. So I took an economics course and I loved it and the professors loved me.

 

They were reading my exams to the class, so I immediately switched into colleague. And I was close as I could in my last two years. Then when it came time to, I said, I think I want to go to graduate school and get a Ph.D. And my professors, who were all Harvard graduates, I said, I don't wanna go to an economics department, I wanna go to a business school.

 

And they were all Harvard graduates. And they said, well, don't go to Harvard, don't go to the University of Chicago. They have more of an academic orientation there. And so I applied, and I never heard back from them. And March came along and not having heard back, I called and the Dean of Students answered the phone.

 

The student doesn't even have a phone now because he's too important, but answered the phone and talked to me for a while. He said, you know, I got some bad news for you, and I don't have any record of your application. But he said, what kind of grades do you have?

 

And I said, well, basically all A's. And he said, well, we just happened to have a scholarship for somebody from Tufts. Do you want it and that's how I ended up at the University of Chicago.

>> Jon Hartley: Wow, that's amazing. And I mean, in terms of your sports interests, it's wonderful.

 

I know you play a lot of golf and you're still playing a lot of golf over the years. So it's great to see that you maintain some of that initial interest in sports as well. You spent your entire career as both a graduate student and professor at the University of Chicago.

 

And you arrived there in the 1960s, and there were a lot of other folks who were there at that time. I mean, it was truly, as I understand, a foundational period for financial economics as a field. There was so little done at that point in time. I mean, my sense is that, you know, Markowitz, Harry Markowitz had just written down the mean variance model in the 50s.

 

Things like the CAPM were sort of just being written down by folks like Bill Sharp. But at Chicago, you had folks like Martin Miller, Harry Roberts, they're your advisors. You had folks like Myron Scholz, who you advised, and other folks like Dick Roll, many, many others who are really foundational to financial economics and developing the field as it was so early.

 

What was it like doing financial economics research at that time? Obviously personal computers didn't really even exist at that point in time. How you would a young Gene Fama even do financial economics research in the 1960s? I mean, what sorts of tools were you using and what sorts of tools were being developed?

 

 

>> Eugene Fama: Well, I got into it because Harry Roberts, who was a statistics professor who I really admired, and Merton Miller, who was my main advisor. The two of them who my advisors, they were both interested in the work that was going on in describing price formation, trying to say something intelligent about it.

 

And in there, people working in it. There were some at MIT, some in Chicago. They were kind of fumbling around the edges. They had no clear conception of what they were trying to do. So they were doing tests and saying these are tests of market efficiencies, but they're basically said efficiency applies, that prices are in walk.

 

But that, that was a very crude way of, of approaching stuff. So basically what I did was I started working on that because I knew it was a quick way to get a PhD because everybody there was interested in it. And I had two kids at the time and I had to get out quickly.

 

So I said, I started working, and then I've been doing it, I guess more or less ever since. But basically what I added to it was a statement that what you're missing here is that you have to have some statement about what equilibrium looks like in this world.

 

So what are expected returns that had been totally left out of the picture? That's what I call the joint hypothesis problem. You have to say something about expected returns in order to say something about market efficiency. That really set the world into thinking in that direction, and research exploded.

 

So I say to everybody, well, I was there at the right time. That's what it comes down to. Nothing had been done. So everything you did was new, it was really very easy. PhD students now have it very difficult because they have lots of stuff they have to learn, and then they make a little play on the wrinkle, adding a wrinkle to it.

 

Whereas when we were doing it early on, it was like shining fish in a barrel, everything had better.

>> Jon Hartley: So, well, now we're staying on the shoulders of giants like yourself. And it's amazing as somebody who's a young researcher. Yeah, it's amazing to imagine just what it would be like sitting in a room with any of those people talking about financial economics and what hadn't been written down yet.

 

It's really quite amazing. And I know, you know, before I get into sort of your body of work here, I know just another amazing story, you know, University of Chicago, that people, some people might know or might not appreciate, is that the University of Chicago Booth School of Business gets its namesake ultimately from, in part, your thinking.

 

You know, two of your students, David Booth and Rex Sinquefield, they were students of yours in the 1980s, and they left to start one of the first index fund businesses and brought you in as part of that effort. And ultimately, because of that success, David Booth made a very big contribution to the University of Chicago.

 

And hence, that's where it got its name from. So the Booth School of Business name, in part is thanks to your ideas. What was that like? And could you explain to me a little bit about, you know, what the early days of dimensional point advisor, DFA, which was founded by.

 

Field and did with your students. What was that like? And, and, you know, being part of it since.

>> Eugene Fama: Well, Booth was my research assistant, my teaching assistant, when at the same time that Rex was in the class, so advanced class for PhD students and ambitious MBA students.

 

And Rex took it all to Hyde, went off to American national instead of really the first index slides based on what he learned in the course and David, who was my research assistant and my teaching assistant, so he came to me and finally after three years said, I see what you do for research.

 

I've been helping you do it, and I don't want to do it. I want to go out and work. So I called John Macquan at Wells Fargo and got him a job, and he went off there and then 10 years later he called me, he said he wanted to start a business.

 

And what he wanted to do was he had read all the recent work and there was a lot of work at that time about how small stocks tend to have high average returns. And he said he wanted to start a small stock fund because none existed for institutional investors at that time.

 

They had stayed away from that, and he wanted to start one. So that's how dimensional fund advisors came about and he said, I want you to be involved. And I said, well, I don't target my research at commercial products and he said, well, you do what you do.

 

We'll figure out if we can use any of it. And that's basically the relation we've had with them forever. First me and then me and Ken French after a while.

>> Jon Hartley: It's amazing. I mean, it's amazing how applicable financial economics is in the real world. And I remember you saying in the past that the future economics is the most successful area of economics.

 

And I think if we're measuring success by application, I think that almost certainly in the sort of magnitude of impact, I think that's almost certainly the case. I can't imagine how finance things like factors, things like the cap and someone who worked in finance, Goldman Sachs asset management for five years, all these ideas like cap and beta or market beta.

 

I mean, these things are just so fundamental to the practice of finance. And what's amazing is, you know, you've done so much of, so much work on this topic, and you've been so early to so many topics. I think my mind, you're one of the few people I think that would deserve two Nobel Prizes.

 

And just to list a few of these ideas like fat tails, were writing about fat tails, the distribution of stock prices in your PhD thesis in the 1960s, the idea that stocks can have extreme events. And that was roughly around the time when Black Swan author Nassim Taylor was just born, you've written about event studies.

 

 

>> Eugene Fama: You're missing was the one who had that idea about the fat tails. He said everything in the world was fat tails, so.

>> Jon Hartley: Wow, that's amazing I applied even earlier.

>> Eugene Fama: I did not invent that concept, SOX. I got it, I got it from him. I applied it.

 

But it was, that was his idea, basically efficient markets, I'll take credit for it, but not fat deals.

>> Jon Hartley: We'll get to efficient markets in a minute here. But you wanna think about event studies and event studies just in general, causal inference is swept economics as a discipline since the 1990s.

 

But you were there in the 1960s with Fama, Fisher, Jensen and Roll, 1969, which sort of laid the groundwork for doing event studies, I think about the forward premium puzzle and carry trades. In 1984, you wrote a paper about the forward premium puzzle. You know, the idea that, you know, currencies aren't necessarily obeying the uncovered interest rate parity, where, you know, the higher interest rate currencies are selling that they're not actually selling off, as sort of theory would predict.

 

And then you've done also a lot of amazing work in sort of the corporate finance, organizational economics theory, the firm kind of area too and a lot of amazing things like the stock market effects of buybacks, dividend announcements agency problems theory, the firm, the idea that competitive markets naturally sort of align with managerial and shareholder interests.

 

I'm just curious. I mean, one, lots of these, all these greatest hits. Many of these greatest hits are covered in a book called the Fondal Portfolio, which is a great collection of your work that's edited by John Cochrane and Tobias Moskowitz as well. But I'm curious, taking a step back, how would you describe the overall theme of your work?

 

What in your mind ties everything together? Is it risk based asset pricing? Diffusion of information, competition? Dare I say efficient markets?

>> Eugene Fama: Well, efficient markets is one but the logic underlying efficient markets would have a lot to do with the way, for example, Jensen and I looked at and his markets more generally in terms of organizational markets and how they form and competition pushes them in a particular direction.

 

So the idea of competition kind of determining how economies work and a lots of different dimensions that's basically the foundation of efficient markets and the foundation of lots of other stuff that I've done. But basically I think I had a knack of going into areas where very little had been done and coming up with simple stuff that people related to.

 

So I've always said that one of my best talents is writing in a very simple way so the maximum number of people can understand it. And I teach that to my students, some of them follow it, some of them don't. But I still think it's a good rule to go by in research.

 

But anyway, I think I was in part lucky and in fact I had a pretty good nose for it, what good topics were.

>> Jon Hartley: Amazing, to say the least. So I want to start by getting into efficient markets here and dive into it. So there's this joint hypothesis problem which you talked about in your Nobel Prize lecture.

 

And that's been sort of a big theme of, I think, a lot of your work. What led you to write your famous 1970 article, Efficient Capital Markets, and sort of what began this lifelong foray into being sort of a defender of the efficient markets hypothesis that says that stock markets are pricing information quickly, was Mandelbrot at all an influence here nd what was your relationship with Mandelbrot?

 

I'm curious.

>> Eugene Fama: No, I had a good relationship with him. He wasn't, he wasn't the motivator for that. Basically, fat tails was his passion throughout his whole life. Fat tails of everything, those spillovers of the River Nile, everything, rainfall, everything was fat tailed. So, And he was right, I think, pretty much true.

 

But that wasn't the motivation for the research that I was doing on markets basically and how they work. Economics of it, So that's where the joy hypothesis problem came up. And it's, An unsolvable dilemma that you can't test market efficiency outside the context of some model that tells you what equilibrium expected returns look like.

 

So you need a model of market equilibrium in order to test whether enterprises conform to that model so when you do the tests. It's always a joint test. You don't know what you're rejecting, whether you're rejecting a model of market equilibrium or whether you're rejecting market efficiency. So that's the conundrum that this insight poses.

 

But as a student of Harry Roberts, what I learned was there's no real truth out there. You're basically just trying to improve your description of the world. There's nothing that's really truth top to bottom. So you try to learn a little bit every time we do something, but don't expect that you learn everything other care anywhere near 100%, right?

 

Somebody's gonna come along and improve on what you do. Maybe it's you, maybe it's somebody else, but somebody will do it.

>> Jon Hartley: I guess my understanding is sort of that hypothesis problems, it says that at some level, efficient capital marks is something that's difficult to test. But a lot of your work though is very empirical.

 

And so I'm curious, how in your mind does you know your work on, say, looking at dividend buyback announcements and so forth? I mean, and seeing how prices respond immediately to these things. I mean, how do you think a lot of your work advance, your empirical work specifically kind of advance this idea of efficient markets?

 

I guess maybe you've just seen that many of these events are sort of immediately incorporated into asset prices.

>> Eugene Fama: Well, that part, farmer fisher, Denson Roll was the first event study. There have been thousands of them since then, but none of us had ever done another one. So the original four never did another event study, and now people do event studies.

 

They don't even give us a reference anymore. It's so built into the literature. It's in macroeconomics, basically, everywhere.

>> Jon Hartley: Applied economics everywhere.

>> Eugene Fama: For example, it's a fundamental way that the law people try to establish precedence in law, so it's everywhere. And-

>> Jon Hartley: As you say, they're used in court cases, event studies.

 

I mean, it's amazing how influential it is not just in academia and academic research, but also in the real world.

>> Eugene Fama: That's only half of it. So the other half is you have to have some statement about how prices get formed. You need a model of market equilibrium.

 

And that's the other side of my research on asset markets is trying to come up with models of market equilibrium that help us describe expected returns better. Some of it worked well and some of it I was really confident in and it seemed to work in the US and around the world.

 

Seems to have basically disappeared or gotten a lot weaker. Maybe we killed it in the process of developing it and investors jumping onto it, but who knows. But anyway, that was the other side of the story that I've worked on basically continuously.

>> Jon Hartley: Good, totally, well, I wanna dive a little bit into, I guess, we'll talk about factors in a second here, but I wanna talk a little bit just about sort of efficient markets versus behavioral finance.

 

And often I hear, when I've heard yourself and Richard Thaler who sort of an emissary that sort of behavioral finance school that when you've been together on panels that you generally agree on the facts but disagree on interpretation. And I think you maybe take more of a risk-based or a rational lens versus Thaler who takes more of say an irrational behavioral lens.

 

I'm curious what you think about the legacy of efficient markets is and what you think the legacy of, say, behavioral variance is. I mean, there's been a massive rise in passive investing over the decades, which is a clear win for official markets obviously, DFA, BlackRock, Vanguard, all part of that.

 

I mean, there's also these super successful quantitative hedge fund stories, Rentech, Shaw, some multimanager. Then one could just argue that they're taking advantage of information. It's a rational story there as well, and maybe only a small pool of investors can do that. They provide liquidity, all these things.

 

Now, alpha is a zero sum game of beta, so they are doing active management that that outperformance has to come at the expense of some losers. But I guess separately, there are some investors out there that I guess use and hold up momentum and some claim that there's momentum factors, those like your student, Mark Carhart.

 

And I think momentum is a pretty behavioral phenomenon. I mean maybe some people are you. There's momentum crashes, which are maybe compensated by risk. But how do you think about things like, say, the 1990s tech boom or bitcoin? I mean, are bubbles real? I'm just curious how you think about these things.

 

 

>> Eugene Fama: Well, the way I think about them is you get to show me, you can't just tell me that the market's inefficient. So Taylor and I are great friends and I have been criticizing him for many years saying basically what you call behavioral finance, really just a criticism of efficient markets.

 

You don't have a theory of your own. It's just a criticism. So I think you're just a branch of efficient markets, Julie, you're afraid to call yourself that.

>> Eugene Fama: So that he doesn't really take to that very well. But the challenge comes, you can see Bob Schiller, who I admire a lot, and he basically came up with a fundamental insight that said prices are much more variable than you can explain if expected returns are constant.

 

So you have to have a lot of variation in expected returns to explain the variation in stock returns. Okay, that's fine, but then you have to tell me that something in there is irrational, either the variation of expected returns or the deviation of returns from expected returns. And they haven't got that far and not got much far.

 

So again, basically, it's all just a criticism of efficient markets. And okay, fine, you're a subbranch of efficient markets then.

>> Jon Hartley: Yeah, I mean, and what you're referring to is Robert Schiller's observation that stock prices are much more volatile than the present discounted value exposed dividends. If you were to look back over the many, many decades or over the centuries and you were to take the future dividends with the benefit of hindsight and to discount them back using a discount rates would from that time.

 

Why is that value more constant than the actual stock prices themselves? And maybe it's something that you're using the wrong discount rate, I guess, is-

>> Eugene Fama: The discount rates are varying through time.

>> Jon Hartley: Exactly.

>> Eugene Fama: That's almost a tautology. You're saying, okay, that will do it, that's true.

 

But then have you got a story about what makes discount rates expected returns rational or irrational. And that's something about, well, what are the limits of a rational model of equilibrium? And that one still is waiting out. We're still waiting for that one to get solved. Either on the efficient market side or the inefficient market side, nobody's coming up with that, a really convincing argument there.

 

 

>> Jon Hartley: How do you think about these things, I guess, the 1990s tech boom or Bitcoin? I mean, these things are extremely-

>> Eugene Fama: I have a problem with Bitcoin. I have a real problem there.

>> Jon Hartley: But what's your problem with Bitcoin?

>> Eugene Fama: Well, Bitcoin Is not a credible medium of exchange.

 

My learning of macro of monetary economics basically said, if you're going to be the medium of exchange, you can't have a highly variable real value. And Bitcoin's real value is highly variable. So think of it as businesses don't want to do business in terms of a unit of account or a currency that's so highly variable it itself can knock them out of business.

 

Don't want to do that. So you don't expect that a, a medium of exchange that's highly variable in terms of its real value, will survive. That's just classic monetary theory. So that's why bitcoin gives me a problem. So I'm basically hoping it'll crash, that it will be a bubble.

 

But the problem with other bubbles is they turn out not to be. You have to have a somewhat strange definition of a bubble to identify them. So, for example, stock prices were supposedly to have been a bubble. And then it turns out they ended up, they eventually went higher than they did when they were called, when it was called.

 

Who was the Fed governor? The Fed guy at the time that said they were a bumble anyway. But it turned out to be prices did go down, but then they went up much more than they had gone down. So at that point that's just a bundle. It's just the random variation in prices.

 

 

>> Jon Hartley: It's so interesting because, I think 10 years ago there was a lot of promises that that Bitcoin was going to become more of a medium of exchange, that people would be using it to make payments regularly in the real economy. And that I think pretty obviously has not happened yet.

 

So it, I think in some weird way it's an asset that doesn't have any cash flows and is just, you know, like in a sense a purely speculative asset where, you know, it's only sort of worth what other people believe it to be worth. And obviously that can generate a lot of volatility if people's thoughts change.

 

But it's interesting that all these folks, you know, some folks have said that it's an inflation sort of hedge. And I don't think that's clear either because in fact it doesn't seem to respond to bad.

>> Eugene Fama: Can't be an inflation hitch. Can't be an inflation because variance is too high.

 

Inflation has very low variance.

>> Jon Hartley: Exactly. So even when you get a negative inflation print, it's not like bitcoin rallies in response to that. But it seems to be very correlated with risk assets and stocks. So it's almost like this pure risk asset in a sense. So it's becoming something like that, based on this kind of idea that other people will evaluate at something in the future.

 

All of crypto I think is interesting or unique in this respect, and we'll see where it all goes. But particularly, interesting same thing I think with other bubbles where there's, I think, often something or what people would call bubbles. You often see either massive technological advances that don't pan out or you know, cases of fraud or other things like that.

 

I guess to be a bubble, you know, you need a big, I guess contraction right after some big run up. And so, I guess you think the 90s tech boom, what happened there, a lot of projects.

>> Eugene Fama: They were going to contend that this wasn't a bubble in the sense that enough companies survived that and got so extraordinarily big that that was a good investment, but you just couldn't pick the winners.

 

That was the only problem. But the activity itself, the idea that somebody was going to emerge from that time that would have a very high valuation, that turned out to be true.

>> Jon Hartley: We now have the Mag 7 stocks or the main stocks, Facebook, Amazon and. Google and all these companies.

 

It came out of that era, I guess, not Facebook, but Amazon, Google came out of that era. I guess sort of the next question really is getting into factors. And so I'm curious what you think about the so called factor zoo for one, 10 years ago, finance researchers spent tons of time researching asset pricing factors like size, value, the market factor, some interesting momentum.

 

Obviously, the fama French Factors from your 1993 paper, Size, Value in the market. Now there's I think a lot of questions about this empirical asset pricing. It's much harder to publish I think papers about factors and I think there's questions about the persistence of factors after they're published.

 

Size factors haven't worked as well in recent decades. The same with value. I think this has created a lot of challenges for value based managers, I think and there's some questions about sort of replicability or maybe if, if a factor is published it gets arbitraged away. I'm curious, what do you think about that and just the legacy of I guess the fama French factors from your 1993 paper.

 

You have a more recent paper that you wrote in the 2010s that offers five factors. I'm curious what you think about this concept of factors to describe the behavior of stock prices.

>> Eugene Fama: When French and I got into this, basically we said from the beginning that we have to look and make sure they're robust.

 

Did you see them not only in the US for a particular period, did you see them in the US for periods outside the period that you use to identify them? And then, you look around the world and see if you see them other markers. And that was the approach we always followed.

 

So first we would expand the data in the US and then we would look outside the US and we only would kind of concentrate something and see it was a real factor if it survived all those tests. And that was fine. But we also said, you know, that once you get past the market factor, these specialized, more specialized factors have to have something else in them that causes people to be afraid of them and to let move in that direction.

 

And if people only are afraid of them, they can kill them. They can kill these expected returns associated with these factors. So we said that from the very beginning and there's some chance that that's what actually happened. So we found the size factor, the value factor, and people weren't afraid of small stocks.

 

Turned out they weren't afraid of value stocks. So maybe they killed it. I don't know. I mean the problem is that these factors are buried in so much variance you can't tell whether they gone or not. So it's going to take another 50 years to come up with the right answer and I won't be alive then.

 

So we won't know.

>> Jon Hartley: Well, you know, I know that. What's amazing, I mean, just to think too, I mean we have, I guess centuries of data now. I mean some people have tried to take the CRSP data and go back further. I mean, were you a part of the found the creation of CRSP, the Center for Research and Security Prices?

 

I know that that's I guess one of the earlier sort of ideas or efforts to compile a lot of asset data. And that's been housed at the University of Chicago for a long period of time. I mean to do early research, pre personal computers, I'm sure you had to do a lot of work to even just get stock price data in those days.

 

People were looking to newspapers still to look up stock price quotes often. I'm, Curious, how did that evolution work in terms of- Okay, I was there so I can tell you that one.

>> Eugene Fama: Larry Fisher developed the NYSE tapes first at the University of Chicago, but they weren't ready when I was ready to write my thesis, they weren't even close to being ready.

 

So I had data that I had collected as an undergraduate at Tufts on the 30 Dow Jones Industrials. So that was the data that I used in my thesis to develop both the fat-tailed distribution stuff and the efficient markets stuff. So I didn't use the CRSP data at all at that point.

 

And then the CRSP tapes came along and the research in that area exploded. But I'm not sure, was that your full question or did I miss some?

>> Jon Hartley: No, that's it. I mean, it's just, it's amazing. I think people don't appreciate, I mean, now everyone has computers and access to high-frequency data.

 

 

>> Eugene Fama: Well, you're right, that's the other problem. So when I was even with the Dow Jones Industrials, you're dealing with a machine that can test problems with any reasonable amounts of data. You're sticking cards into this machine to, to put it there. And I used to go over in the middle of the night into the computation center and do my work cuz there was nobody there at that time.

 

Me and another guy in the physics departments were the only ones there that we could have access to this machine that could do almost nothing and fill the whole room. But anyway, that's what I use with these 30 Dow Jones Industrials to do my thesis. And so I work from it.

 

 

>> Jon Hartley: That's amazing. And yeah, just to think how just empirical research has exploded since then. And I guess I'm curious just to, I guess, get back to this question of sort of factors and thinking about the structure of asset prices. So one, I mean, there's been a massive outperformance in the market factor, especially in US equity markets in sort of the past decade or since the financial crisis.

 

Whereas other advanced economy equity markets have been generally flat for the past decade or so comparatively. And maybe that's because GDP per capita has also flatlined in these sorts of countries. I mean, do you have any thoughts on the equity risk premium or why it's been so large compared to other countries?

 

I mean, there's some people out there who say, well, quantitative easing is a big part of the story and the Fed wasn't doing that before 2008. But what I would also say, would challenge people when people say that QE is responsible for the massive run up in the stock market and causing things like wealth inequality, so forth.

 

I mean, other central banks around the world, the ECB, the Bank of Japan, they were doing just as much quantitative easing as a fraction of GDP as the Federal Reserve. So I don't really think that the story is QE either. I mean, the Fed buys a bond and also issues reserves, and maybe it's just sort of a wash as a result of that.

 

But I'm curious, this massive outperformance of the US equities, is that really a growth story in your mind or do you have any other thoughts-

>> Eugene Fama: I think it's just a growth story, right, the fact that the US won on the growth story in that period of time.

 

Europe that had been doing very well, Japan that had been doing very well, didn't do so well in that period economically. So stock returns are the basically highly leveraged claim on the output of the country. That's the explanation as far as I'm concerned, as far as I know.

 

 

>> Jon Hartley: It's just amazing to think, I mean, the idea that there would be so much divergence between the US and other advanced economy countries. I mean economists, macroeconomists for a long time talked about divergence in general, which is really richer countries, advanced economy countries getting richer while poor countries that presumably could import the same technology and the same ideas weren't catching up.

 

And there's some degree of evidence that there's been a convergence across all countries in, say, the 90s and 2000s. I think since COVID, growth rates have gone back a bit. But I think there's this kind of new type of divergence that we're seeing, which is just there's the US and everybody else and all the other countries.

 

And I think a lot of that might have to do with technology, why most of the largest technology companies in the world are all based in the US. And there's some story there, maybe it's a long run institution story, that the US always been a very good place to do business or that these entrepreneurs came a long time ago and sourced at the seed and now all the top talent from around the world wants to come to the US.

 

I mean, do you have any sort of macro thoughts on why the US has kinda won this race, if you will?

>> Eugene Fama: Well, that's a good one. We've imported lots of high-end people in the tech industries that have been instrumental in developing all these firms that have become massively profitable.

 

I don't know if you have to go any further than that. So the talent wants to come here. If we can keep it that way, we'll be happy.

>> Jon Hartley: Yeah, I want to talk about some newer theories that I think try and challenge efficient markets a little bit.

 

And it's interesting because we're talking a lot about the 1960s and what the prevailing sort of theories were about what moved asset prices prior to the advent of modern finance, which is, you've been a central part of developing. A lot of that has to do with the role of information, expected future dividends, expected returns.

 

 

>> Jon Hartley: And obviously equilibrium, no arbitrage, all these things playing a big role in that. But what's interesting is prior to the 1960s, my understanding is that there was a big emphasis on supply and demand curves kind of determining stock prices. And what's interesting is I think some of those ideas have come back, and there's a big debate right now about the slope of the demand curve for stocks.

 

And of course, if markets were perfectly informationally efficient, I think the demand curve for stocks is perfectly elastic or the demand curve is essentially totally horizontal.

>> Eugene Fama: I don't so.

>> Jon Hartley: You don't think so?

>> Eugene Fama: No, of course not. Stock market is no different from any other market.

 

If resources pour into it and push prices up, expected returns are gonna go down rather than other forms of investment. So it can't be perfectly flat. It's part of the overall, that the wealth in the world is limited, and if more of it goes into one asset than another, that asset's price gets bid up and its expected return goes down.

 

So it can't be perfectly horizontal, not at the level of the entire market.

>> Jon Hartley: I mean, well, it's interesting because I think behavioral finance researchers, for example, like Andre Shleifer, he wrote a famous paper in the 1980s that Titled yet does the demand for stock slope down? And, you know, that is what happens if there's, you know, some flow, some exogenous flow into the stock market from, say, you know, a big index rebalance, like, you know, the Russell 2000, it reconstitutes once a year.

 

And he looked at these index adjustment or index reconstitutions, like the Russell 2000 ads, takes out companies that have changed in their size over the year and they add a new one. They do it on a certain date. And that causes lots of flows from index funds in and out of certain stocks.

 

And, you know, you looked at these stocks and argued, you know, there's a reaction in stock prices in that clearly quantities matter. And then he concludes that the demand curve for for stock prices, do slope down, but just a bit, these demand curves are still elastic. And we'll talk about what that kind of means.

 

But in part what it means is that a elastic means that, you know, a $1 billion flow would lead to a less than $1 billion change in, say, the market cap of stocks. And I'm curious what you think about some of this even newer research on quantities, like, for example, you know, this new area called demand based asset pricing.

 

A lot of it's led by Ralph Koijen, who's a finance colleague of yours at Booth, part of his research agenda, he also has this paper with Xavier Gabaix that's titled the Inelastic Markets Hypothesis. And we've spent some time talking about this paper before. And they essentially claim that the demand curves for stocks are even more downward sloping, that they're very downward sloping.

 

And they claim that a $1 billion inflow into the stock market will cause a $5 billion appreciation approximately in market cap, that stocks, at the macro level, are very responsive to flows. And in part what they're trying to do is sort of get at the origins of financial fluctuation, what's causing financial fluctuations.

 

So what they claim is that it's really quantities, I think, that are really driving fluctuations in asset prices, I think less than just information. But I'm curious what you think about all this research that claims that quantities matter just a ton for stock, for stock market prices in determining them.

 

And I think at some level it's a bit of an affront to modern finance and trying to go back to this era prior to modern finance, which obviously plays a huge role on information equilibrium, no arbitrage and so forth.

>> Eugene Fama: I'M not that familiar with that research. So I mean it comes down to are these, are these effect permanent?

 

Are these effects permanent or transitory? So it's just a matter of trading pushes' prices around temporarily. That's, that's testable. There should be some part of the variance of the prices that's temporary that you can get out of, get around. And there should be trading opportunities for people who want to take advantage of this as well.

 

So it better be permanent, otherwise it gives rise to lots of profit opportunities. But I haven't followed it that closely, so I can't really comment on this.

>> Jon Hartley: I do think that. So my understanding is that the inelastic markets hypothesis does claim that these effects are permanent. That a $1 billion flow into say the equity market, say someone takes money out of bonds or, or just they have a billion dollars in cash and in their bank account and they, they put that billion dollars, you know, it could be a corporation or have you, or investment manager, they put that money into the stock market.

 

They say that that's gonna lead to a $5 billion appreciation in the total market cap.

>> Eugene Fama: That's possible. You know, when you said earlier that the demand curves were flat, we don't really know how elastic they are at the aggregate level when you're looking at the total shifts of total wealth between different asset classes.

 

So we don't know what the effects are. And I think that's what Ralph is working on there. I'll have to go back and read that stuff a little more carefully. It's not that easy for me, but I'll do it.

>> Jon Hartley: Yeah, well, it's very interesting I think, and they look at things like flows into US equity markets.

 

And I think that there's, I think some challenges too in terms of, you know. Well, you know, what's driving those flows to begin with. Right. Are they truly exogenous or is it just, you know, this great US stock market run up that we've seen, is that what's maybe causing the quantity in the first place?

 

So I think it's a little hard to disentangle the two. And they use other strategies like granular instrumental variables and so forth. I sort of have my own paper on this. It's sort of a tongue in cheek titled the Elastic Markets Hypothesis, is sort of using country equity index additions and deletions for identification.

 

So you have big index funds which from time to time will have to take their money out of a certain country or put money into a country, say the MSCI Emerging Markets Index, say, promotes a country into its index. And there's billions of dollars, or if not trillions of dollars that follow, that kind of an index, and using those for identification.

 

So I mean, we don't really find that, you know, that prices are all that responsive to, to, to clients, but, but, but that there is some response. And typically it's a bit more transitory and temporary than, than something that would be a permanent change. But what's interesting too is like, I think in the practitioner lens, there's a lot of these rules of thumb, like the quadratic rule when we think about things like transaction costs, for example, say you have some purchase of stocks, that it follows this three halves function in terms of the market impact of a purchase.

 

When investment managers are trying to think about what the impact of their own trades are, they use this model to sort of assume that going into the market actually buying some stocks will have some effect. They measure it, I think, pretty regularly using the sort of three-halves, this kind of quadratic type rule.

 

But I think it's very much a transitory thing. I don't know. Have you ever thought too much about say, transaction costs and things of that nature, as maybe more of a practitioner?

>> Eugene Fama: I know, for example, that at Dimensional they've always been very concerned about the effects of trading on prices, especially when they were in a small stock business.

 

But they could never really find that there were lots of strong temporary effects. In all the research that was done there, they never could find that. I never delved into it very much. They have a whole crew of PhDs that do this kind of stuff for them. But I was pretty well convinced that they were finding that the prices were, at least for individual stocks, were pretty elastic.

 

They weren't that responsive to magnitudes of money going into them.

>> Jon Hartley: Yeah, and I think that's right. I think, I do think that markets are pretty elastic and there's lots of active managers that are trying to look at moments where things are, maybe there's a bit of market impact from say, some sort of a flow, or maybe there's these things like the.

 

Lipper a fund data that tracks mutual fund flows and this data comes out pretty regularly. I know a good number of bond traders sort of follow these sorts of things or think about like month end effects for example, like all the bond indices reconstitute at the last day of every month.

 

There's a paper I wrote with a co author on how prices, how treasury typically rally on the last day of the month just because there's all these newly issued Treasuries that don't enter the big bond indices until the last day of the month. It's the same thing with stocks.

 

And typically a lot of rebalancing happens at the end of the quarter. And so if there's big fund flows and maybe there's some empirical finding that there's a jump in prices along those days but typically, these things aren't that long lasting, they're temporary. And so the extent that they exist, sure demand curves slope down a little bit but not too much.

 

And I think I agree with you there on demand curves being fairly elastic but not perfectly elastic. And two, I think it's possible that efficiency is saying something really different which is saying something more about how information gets incorporated and that's, that's different from, from, from demand too in quantities.

 

I think those things are, are a little bit different.

>> Eugene Fama: Miller always said, when information comes into the market, they didn't even be any trading and prices adjust just the best bid ask prices adjust. So it doesn't really take trading to do it turns out it does take some trading to, to do it as it turns out.

 

But you know, the information effects and price pressure effects because relative demand shifts for different asset classes are two different things. These are those two different things, one's kind of a micro thing and the other is a macro thing. So the macro thing is I think with Ralph and Gabe are Interested in and that one is an open issue.

 

I think we don't really know the answer there. They think they have it. They're sure to attract people that will try to substantiate what they're claiming. So we'll, we'll see about that one.

>> Jon Hartley: And other folks that may find the contrary as well and maybe that's really kind of the new efficient markets versus behavioral finance kind of a debate going forward.

 

 

>> Eugene Fama: That isn't though that's just relative demand. Give me shifts in relative demand for different asset classes. You can have price effects. How big they are is the issue. They could be big, they could be small. I really don't know the answer.

>> Jon Hartley: That's a great point. I'm curious, one last question, I guess on just intermediaries and intermediary.

 

Asset pricing has been I think a big new kind of area of research or renewed area research in the, I think years after the financial crisis. A lot of great researchers and potential economists I think have turned their attention to this. I think of folks like Daryl Duffy, Arvin Christian Murthy and at Bismuth Jordan and many others who are particularly interested in the effects of thinking about things like fire sales that we saw maybe during the financial crisis and who is the marginal investor?

 

Who is, who's really determining asset prices and there's a whole, who's pricing on their kernel and so forth. I'm curious what you think about that sort of strand of literature and how you think about intermediaries and in your mind does the marginal investor matter in the determination of asset prices or is everyone the marginal investor?

 

I'm curious, how do you think about all that?

>> Eugene Fama: I think everyone is a marginal investor. I'm concerned because everybody is, everybody's holding the stock is basically deciding instant by instant implicitly or explicitly to continue holding based on the prices or any assets. So everybody's a module investor as far as I'm concerned, I don't really relate very well to that literature.

 

 

>> Jon Hartley: And even I guess a retail investor or so called passive investor, you don't think that they're maybe less attentive or, and that that would really matter or I guess that's a different issue.

>> Eugene Fama: We can't have 100% passive investing, that's for sure. There has to be somebody out there that's concerned about the prices being right and there's somebody who makes money based on doing that.

 

Otherwise you're not going to get an efficient market. You know, that's market can't be efficient for everybody sufficient for me. Maybe it's efficient for you but there have to be some knowledgeable investors out there. So for example, insiders trading the stocks of their company, they have inside information that's been well established.

 

But otherwise, you know, then they're also, I think now Ken French and I have a paper on mutual fund investing where we try to identify how much information there is out there that the mutual funds capitalize on. If you give them back all the money that they spend, fees and expenses, then you can see that there are winners and there are losers and they're that they deviate from what you would expect by pure chance if none of them had any special information.

 

And that, that's fine. I mean, they're helping to make the market more efficient. But.

>> Jon Hartley: And I think that's the kind of maybe the insider, but I guess Grossman, Siglitz, and I guess the idea is that there always is some a bit of alpha out there and that generates these, there's always people seeking this little bit of alpha and that there always has to be a little bit in order to make markets efficient.

 

 

>> Eugene Fama: Right. You know, the, the, the question always arises, how much of that do you need to make it work? And the answer is, well, depends on how many bad guys there are out there, how many disinformed investors are out there, because they're the ones you have to offset.

 

So you need fewer active investors. If you, if all the disinformed guys become passive investors, one guy, one belligerent active investor might be enough if all the bad ones drop out. But we'll never know.

>> Jon Hartley: Well, Gene, this has been an amazing conversation, I really wanna thank you for coming on.

 

It's been a real delight to talk about your career and ideas and really just this set of ideas that really began at the University of Chicago, which you largely led in establishing modern finance. Really want to thank you for coming on. This has been a truly amazing conversation.

 

 

>> Eugene Fama: My pleasure.

>> Jon Hartley: This is the Capitalism and Freedom in the 21st Century podcast, an official podcast of the Hoover Economic Policy Working Group where we talk about economics, markets and politics policy. I'm Jon Hartley, your host, thanks so much for joining us.