Are We All Behaviorists Now?
By Stephen Bainbridge

The Wall Street Journal recently published a fascinating article on the debate between efficient capital markets theorists (exemplified by Eugene Fama) and behavioral economists (exemplified by Richard Thaler). As the Journal explained:

For forty years, economist Eugene Fama argued that financial markets were highly efficient in reflecting the underlying value of stocks. His long-time intellectual nemesis, Richard Thaler, a member of the "behaviorist" school of economic thought, contended that markets can veer off course when individuals make stupid decisions.

In May, 116 eminent economists and business executives gathered at the University of Chicago Graduate School of Business for a conference in Mr. Fama's honor. There, Mr. Fama surprised some in the audience. A paper he presented, co-authored with a colleague, made the case that poorly informed investors could theoretically lead the market astray. Stock prices, the paper said, could become "somewhat irrational."

Coming from the 65-year-old Mr. Fama, the intellectual father of the theory known as the "efficient-market hypothesis," it struck some as an unexpected concession. For years, efficient market theories were dominant, but here was a suggestion that the behaviorists' ideas had become mainstream.

"I guess we're all behaviorists now," Mr. Thaler, 59, recalls saying after he heard Mr. Fama's presentation."

The debate between Thaler and Fama matters a lot -- a whole lot.

The efficient capital markets hypothesis (ECMH) is one of the most basic - and influential - principles of modern corporate finance theory. During the 1980s, for example, the Securities and Exchange Commission (SEC) relied on the ECMH to justify many deregulatory initiatives. In the capital markets, acceptance of the ECMH by investors drove the burgeoning popularity of indexing as an investment strategy. The ECMH's validity thus has enormous implications both for the way in which we invest and how the government will regulate the capital markets. As the Wall Street Journal put it, the debate affects a host of "real-life problems, ranging from the privatization of Social Security to the regulation of financial markets to the way corporate boards are run."

The ECMH's fundamental thesis is that, in an efficient market, current prices always and fully reflect all relevant information about the commodities being traded. As applied to stock markets, the ECMH thus has two principal implications. First, stock prices follow a random walk. Put another way, the ECMH predicts that price changes in securities are random. Randomness does not mean that the stock market is like throwing darts at a dart board. Stock prices do go up on good news and down on bad news. Randomness simply means that stock price movements are serially independent: future changes in price are independent of past changes. In other words, investors can not profit by using past prices to predict future prices.

Second, the ECMH posits that current prices incorporate not only all historical information but also all current public information. This form predicts that investors can not expect to profit from studying publicly available information about particular firms because the market almost instantaneously incorporates information into the price of the firm's stock.

The ECMH assumes investors are rational actors whose behavior is consistent with that predicted by the rational choice model. Over the last decade or so, behavioral economists (such as Thaler) have drawn on experimental economics and cognitive psychology to identify systematic departures from rational decisionmaking, even in market settings. Put another way, behavioral economics claims that humans tend to make decisions in ways that systematically depart from the predictions of rational choice.

The ECMH has been one of the behavioralists' favorite targets. Thaler and others have argued that markets are made of human actors, who bring to bear their own individual foibles. Idiosyncratic valuations generate noise that may skew the market's valuation of stock prices. (Just as it is hard to carry on an accurate conversation in a noisy room, it is hard to accurately value stocks in a noisy market.) Research in cognitive psychology suggests that investor idiosyncrasies do not always cancel one another out. Instead, investors sometimes act like a herd all running in the same direction, which can produce pricing errors. Large speculative bubbles that appear out of nowhere and crash without apparent reason are the most visible form of this phenomenon.

The behavioralists have also identified a host of lesser anomalies that are hard to explain in ECMH terms. Stocks tend to suffer abnormally large losses in December and on Mondays. Stocks with low price/earnings ratios tend to outperform the market, as do stocks of the smallest public corporations. Big round numbers (like 10,000) tend to act as psychological barriers. And so on.

So is Thaler right? Are we all behavioralists now? Well, perhaps not quite.

There is considerable evidence that markets adapt to investor irrationality over time. If investor irrationality produces pricing errors, it becomes possible to profit by taking advantage of them. At one time, for example, the capital markets showed a systematic bias against small cap firms. As a result, it was possible to earn abnormal returns by investing in a portfolio weighted towards small caps. Over time, many investors did so, including a substantial number of mutual funds that specialized in small cap investing. As a result, the small cap anomaly gradually faded to the point at which it was no longer possible to systematically beat the market by investing in them. We have observed much the same with respect to other anomalies. Hence, there is considerable evidence that experienced traders can learn their way out of the irrational behavior patterns that lie at the bottom of so many market anomalies.

Accordingly, while the ECMH may not be perfect, it still probably does a better job of predicting market behavior over time than any of the behavioral theories. Indeed, Richard Thaler apparently admitted as much to the WSJ:

Mr. Thaler ... concedes that most of his retirement assets are held in index funds, the very industry that Mr. Fama's research helped to launch. And despite his research on market inefficiencies, he also concedes that "it is not easy to beat the market, and most people don't."

So where are we? It is clear that behavioral economics can identify instances in which the capital markets are inefficient, some of which persist for very long periods and /or across many market sectors. Yet, on balance, the capital markets still appear to be pretty efficient, if not perfectly so.

Can the Market Add and Subtract? Mispriced Stocks Break the Rules of Efficient Markets
by Richard H. Thaler

According to the law of one price, identical assets should have identical prices. Driving this law is arbitrage, in which an investor buys and sells the same security for two different prices to make a profit. In a well-functioning capital market, arbitrage prevents the law of one price from being broken, and in fact, violations of the law are rarely seen.

Consider the investor who buys an ounce of gold in London for $100 and sells the gold in New York for $150, locking in a profit of $50. This is an example of arbitrage. As a result, the price in London should be driven up, and the price in New York should be driven down so that arbitrage is no longer possible.

During the late 1990s boom in technology stocks, several cases emerged where the law of one price was violated, and high transaction costs limited arbitrage, allowing the mispricing to persist. University of Chicago Graduate School of Business professor Richard H. Thaler and Owen A. Lamont of the Yale School of Management investigate these unusual cases in their paper , "Can the Market Add and Subtract? Mispricing in Tech Stock Carve-Outs."

The study focuses on recent equity carve-outs in technology stocks in which the parent company stated its intention to spin-off its remaining shares. The authors examine several cases of mispriced stocks and document the precise market friction that allows prices to be wrong, concluding that two things are necessary for mispricing: trading costs and irrational investors.

Not One Price But Two

Also known as a partial public offering, an equity carve-out is defined as an IPO for shares (typically a minority stake) in a subsidiary company. A spin-off occurs when the parent firm gives remaining shares in the subsidiary to the parent's shareholders.

The most prominent example of mispricing in the study is the case of Palm and 3Com. Palm, which makes hand-held computers, was owned by 3Com, a profitable company selling computer network systems and services. On March 2, 2000, 3Com sold 5 percent of its stake in Palm to the public through an IPO for Palm. Pending IRS approval, 3Com planned to spin off its remaining shares of Palm to 3Com's shareholders before the end of the year. 3Com shareholders would receive about 1.5 shares of Palm for every share of 3Com that they owned, thus the price of 3Com should have been 1.5 times that of Palm. Investors could therefore buy shares of Palm directly or buy shares embedded within shares of 3Com. Given 3Com's other profitable business assets, it was expected that 3Com's price would also be well above 1.5 times that of Palm.

The day before the Palm IPO, the price of 3Com closed at $104.13 per share. After the first day of trading, Palm closed at $95.06 per share, implying that the price of 3Com should have jumped to at least $145. Instead, 3Com fell to $81.81 per share.

The day after the IPO, the mispricing of Palm was noted by the Wall Street Journal and the New York Times. The nature of the mispricing was easy to see, yet it persisted for months.

In cases of equity carve-outs, a negative "stub value" indicates an extreme case of mispricing. The stub value represents the implied stand-alone value of the parent company's assets without the subsidiary, a projection of what the company will be worth after it distributes these shares.

In the case of Palm and 3Com, after the first day of trading, the stub value of 3Com, representing all non-Palm assets and businesses, was estimated to be negative $63, a total of negative $22 billion. Since stock prices can never fall below zero, a negative stub value is highly unusual.

To study this and other cases of mispricing, the authors built a sample of all equity carve-outs from April 1985 to May 2000 using a list from Securities Data Corporation. They combined this list with information on intended spin-offs from the Securities and Exchange Commission's Edgar database. The final sample contained 18 issues from April 1996 to August 2000.

In order to focus on cases of clear violations of the law of one price, the authors looked for potential cases of negative stubs. Besides Palm, they found five other cases of unambiguously negative stubs in their sample, all technology stocks: UBID, Retek, PFSWeb, Xpedior, and Stratos Lightwave. While the number of negative stubs is not significant, even a single case raises important questions about market efficiency. The fact that five other such cases of mispricing existed indicates that the highly publicized Palm example was not unique.

The time pattern of these six negative stubs suggests that the stubs generally start negative, gradually get closer to zero, and eventually become positive. This implies that market forces act to correct the mispricing, but do so slowly, reflecting the sluggish functioning of the market for lending stocks.

Problems with Shorting

To determine ways that an investor could profit from the mispricing, the authors tested an investment strategy of buying the parent and shorting the subsidiary, which on paper yielded high returns with low risk for these six cases.

In order to short a stock, an investor bets that a stock will go down in value and looks for an institution or individual willing to lend shares of this stock. The investor then borrows the shares, sells them to another individual, and later buys the shares back at a hopefully lower price to cover the short. Buying the shares back at this lower price yields a profit for the initial investor.

While these negative stub situations present attractive arbitrage opportunities, the high returns the authors calculated are difficult to realize due to problems with shorting the subsidiary.

The chief obstacles to arbitrage in these cases were short sale constraints, which make shorting very costly or impossible. In some cases, institutions or individuals may be unwilling to lend their shares to short sellers, the cost of borrowing the share may be too high, or the demand for shares may exceed what the market can supply, creating a price which is too high.

Many investors were interested in selling the subsidiaries short for the six cases in question. In the case of Palm, at the peak level of short interest, short sales were 147.6 percent, indicating that more than all floating shares had been sold short. Given that the typical stock has very little short interest, it is extremely unusual that more than 100 percent of the float was shorted.

As the supply of shares grows via short sales, the stub value gets more positive, indicating less demand from irrational investors, and causing the subsidiary to fall relative to the parent.

Next, the authors studied the options market for more evidence on how high shorting costs eliminate exploitable arbitrage opportunities. Options can make shorting easier, both because options can be a cheaper way of obtaining a short position and because options allow short-sale constrained investors to trade with other investors who have better access to shorting.

In a well-functioning options market, one expects to observe put-call parity. A put is the right to sell a stock at a certain price, and a call is the right to buy a stock at a certain price. These two rights together allow an investor to reproduce the stock itself, synthetically creating a security identical to Palm, for example. Under the law of one price, this bundle of securities that mimics Palm should have the same price as Palm.

"The concept that a bundle of securities should have exactly same price as whatever it replicates is the most fundamental thing in all of finance-the law of one price," says Lamont.

The options on Palm display unusually large violations of put-call parity, with puts about twice as expensive as calls. Calculating the implied price of synthetic securities, the authors found that on March 16, 2000, the price of the synthetic short was about $39.12, far below the actual trading price of Palm, which was $55.25 at the time. This difference in prices indicates a significant violation of the law of one price, since the synthetic security was worth 29 percent less than the actual security.

The options prices confirm that shorting Palm was either incredibly expensive or that there was a large excess demand for borrowing Palm shares that could not be met by the market.

"Given that arbitrage cannot correct the mispricing, why would anyone buy the overpriced security?" write Thaler and Lamont. One plausible explanation is that the type of investor buying the overpriced stock is ignorant about the options market and unaware of the cheaper alternative. In looking at who buys the expensive shares and how long they hold them, the authors find numerous patterns consistent with irrational investors.

Larger Problems for the Market?

While the authors do not generalize that these overpriced stocks reflect problems with all stock prices, their evidence casts doubt on the claim that market prices reflect fundamental values because these cases should have been easy for the market to get right. Their analysis offers evidence that arbitrage doesn't always enforce rational pricing.

If irrational investors are willing to buy Palm at an unrealistically high price, and rational but risk averse investors are unwilling or unable to sell enough shares short, then two inconsistent prices can co-exist.

One law of economics that still holds is the law of supply and demand, namely that prices are set where the number of shares demanded equals the number of shares supplied. If optimists are willing to bid up the shares of some faddish stocks, and not enough courageous investors are willing to meet that demand by selling short, then optimists will set the price.

"Regarding tech stocks in general, I don't think that there were enough pessimists shorting the NASDAQ in March 2000," says Lamont. "The short sale constraints that applied to Palm were not true for the entire NASDAQ. It would have been easy to short the whole market with futures, for example, but basically no one shorts. This means that sometimes the optimists go crazy, and things get overpriced."

Lamont adds, "Whether you are an executive doing a takeover or buying the stock for your own account, if stocks can get overpriced, the key to success is identifying what's overpriced and avoiding it."