Divining stock price forecasts

Oct 16 2013, 04:05 IST
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SummaryThis years Nobel Prize rewards asset price analysis which have led to many innovations that benefit small investors

It is hard to imagine that people can be awarded prizes for saying opposite things, harder still to picture them sharing the prize for it. Yet that is exactly what has happened in economics this year.

The 2013 Nobel Prize for economics has been jointly awarded to three peopleEugene F Fama, Lars Peter Hansen (both of University of Chicago), and Robert J Shiller (of Yale University)for their empirical analysis of asset prices. Fama and Shiller are known for their financial market theory, while Hansen made his name developing econometric tools that have been widely used in studying asset prices, among other things. This split is in keeping with the recent trend of jointly honouring theoretical and empirical contributions to the field.

In the aftermath of the financial crisis, the study of asset prices is particularly important. Everybody agrees that the crisis was exacerbated by the complexity of the assets being traded. Even now, nobody knows how to accurately price a collateralised debt obligation (CDO) or a mortgage-backed security (MBS). Even though they generate relatively high returns, the markets for these products are a fraction of the size they once were, because nobody trusts their valuations any more. Forecasting their prices is a fools game.

Yet simpler assets like stocks and bonds continue to be traded widely, and in large volumes. Some of this is due to confidence: investors have more faith in how stocks and bonds should be priced, and in forecasts. This faith comes from extensive researchin a large measure based on the works of this years laureates.

Eugene Fama is mainly known as the proponent of the Efficient Market Hypothesis (EMH), which asserts that since markets are efficient, there is no investment strategy that is guaranteed to make money via short-term trading.

In particular, the EMH says that since anybody can become an investor, financial markets are fully (and fiercely) competitive. In such a market, everybody brings their information to be priced in, and so todays opening price of a stock reflects all information up to today. And so, todays price changes must reflect only todays news, which is inherently unpredictable. Stock prices therefore follow a random walk, which cannot be forecasted in the short term.

Instead, if price movements were predictable, a rational investor would be able to make a killing with this information. This seldom happens, except for cases involving insider trading, where some traders are made privy to news before the

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