Stumbling and Mumbling

Author: chris dillow   |   Latest post: Tue, 16 Oct 2018, 01:25 PM


Progress in economics

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I'm getting cheesed off with the economic culture war. One peeve I have with it is that economists do so many things that it's easy to find examples of both bad work and good. Rather than speak in generalities, I'd prefer critics and defenders to focus more upon specific aspects of economics.

As an example of what I mean, I'll take a bit of financial economics, as this might highlight what's both good and bad in economics.

For years, we've had a mainstream theory here. The efficient market hypothesis says that all information is embedded into share prices and so you cannot beat the market without taking extra risk. And the capital asset pricing model tells us that the risk that matters is a share's covariance with the market (or beta); idiosyncratic risk doesn't matter.

Now, there is a distinction between these theories. From the off, the EMH arose from an empirical observation, that share prices seemed (pdf) random and the market was hard to beat*. Way back in 1953 Maurice Kendall pointed out the former (pdf). And in his excellent book Fischer Black and the Revolutionary Idea of Finance Perry Mehrling points out that Black had good evidence in 1967 that mutual funds under-performed the market. Even men who otherwise disagreed with the EMH shared this view. Benjamin Graham, for example, wrote (pdf) in 1972 that "the majority of the investment funds, with all their experienced personnel, have not performed so well as the general market."

The CAPM, however, was less rooted in evidence and more a theory of equilibrium prices: in Bill Sharpe's** paper (pdf) introducing the theory, there is pretty much no empirical evidence.

And in fact, there never has been any. Eugene Fama, the high priest of the EMH, has said that it "has never been an empirical success". Others have been less kind. Eben Otuteye and Mohammad Siddiquee say it has been "60 years of wasted effort". Economists have long known that beta isn't the only determinant of returns, believing that size and value also matter - hence the so-called three factor model.

In fact, economists claim to have discovered countless "anomalies" - exceptions to both the CAPM and EMH. Many of these, however, are fragile: Campbell Harvey has said they are "likely false". And many others have diminished since they were pointed out - at least in the US and UK if not elsewhere - which is sort of consistent with a weaker version of the EMH: money-making opportunities don't last for long.

There seem to me, however, to be two pretty robust anomalies.

One is the tendency for low-beta stocks do better than they should and high beta ones worse. This was first pointed out by Fischer Black, Michael Jensen and Myron Scholes in 1972 but has since been corroborated by lots of other evidence (pdf). The other is that stocks which have done well in the past tend on average to subsequently out-perform. This has been found not just in shares but in other assets too. In my day job, I have constructed very simple defensive and momentum portfolios in real time. Both have for years beaten the market.

There are, I think, some general messages to take from all this.

One is that the distinction between mainstream and heterodox doesn't mean much. The first evidence against the "mainstream" CAPM came from "mainstream" economists.

Secondly, bad theories such as the CAPM are beaten not by competing theories but by facts. Of course, behavioural finance is an alternative to the CAPM. But what gives it credence is not the plausibility of its assumptions but the existence of some facts that are easier to square with behavioural finance than the CAPM. The momentum effect, for example, might well be due in part to investors' tendency to under-react to news.

Thirdly, all this is a counter-example to what Jason Smith says. He claims that of both heterodox and mainstream economics that "neither appear to value empirical data. Neither appear to make accurate forecasts." But this is not true in this case. There's a vast library of research on empirical asset pricing, some of which - momentum and low-beta - survives the replicability crisis. And we do have some (so far!) successfully accurate forecasts, that momentum and low-beta stocks generally out-perform.

Fourthly, my story is of a retreat from a single unified theory. Empirical evidence has undermined an elegant parsimonious theory (the CAPM) and left us with a few hard facts and a few mechanisms to explain them, such as constraints upon short-sales and leverage, and the presence of at least some cognitively-constrained investors. I think there's been progress, but it's away from grand theory and towards messy reality. Maybe this is - or will be - true of other parts of economics.

* I'm speaking here of the EMH as applied to individual stock prices rather than the overall level of share prices. It's quite possible, as Paul Samuelson said, that stock markets are "micro efficient but macro inefficient."

* Sharpe was only one of several fathers of the CAPM.

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