Good in Theory
STATISTICIAN GEORGE E.P. Box once made this observation: “All models are wrong,” he said, “but some are useful.” This certainly applies to finance, where many of the concepts are imperfect but can nonetheless still be useful. Below are four such examples.
Market valuation. Are stocks overpriced? It’s a question without an easy answer. Even academics who have studied the topic can never be entirely sure. Consider the cyclically adjusted price-earnings (CAPE) ratio. Developed in the 1980s by Yale professor Robert Shiller and a colleague, the CAPE ratio gained fame for correctly forecasting the bursting of the “dot-com” technology bubble in 2000. Shiller’s book Irrational Exuberance was published just days before the market peaked. That forecast cemented the CAPE’s reputation.
But in 2013, a group of researchers at London Business School took a closer look and found that—aside from the CAPE’s success in 2000—its forecasts wouldn’t have been very helpful. Elroy Dimson, who led this research, concluded: “We learn far less from valuation ratios about how to make profits in the future than about how we might have profited in the past.”
Even Shiller acknowledges that the CAPE’s predictive abilities can fall short. In 2021, Shiller made this seemingly contradictory statement in an opinion piece: “The stock market is already quite expensive. But it is also true that stock prices are fairly reasonable right now.”
Here’s how he explained this: While the stock market at the time was expensive by historical standards, Shiller noted that investors should never look at any one metric in a vacuum. Investments need to be considered in comparison to other available investment options. On that basis, he said, stocks were not expensive, because bonds at the time were also expensive.
The bottom line: We shouldn’t ignore valuation ratios. They can provide a useful point of reference. But we should never react too strongly to any particular reading.
Market efficiency. In 2013, an unusual event occurred in Stockholm. When that year’s Nobel Prizes in economics were awarded, two of the winners presented a seeming contradiction. One was Eugene Fama, who developed key ideas in finance that are known as Modern Portfolio Theory (MPT). According to this theory, stock prices are always rational because they reflect all available information. Thus, according to MPT, there can be no such thing as a bubble, because—by definition—prices are always accurate. When share prices are high, in other words, it’s for a good reason and not because investors are irrational.
Another of the Nobel winners that year, however, was Robert Shiller, whose work argued precisely the opposite. In Irrational Exuberance, he demonstrated that markets aren’t always rational and that asset bubbles can and do occur—with the run-up in the late 1990s being a prime example.
Despite these opposing views, the Nobel committee granted both Fama and Shiller the prize in economics at the same time. How did the committee explain its decision? On the one hand, it agreed with Fama: “Stock prices are extremely difficult to predict in the short run.”
But over the long term, the committee said, prices are more predictable, and valuation metrics like the CAPE—while not perfect—can be helpful.
In other words, Shiller and Fama can both be right, even if their ideas seem at odds. Both have acknowledged this, if grudgingly. In an interview, Fama explained it this way: Modern Portfolio Theory “is a model, so it’s not completely true. No models are completely true.” But, he added, “It’s a good working model for most practical uses.” And that’s the key point: Markets may be rational over the long term but are often irrational in the short term. This idea can help investors maintain equanimity through the market’s regular ups and downs.
Inflation. Another model which is sometimes accurate is the Phillips curve, which suggests an inverse relationship between inflation and unemployment. It says that when unemployment is low, inflation will tend to be higher, and vice versa. This theory was developed in the 1950s and seemed to hold true for a time. But more recently, that relationship appears to have broken down. Between 2000 and 2020, inflation was extremely low despite unemployment also being low.
In 2019, Mary Daly, president of the San Francisco Federal Reserve Bank, commented: “As for the Phillips curve… most arguments today center around whether it’s dead or just gravely ill. Either way, the relationship between unemployment and inflation has become very difficult to spot.”
Why the change? A key factor is globalization. Low-cost imports, especially from China, grew substantially, helping to hold down consumer prices. It was an ideal economic situation. This is a reason higher tariffs are a concern. If imports from Asia are limited, the Phillips curve tradeoff between inflation and employment may once again become a problem.
Taxes. Another economic model that seems to be partly true is the Laffer curve. Developed in the 1970s by economist Arthur Laffer, this theory argues that government revenue should increase when tax rates are lower. It’s counterintuitive, but the idea is that tax cuts should spur economic growth.
The Laffer curve is presented as a bell curve. At one end, with a 0% tax rate, the government would collect no revenue. And at the other, with a 100% tax rate, the government would also collect no revenue, because no one would work. Therefore, Laffer argued, there must be an optimal rate in between that maximizes government revenue.
The question: What is that rate? This is precisely the debate that’s occurring today in Washington.
The bottom line for investors: Economics is not a perfect science. It describes relationships which are sometimes true, but can also change, sometimes permanently. For that reason, these models are useful to understand—but should never be taken as gospel.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam's Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
Market valuation. Are stocks overpriced? It’s a question without an easy answer. Even academics who have studied the topic can never be entirely sure. Consider the cyclically adjusted price-earnings (CAPE) ratio. Developed in the 1980s by Yale professor Robert Shiller and a colleague, the CAPE ratio gained fame for correctly forecasting the bursting of the “dot-com” technology bubble in 2000. Shiller’s book Irrational Exuberance was published just days before the market peaked. That forecast cemented the CAPE’s reputation.
But in 2013, a group of researchers at London Business School took a closer look and found that—aside from the CAPE’s success in 2000—its forecasts wouldn’t have been very helpful. Elroy Dimson, who led this research, concluded: “We learn far less from valuation ratios about how to make profits in the future than about how we might have profited in the past.”
Even Shiller acknowledges that the CAPE’s predictive abilities can fall short. In 2021, Shiller made this seemingly contradictory statement in an opinion piece: “The stock market is already quite expensive. But it is also true that stock prices are fairly reasonable right now.”
Here’s how he explained this: While the stock market at the time was expensive by historical standards, Shiller noted that investors should never look at any one metric in a vacuum. Investments need to be considered in comparison to other available investment options. On that basis, he said, stocks were not expensive, because bonds at the time were also expensive.
The bottom line: We shouldn’t ignore valuation ratios. They can provide a useful point of reference. But we should never react too strongly to any particular reading.
Market efficiency. In 2013, an unusual event occurred in Stockholm. When that year’s Nobel Prizes in economics were awarded, two of the winners presented a seeming contradiction. One was Eugene Fama, who developed key ideas in finance that are known as Modern Portfolio Theory (MPT). According to this theory, stock prices are always rational because they reflect all available information. Thus, according to MPT, there can be no such thing as a bubble, because—by definition—prices are always accurate. When share prices are high, in other words, it’s for a good reason and not because investors are irrational.
Another of the Nobel winners that year, however, was Robert Shiller, whose work argued precisely the opposite. In Irrational Exuberance, he demonstrated that markets aren’t always rational and that asset bubbles can and do occur—with the run-up in the late 1990s being a prime example.
Despite these opposing views, the Nobel committee granted both Fama and Shiller the prize in economics at the same time. How did the committee explain its decision? On the one hand, it agreed with Fama: “Stock prices are extremely difficult to predict in the short run.”
But over the long term, the committee said, prices are more predictable, and valuation metrics like the CAPE—while not perfect—can be helpful.
In other words, Shiller and Fama can both be right, even if their ideas seem at odds. Both have acknowledged this, if grudgingly. In an interview, Fama explained it this way: Modern Portfolio Theory “is a model, so it’s not completely true. No models are completely true.” But, he added, “It’s a good working model for most practical uses.” And that’s the key point: Markets may be rational over the long term but are often irrational in the short term. This idea can help investors maintain equanimity through the market’s regular ups and downs.
Inflation. Another model which is sometimes accurate is the Phillips curve, which suggests an inverse relationship between inflation and unemployment. It says that when unemployment is low, inflation will tend to be higher, and vice versa. This theory was developed in the 1950s and seemed to hold true for a time. But more recently, that relationship appears to have broken down. Between 2000 and 2020, inflation was extremely low despite unemployment also being low.
In 2019, Mary Daly, president of the San Francisco Federal Reserve Bank, commented: “As for the Phillips curve… most arguments today center around whether it’s dead or just gravely ill. Either way, the relationship between unemployment and inflation has become very difficult to spot.”
Why the change? A key factor is globalization. Low-cost imports, especially from China, grew substantially, helping to hold down consumer prices. It was an ideal economic situation. This is a reason higher tariffs are a concern. If imports from Asia are limited, the Phillips curve tradeoff between inflation and employment may once again become a problem.
Taxes. Another economic model that seems to be partly true is the Laffer curve. Developed in the 1970s by economist Arthur Laffer, this theory argues that government revenue should increase when tax rates are lower. It’s counterintuitive, but the idea is that tax cuts should spur economic growth.
The Laffer curve is presented as a bell curve. At one end, with a 0% tax rate, the government would collect no revenue. And at the other, with a 100% tax rate, the government would also collect no revenue, because no one would work. Therefore, Laffer argued, there must be an optimal rate in between that maximizes government revenue.
The question: What is that rate? This is precisely the debate that’s occurring today in Washington.
The bottom line for investors: Economics is not a perfect science. It describes relationships which are sometimes true, but can also change, sometimes permanently. For that reason, these models are useful to understand—but should never be taken as gospel.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam's Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.The post Good in Theory appeared first on HumbleDollar.
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