Eugene F. Fama, the father of the efficient-markets theory, says the stock market can’t easily process “irrational” behavior. What will happen? “Who knows?” he says.
After watching financial markets gyrate from hour to hour as Russia attacked Ukraine, I was getting dizzy myself.
People in Ukraine were dying. The Russian president, Vladimir V. Putin, put his nuclear forces on alert, and Western sanctions were beginning to bite. One moment stocks were up, the next they were falling. Then they were up again.
On Wall Street and in other financial centers, plenty of analysts had elaborate explanations for what was going on, but if the markets were conveying a coherent message, I didn’t see it.
So in search of some deep, contrarian thinking about the markets, I called Eugene F. Fama, the University of Chicago economist who is widely known as the father of the efficient-markets theory, on which much of contemporary finance is based. Now 83 and still hard at work, he shared the Nobel Memorial Prize in Economic Science in 2013.
Through many head-spinning market upheavals over the years, he has patiently explained his view: that markets contain all available information, which they always try to process as efficiently and rationally as possible, and turn into prices. But where those prices are heading, no one can say.
To me, it is self-evident that the markets often behave irrationally. Not so, he invariably says: What may look like craziness is really just the markets attempting to evaluate information they can’t entirely digest.
Irrational people and rational markets
On the evening of Feb. 24, when Russian troops invaded Ukraine, I called him, and followed up a few times over the last week.
He presented a perspective on markets that is iconoclastic and possibly quite troubling, if you are not prepared for it.
Gene, I said, the markets seemed to be behaving insanely yet again. How can this be rational, really, when the market is changing its mind several times a day, often rising when the news is grimmest?
He chuckled, then apologized for laughing. “I’m laughing because I don’t know what else to do,” he said. “It’s terrible, what’s happening to Ukraine. But the markets are behaving rationally. It’s Putin who is irrational.”
I reminded him that, unlike his fellow Nobel laureates, Robert J. Shiller of Yale and Richard H. Thaler of the University of Chicago, he has not, in the past, talked much about human irrationality, stressing instead the rational decision-making that is the basis of traditional economics.
“So you acknowledge that people behave irrationally?” I asked.
“Sure, of course they do,” he said. “Anyone who starts a war is irrational. Wars should never happen. They don’t make sense. Why go to war? It’s always better to trade. Trade makes everyone better off.
“War? No, it isn’t rational, it’s just destruction,” he continued. “Take World War II. Rationally, it should never have happened. Hitler? He was irrational; of course he was. And Putin, he is irrational. Who can understand why he’s doing what he’s doing?”
I pressed him further. What message, if any, have the markets been imparting since the start of the coronavirus pandemic, or, now, during the war in Ukraine, when stocks rise and fall with no discernible regard for human life?
The markets aren’t telling us much, he said. Some people interpret efficient markets as the source of “the wisdom of crowds.” This is the idea that, together, through the mediation of markets, crowds of people come up with answers about important questions that are much smarter than the conclusion of any one individual. But there’s no great wisdom evident now.
The markets are struggling to come up with prices for stocks, bonds, commodities, all kinds of things, he said. They aren’t necessarily conveying any deeper meaning.
“Basically, we’re in a period where we have had an injection of uncertainty into the world, so speculative prices are going to go up and down in response,” he said. “People are continuously trying to evaluate information. But it’s impossible for them, given the amount of uncertainty that’s out there, to come up with good answers.”
“But that doesn’t mean the market is inefficient,” he added. “Markets can be rational without politics being rational or people always being rational. The problem with pricing is a question of how much is knowable right now. How’s this Russia thing going to work out? Who knows?”
I said I certainly didn’t.
“Has anybody got a better answer than that? I don’t think so,” he said.
You call that investment research?
I asked whether he’s been reading the analyses of Wall Street investment houses like Goldman Sachs or Morgan Stanley, or of those by independent market researchers. They don’t predict how the war in Ukraine will end. But they often recommend strategies for coping with tumultuous markets in what may be the start of a new Cold War and is certainly an era of high inflation, severed supply chains and extreme volatility.
“No, he said. “I don’t read any of that. It’s investment porn,” he said.
I was taken aback. “That’s a little harsh, isn’t it?”
“Maybe. But that stuff isn’t based on deep research. What do they really know?”
I pointed out that some of the people at investment and research firms know quite a lot. Some are economists trained by the University of Chicago and other fine institutions. He laughed. “OK,” he said. “I get it.”
In fact, along with his frequent research partner, Kenneth R. French, he is on the board of directors of Dimensional, a major investment fund company, and consults on its research, which relies heavily on his work. Much like Vanguard, the indexing giant, Dimensional eschews market timing and generally recommends long-term, diversified, buy-and-hold investing, precisely because it is so difficult to accurately forecast market returns.
I told him I’ve been receiving market analyses from Dimensional. “How does it look?” he asked. I assured him it was generally quite careful and didn’t make claims of omniscience that could not be supported.
“Good,” he said. “That’s the way it’s supposed to be.”
You can never relax about the stock market
Even so, he said, what isn’t adequately stressed in most of the so-called professional investment analysis he’s seen, “is that there is always risk in the stock market, always. It never goes away. People have to remember that.”
And, he said, it’s impossible to know which way the market is heading. “My whole life’s work says you can’t answer that question.”
The faint of heart may not want to hear this, he said, but the stock market can always go into a deep and long decline.
“We’ve done a lot of research on that,” he said. “It doesn’t matter how long you hold stocks. Some of that risk is always there.” Sure, he said, stocks have generally paid off for the long term, he said. But, he added, “How long does that have to be?”
The Russia-Ukraine War and the Global Economy
Rising concerns. Russia’s attack on Ukraine has started reverberating across the globe, adding to the stock market’s woes and spooking investors. The conflict could cause dizzying spikes in prices for energy and food, and severely affect various countries and industries.
The cost of energy. Oil prices already are the highest since 2014, and they have jumped as the conflict has escalated. Russia is the third-largest producer of oil, providing roughly one of every 10 barrels the global economy consumes.
Gas supplies. Europe gets nearly 40 percent of its natural gas from Russia, and it is likely to be walloped with higher heating bills. Natural gas reserves are running low, and European leaders have accused Russia’s president, Vladimir V. Putin, of reducing supplies to gain a political edge.
Food prices. Russia is the world’s largest supplier of wheat and, together with Ukraine, accounts for nearly a quarter of total global exports. In countries like Egypt and Turkey, that flow of grain makes up more than 70 percent of wheat imports.
Shortages of essential metals. The price of palladium, used in automotive exhaust systems and mobile phones, has been soaring amid fears that Russia, the world’s largest exporter of the metal, could be cut off from global markets. The price of nickel, another key Russian export, has also been rising.
Financial turmoil. Global banks are bracing for the effects of sanctions intended to restrict Russia’s access to foreign capital and limit its ability to process payments in dollars, euros and other currencies crucial for trade. Banks are also on alert for retaliatory cyberattacks by Russia.
Professor Shiller has found that, adjusting for inflation, it took two decades for the stock market to come back from its losses in the Great Depression, I said.
Professor Fama said, “Yes, but two decades might not be enough. In the future, it could be longer. Really, there’s no answer. You just don’t know. There’s always a risk it will take longer than your lifetime.”
What would Milton Friedman say?
Professor Fama doesn’t like to talk much about politics except to say he is an “extreme libertarian.” When pressed, he says he isn’t a fan of either the Democratic or Republican Parties. He calls himself a “radical skeptic” but, unlike his mentor, Milton Friedman, another Nobel laureate in economics from the University of Chicago, he doesn’t prescribe public policy solutions.
He asks questions, lots of them.
“As a student of Milton Friedman, you must have a view on inflation,” I said.
The Fed is likely to start raising interest rates at its next meeting, March 15 to 16. Can it bring inflation down from its current level, 7.5 percent, without causing a recession, I asked?
“I have no idea,” he said. But he has his doubts. “Unfortunately, Milton, if he were alive today, wouldn’t know either. He’d be shocked, really. He’d have to rethink everything.”
Why? He quoted Friedman from memory: “Inflation is always and everywhere a monetary phenomenon.” High inflation, in the Friedmanite doctrine, resulted from excessive growth in the money supply.
The problem now, Professor Fama said, is that it’s no longer possible to measure the money supply in an accurate and meaningful way. That’s because the Federal Reserve changed its approach in ways that were “unimaginable when Milton was alive,” he said.
Some of this is technical: The Fed has shifted from a regime of scarce reserves available to banks to one of “ample reserves.” It has held interest rates near zero percent and expanded its balance sheet. (The Fed, itself, recommends a shift in teaching about inflation and the money supply to take account of the new, complex realities.)
“It’s an experiment,” he said. If we’re lucky, inflation will come down to a reasonable level. If we’re not, well, “that wouldn’t be surprising. It may take a recession,” he said.
Given this fairly bleak outlook, I asked what ordinary people ought to do, in the current crisis and in thinking about the future.
He was reluctant to give advice or make any predictions. “I’ve learned not to make predictions,” he said. “Can’t do it. Who knows?”
But he agreed that based on the historical data, for the long run the stock market is “probably” a good bet. He stressed, though, it was absolutely not a sure thing.
Hold whatever money you need to survive in some other asset, he said, probably in Treasuries. Then, if you can stand the stress and the risk, invest in stocks. “If you can’t handle it, you shouldn’t do it,” he said.
After a lifetime of study, he’s concluded that the markets do provide answers. But they may not be what you want to hear.