Asset prices: A very rational award IF THE credit boom and bust of the past decade taught economists anything, it was that asset prices matter. So it is right and proper that three academics who have worked on the difficult issue of understanding why such prices move have won this year's Nobel prize for economics (see article). At first sight, it may seem odd that Eugene Fama (pictured left), a Chicago professor who believes in efficient markets, should share the award with Robert Shiller (centre), a Yale academic who argued that the stockmarket in the late 1990s and American house prices in the early 2000s were driven by "irrational exuberance." The third winner, Lars Peter Hansen, on the right, also of Chicago, developed statistical techniques to analyse asset prices. But there is more common ground than meets the eye. Mr Fama's great insight was that, because profit-seeking investors quickly incorporate new information into asset prices, the movements of those prices are not predictable in the short term, and thus professional fund managers are unlikely to beat the market. This revolutionary notion led to the development of the index-tracking industry, which allows small investors to diversify their portfolios at very low cost. Pundits who seek to persuade the public to follow their stockmarket tips may curse Mr Fama's work, but the underlying principle - there are no free lunches to be had - still holds good. Mr Fama's faith in the efficiency of markets has some limits, however, since he set up a fund-management firm that exploits market anomalies, such as the way that companies which are priced cheaply relative to their assets tend to outperform. Mr Shiller's pioneering paper in 1981 looked at the relationship between the prices of shares and their intrinsic value - the cashflows that shareholders will eventually receive. He found that prices were much more volatile than their intrinsic value would suggest, something that is hard to square with the idea of efficient markets. In the long term the valuation of assets tends to revert to the mean, and thus market movements are eventually predictable. But that element of Mr Shiller's work does not invalidate Mr Fama's insight that it is hard to make money from short-term trading. The reason markets are volatile, according to Mr Shiller, is that financial assets are unlike consumer goods; when their prices rise, that creates more demand, not less. Nothing is more intoxicating to an investor than seeing a friend get rich; everyone wants to jump on the bandwagon. It is no use hoping that "rational" investors will drive prices back to fair value. Such sobersides get knocked over by the stampede, losing their shirts or their clients. Hence the recent bubbles in asset markets. Mr Shiller's data show that house prices rose by 7% in real terms between 1890 and 1997 and then by 85% between 1997 and 2006. As for American shares, equities traded at 44 times cyclically adjusted profits (using a ten-year average) at the height of the dotcom boom, compared with a long term average of 16. Central bankers, led by Alan Greenspan, the Federal Reserve's chairman from 1987 to 2006, argued that it was impossible to spot bubbles when they are happening. They also said that using higher interest rates to prevent bubbles from forming would do the economy more harm than good. But the central banks did intervene to prop prices up when markets wobbled in 1987 and again in 1998, even when the economy was fairly robust. This "asymmetric ignorance," as it was dubbed, may have led to greater risk-taking and more bubbles, because traders felt they were underwritten by the "Greenspan put." Is this a bubble that I see before me? Even today, too many of those who play financial markets ignore Mr Shiller's work. A new book on forecasting from Mr Greenspan fails to mention him at all. Wall Street strategists, keen to sell equities, rarely refer to his valuation approach. Investors would do well to pay attention. Just as they should bear in mind Mr Fama's research and put the bulk of their portfolios in low-cost trackers, they should be wary of stockmarkets when they look expensive relative to the long-term trend in profits. And that is the case with Wall Street at the moment; the cyclically adjusted ratio is 23.5, well above the long-term average. After this week's Nobel awards, investors cannot claim they have not been warned.