A Battle for the Stock Market's Soul

Are markets efficient or prone to bubbles? Maybe both.

One phase.

Photographer: Danny Martindale/WireImage/Getty Images

In the 1980s, economist Robert Shiller shocked the world of academic finance with a finding for which he would eventually win a Nobel Prize. He discovered that stock market returns are predictable. 

This flies in the face of our most basic theories and intuitions. If you know that prices are going to go up tomorrow, you buy today, and the price goes up today instead. Only randomly fluctuating prices prevent people from taking easy profit opportunities in the market. 

But Shiller showed that over the long term, prices are far from random. When price-to-dividend ratios are high -- that is, when stocks are expensive relative to the dividends they produce -- we can expect prices to fall. When ratios are low, we can expect prices to rise. The fall or the rise often takes a number of years to materialize, but it usually comes. If you’re patient and willing to take some risks, you can use this fact to make money in the long run. 

Basically, this means that the stock market tends to overshoot and then correct. But how long has this overshooting gone on? Is it a recent phenomenon, caused by mass entry of retail investors into the market? Or is it some deeper property of how information creates supply and demand in financial markets? 

Economists Benjamin Golez of Notre Dame and Peter Koudijs of Stanford set out to answer this question. Instead of only looking at modern times -- as most financial economists do -- they went all the way back to the dawn of stock markets in the 1600s. 

That meant examining the stock markets of Amsterdam -- the first modern equity markets. Those markets reigned supreme until the financial center shifted to London in the 1800s, then to the U.S. Of course, in the 1600s, there was only one stock you could trade on the Amsterdam market -- the Dutch East India Co. The 1700s added only a handful of others. So these stock markets had nothing close to the massive diversification we have today. But despite the dearth of tradeable securities, old stock markets were surprisingly efficient, responding quickly to news and offering low trading costs. 

Golez and Koudijs find one more way in which these markets were similar to those of today: Their movements were predictable. When price-to-dividend ratios were high relative to their long-run averages, it was a reliable indicator that stocks were overvalued. When price-to-dividend ratios were low, you could make some extra money by buying. 

This market predictability was about the same back then as it is now. The authors find very little variation in the usefulness of overvaluation and undervaluation metrics over hundreds of years. The only big change has been that while in modern times it’s share prices that gyrate while dividends stay relatively constant, in the past it was dividends that gyrated more -- with some notable exceptions, such as the South Sea Bubble of 1720. 

Watching for Bubbles

Golez and Koudijs’s result is very interesting, and also a little spooky. It suggests that there is some deep property of stock markets that we don’t understand -- some force as profound as the concept of efficient markets, but which also makes markets inefficient. In other words, this result means that Bob Shiller’s Nobel-winning finding may be as fundamental as the findings of Gene Fama, the founder of efficient markets theory, with whom Shiller shared the prize. There may be one force moving the market toward efficiency, and another making it oscillate around the efficient level. Bubbles and efficient markets may be locked forever in combat, neither one able to permanently overcome the other. 

The question of why stock markets fluctuate like this has bedeviled finance researchers for more than three decades now. Shiller and his followers place emphasis on the role of human psychology -- overreaction, optimism or other such forces. Fama’s adherents chalk up market behavior to changes in investors’ willingness to take on risk. 

Whatever the reason, however, one thing is certain: Stock prices are not a perfect guide to company performance. What do stock prices actually tell us? That’s something we’re still trying to figure out. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.