Broadly speaking, their contribution goes this way. When we look at asset prices, be it stocks or bonds, it is difficult to conjecture their price movements in the short run, which could be, say, a few weeks or even months, though the same can be guessed well in the long run, which could be 3 or 5 years. This makes sense when we look at our own stock market. On a daily basis, we cannot make guesses because there are new bits of information coming in every now and then (Fama), which guides prices. RBI announcement of new banks can push up prices of bank scrips while an impasse on mining laws in Parliament can push back the stocks of mining and related companies.
Therefore, predictability is the issue. If all players knew the price and start buying the stock, the price would automatically move up until such time that it becomes less attractive. The unpredictable pattern is more often the case and the movements are random, and hence it is said that stock prices follow a random walk. Therefore, Fama argued that todays price is no guide to tomorrowwhich is seen in our own stock price movements, where the Sensex or Nifty yo-yo on a daily basis being affected more by distant effects such as the Dow Jones or Fed actions in the interim period.
In fact, an interesting outcome of Famas work is that lots of the information we are talking of have an impact on just one day. A dividend announcement or a stock split will affect the share price on the day and move back to the trend line subsequently. This also appears to be the case with Indian markets, where the Sensex moves up or down to news for a single day and then gets back to the trend, which has been upwards. Therefore, to put the theory into a diagram, daily movements will have sharp or smooth peaks and troughs, but the direction along the trend will be upwards normally for a growing economy.
But, over the long run, these things iron out and there are broad principles that are adhered to. Shiller showed that prices would tend to get related to the future dividends on almost all occasions. Also, periods when stock prices are high relative to corporate earnings tend to be followed by periods of below-par returns, and vice-versa. Hansen's view was that mispricing had to do with fluctuations in how much appetite investors had for risk. When times are bad, investors become more cautious, and when times are good, they are more willing to pay high prices for assets.
Simply put, the rationale is that when you take more risk while waiting, the return must be commensurate with the deserved compensation. The models that have been used by them have gotten refined over time, enabling better use of data and deriving more rational conclusions. This has improved the power of forecasting of asset prices in the long term and helped the emergence of index funds in stock markets. An interesting outcome of their research is when it is stretched to the performance of mutual funds. Can mutual funds generate returns above the level of risk taken Their answer is that their returns would be lower once adjusted for their own fees and expenses.
The behaviour of asset prices is important for households as the decision to choose from across alternative assets will be contingent on them. For example, when deciding on, say, a deposit or tax-free bond or a corporate bond or equity stock, the asset price matters. Similarly, asset prices are important as they provide information for economic decisions in investment. The market for corporate bonds is not well developed primarily because pricing is an issue. Once the bond is issued it is not easy to gather data on the daily price due to the absence of liquidity. Unless the asset is properly priced (need to have the yield curve in place), the secondary market will not evince interest, which, in turn, has a bearing on the state of the primary issuance market.
Their research also shows that, at times, excessive optimism or other psychological mechanisms may explain why asset prices deviate from fundamental values. These high prices may reflect overestimates of future payment streams. A question raised by them is why more rational investors do not eliminate the excessive price swings by betting against less rational investors. Their response is that rational investors may face various institutional limits, such as credit constraints, that prevent them from going against the market on a sufficiently large scale.
The US scene of 2007 is interesting. Asset prices existed for the mortgage-backed securities and the entire gamut of structured products. But the pricing was inaccurate or mispriced as institutions multiplied their risks. Mispricing meant that the asset prices were not reflective of the underlying, which led to the crisis. Keeping in mind the financial crisis, one can understand the importance of such theories because ultimately it was a case of mispricing of the assets under questionCDOs and CDS.
Therefore, the clue really is that we cannot do much in the short run, but as policy regulators, must watch out for the building bubble once we smell serious mispricing, especially in a boom.
The author is chief economist, CARE Ratings. Views are personal