Outstanding Issues in Finance: A Critical View of the Field

I am convinced that today’s Finance is still in its infancy as a science. The domain of what we know pales in comparison to what we actually know we don’t know. For example, we know that our understanding of the basic mechanisms of asset valuation (stocks, real estate, gold) is limited, confused and non-operational for the most part. Who can tell and predict the value of stocks today? Investors are offered conflicting views (rational vs. irrational), quick recipes, and voodoo advice. The “pseudo” scientific mathematical models that are offered today, far from resolving real-world problems do revel in their own complexity in exchange for minor incremental learning. Below, I am addressing several outstanding issues in Finance. I also offer a new way of viewing ourselves much more like engineers or physicians, in our capacity as social scientists. We are living in exciting times, the science is young, the questions are still open, novel thinking and scientific breakthroughs await us. Please feel free to e-mail me if you agree, disagree or would like to offer suggestions. By the way, also read a concurring opinion from Arnott’s ‘take-no-prisoner’ editorial in the Financial Analysts Journal about the State of the Finance Industry.

Let me give you a few examples of major unresolved issues:

· The CAPM dead or alive? Over the last few decades one of the most prominent model of Finance called the CAPM has been under attack, not because its logical foundations are wrong or limited, but rather since it does not explain returns, the way it was intended t higher contribution to systematic risk leads to higher returns. Noteworthy, is the French-Fama (1992[f1] ) paper showing that price to book is a better predictor of stock returns than beta. Now, we can accept that an essentially static model created about 40 years ago can fall short of explaining reality. Maybe the reason is that we are not capturing expected returns properly. Recently, there have been new attempts to validate the model (for example showing that a form of inflation illusion has an effect on the Beta-expected return relationship (Cohen, Polk and Vuolteenaho (2004)), or that the French-Fama result can be explained by incorporating leverage as a factor, thus rendering the beta effective again (Ferguson and Shockley (2003)). These results may be incrementally informative but it is important to know if the stream of new insights about CAPM is fundamental enough to repair the model.

· Beta only a measure of risk? Beta, since it measures the contribution of a single stock to market volatility, may not represent risk in all instances but rather growth. For example, since the stock market moves upward in the long-run, and market returns are positively serially correlated (low frequency data), then a high beta stock may in fact capture a boost to the average market return due to faster than normal growth (in earnings). The extra premium is not for risk but for growth. Here are some new views about redefining the standard CAPM model in terms of beta linked to downside risk (Kaplansky (2004) or Post and Van Vliet (2004)).

· What about those macro-finance models? Since the static model has not done so well, what about the dynamic models? These have not fared better since the middle of the 1970’s (essentially since the works of Merton (1973)[f2] and Lucas (1978)[f3] . Both are Nobel laureates in Economics).

· Valuation of stocks, anyone? The standard dividend discount model taught in our schools (and many variations on it) has not borne its fruits. Stock prices MUST be based on the present value of expected future cash flows accruing to investors (Warren Buffett concurs). The questions are: 1) Are these cash flows adequately represented by forecast dividends or proxies? 2) How do we account for expected price appreciation independently of future dividend proxies? 3) How can we narrow the choices for the right discount rate(s) and other inputs to apply to these models? Still, it appears that demand often forces prices to temporarily diverge from a present value calculation due possibly to “irrational exuberance”, then 4) How fast does the reversion mechanism to fair value operate (if any)?

· Is the stock market rational or irrational? This is a very confusing issue since the latest conventional wisdom is that the stock market is mostly irrational (Shiller 2001). In fact, it is probably a mixture: an undercurrent of fundamental value plus superimposed short-term deviations due to irrational behavior and/or news. Let us be careful though, one reason why markets are seen as irrational is that Finance has been unable to provide a logical/mathematical foundation to valuation since the current models have fallen short. Thus, our definition of “rational” is contained within the rationality of the models we have so far developed. The core guiding principle of investors’ decisions may very well be founded on economic laws (systematic and reproducible) left to be discovered…

· What are we (investors) to do? If markets are irrational what is there to learn about investing in stocks? Are we investors supposed to throw in the towel when there is no solid ground on which to make a stock investing decision? Maybe some investors can capitalize on the irrationality of other investors? (Contrarian trading: Am I irrational or is she?). On the other hand, you’ll say there is always the motto of Value Investing: buy companies for which you understand the business model, scrutinize the financial statements, do they have a good cash position, low PEG, etc… There is no argument that these factors can contribute to good stock selection. More to the point though: an entire industry has sprung-up not necessarily caring about how stocks are truly valued. Yes, I’m talking about the mutual fund industry. How so? The industry creates portfolios with particular flavors: Growth oriented, Large caps, Small caps, Blends etc... The game in town is product differentiation and finding a market niche. A marketing game! Since no one truly understands the pricing of stocks, mutual fund managers attract investors by promising to replicate ‘good’ past records, or to generate great returns based on the fund’s investment style (an oxymoron). Since portfolios are turned over to dump losers and buy winners (often late), these outfits are not in the business of fully understanding stock valuation but rather in the business of maintaining or growing their fund participation by minimizing quarterly losses and riding the growth endemic to a capitalistic economy.

· The (in)famous Equity Premium puzzle. The Equity Premium (EP) is the difference between the stock market return and a Treasury yield (also referred to as risk free rate). Now, if there were an equivalent to the speed of light in E = MC², as applied to the valuation of most assets, this would be the EP. However, the EP is typically not constant over time. It is what economists call counter-cyclical: it rises during recessions and lowers during booms. Now, since stocks are riskier than bonds in the short-term, following the CAPM logic they should pay a higher return. Thus, the EP should be explained by risk avoidance. However, the current macro-economic and finance models are unable to confirm this intuition, since (not to bore you too much) the size of actual equity premium does not reconcile with what the models need to assume for the level of risk aversion in the economy. Here is some of my joint work on the issue of understanding the equity premium in the long run The Equity Premium: Explained by GDP Growth and Consistent with Portfolio Insurance.

· Stock returns that compound faster than economic growth? No kidding! Current theories accept that compound equity returns have been around 11% nominal in the long-run. This far outpaces the nominal GDP growth of the US economy about 6.5%. Imagine a savings account paying 11% when the bank’s profits only grow at 6.5%… Why are current theories endorsing this result? Well, the key to this gap is that the equity compounded return calculation assumes that dividends are fully reinvested period after period. A single investor may be able to do this for a while as he/she can increase their market share, but since aggregate stock wealth cannot grow faster than GDP in the long-run, all investors at large cannot do that. The pricing of stocks must incorporate a relationship to feasible wealth compounding. Right now, the current theories do not link returns to GDP growth in a convincing manner. Check out my A General Theory of Stock Market Valuation and Return where we argue that stock valuation is affected by the feasible rate of wealth compounding.

· Loving or fighting the Fed model. The Fed model (Orphanides and al. (1997)) is highly controversial. Many practitioners love it (see Dr. Yardeni’s page); academic pundits hate it (Asness (2003)). The Fed model is the result of a discovery that the SP 500 forward earnings yield is highly correlated with the 10- year Treasury yield, since the 1970s. This is the best working model we have for the SP 500. Academics believe the model is logically flawed, based on thinking that the earnings yield is a real rate of return. Yes sure, how can you compare a real rate to a nominal yield? Since the Fed model is flawed, the observed correlation must be a fluke and since reality violates our current accepted theories, then reality must be wrong! (This is an actual quotation!) Well, try to tell that to practitioners! We must attempt to better understand why the Fed model works. We show some love to the Fed model in A General Theory of Stock Market Valuation and Return.

What you just read may seem like a dire indictment of Finance. Not so fast, I do intend to make a living in this profession for a long while. However, let’s not forget that in essence we are all truth-seekers. Thus, to no severe fault of our own, this is where we find ourselves. I think that we, as social scientists, should be hungrier to search for the truth and use the frustration engendered by theories with limited applicability to create truly operational tools. Similarly to engineers or physicians, we should look at our subject matter as being vital to the financial health and wealth of our society. Finding cures and solutions should be of primordial interest. Is current Finance a lot like ancient Greek medicine? Possibly. What would Hippocrates have to say about this?

Hippocrates was a Greek physician born in 460 BC on the island of Cos, Greece. He became known as the founder of medicine and was regarded as the greatest physician of his time. He based his medical practice on observations and on the study of the human body. He held the belief that illness had a physical and a rational explanation. He rejected the views of his time that considered illness to be caused by superstitions and by possession of evil spirits and disfavor of the gods.

Hippocrates’ Oath (400 BCE) as Translated to Finance (2004 AD) Excerpt:

“…I will follow that system of regimen (scientific inquiry) which, according to my ability and judgment, I consider for the benefit of my patients (investors and economic decision-makers), and abstain from whatever is deleterious and mischievous. I will give no deadly medicine (potentially wealth destroying advice based on ill-suited theories) to any one if asked, nor suggest any such counsel…With purity and with holiness; I will pass my life and practice my Art… Into whatever houses I enter, I will go into them for the benefit of the sick (investors and other decision-makers seeking understanding), and will abstain from every voluntary act of mischief and corruption… While I continue to keep this Oath unviolated, may it be granted to me to enjoy life and the practice of the art, respected by all men, in all times! But, should I trespass and violate this Oath, may the reverse be my lot!”