An Email Exchange on Efficient Markets

The following is a slightly edited version of an email conversation between Eugene Fama (perhaps the most prominent financial economist alive today), and myself (Ivo Welch), with John Cochrane and Jay Ritter weighing in, too.

Some background: Eugene Fama was instrumental in pioneering the concept of Efficient Markets. Richard Thaler, who is repeatedly mentioned in the exchange, is a leading economist scholar who is proposing a view of finance that argues that markets are less efficient. This is sometimes called "behavioral finance," although "imperfectly rational finance" would be a more apt description.

From: Eugene F. Fama Date: 10/14/2002 To: (long list of recipients, incl. Ivo Welch, Jay Ritter, Richard Thaler, etc.) Hi guys: I enjoyed your review of the IPO literature in the August JF. But I think it's spoiled by repeated unsubstantiated use of the term "internet bubble." What exactly do you mean by a "bubble" and what is the scientific evidence that this was one? I'm surprised that this term didn't ring a bell with the editor as a blatant example of loose talk that shouldn't be allowed in a scientific journal. Except on this point, you are clear when you are stating personal opinions, and I have no quarrel with that. Regards, Eugene F. Fama
From: Ivo Welch Date: 10/16/2002 10:40am To: (same long list) hi Gene: Thanks for your comments. I think you are correct, in that we should have stated once that we are using the term bubble just loosely. The justification is that the reader (public+profession) already has the appropriate association. Even you knew what we meant (plus, it seemed to have kept you awake! ;-) ), and it must have been easier reading "during the Internet bubble" than a constant reiteration of "slowly beginning with the Netscape IPO of 1995, happening mostly in the tech sector, Nasdaq increasing from about 1000 in 1995 to 4600 in March 2000, and then descending back down to 1200 today." However, I am curious myself now: PS: Mind you, I believe that there are no bubbles where money-making is easy. We are talking about prices deviating from underlying fundamentals, and exploitation being difficult due to the long-run nature, high volatility, and high transaction costs. As one of your former students, may I suggest that we adopt a different taxonomy of Market Efficiency now? true believer: prices are always equal to fundamentals <-- Gene Fama ;-) mild believer: prices sometimes deviate, but exploitation is very difficult. <-- Ivo Welch unbeliever: prices are often so far off that great bets or even arbitrage pop up all the time. <-- Richard Thaler ;-) PPS: I am trying to poke fun at you, too, Dick.
From: Eugene F. Fama Date: 10/16/2002 12:11pm To: Ivo Welch Gene's comments were interspersed. Therefore, this email was edited. (In response to my claim of describing mostly the period.) You might have explained that this is all you meant by a bubble. > However, I am curious myself now:
  • What sort of evidence would it take for you to conclude that a bubble exist(ed)?
  • (And, vica-versa, what sort of evidence would it take for you to conclude that no bubble exist(ed)?)
A rigorous definition of a bubble and empirical tests on more than one episode.
From: Ivo Welch Date: 10/16/2002 To: Eugene F. Fama Hi Gene: I agree that we should have stated at least once upfront what I mean by use of the phrase "bubble" (although I suspect that Jay R. would have protested), and that I believe it also was a bubble, but that I have no scientific proof that it was such. I like your definition of bubbles as deviations from suitable long-run expected rates of returns. John's is also interesting and related. Can I reiterate my suggestion that I think it would be good for the profession if you indeed wrote a taxonomy (and with it a potential research agenda) for the rest of us? I disagree with you, however, that we need multiple episodes: I think it is perfectly ok to believe in rare and occasional presence of bubbles, only. Given our asset pricing malaise, Market Efficiency is so powerful on short horizons, and so weak on long horizons. Given that it is so difficult to pin down a definite long-run equilibrium model for stock returns, I wonder whether there is any hope of ever deciding based on the/any evidence whether bubbles exist or long-run Market Efficiency holds. I wonder: will this always remain a faith-based issue? Let me prod you again with my questions: (PS: I lost a ton of money shorting Internet bubble firms. I could not afford holding on. But, I definitely did believe at the time, too, that it was a bubble. This is not just ex-post for me.) Regards, /iaw
From: Eugene F. Fama Date: 10/17/2002 10:20 To: Ivo Welch Gene's comments were interspersed. Therefore, this email was edited. "Internet period" is a less charged term. > I disagree with you, however, that we need multiple episodes: I think it is > perfectly ok to believe in rare and occasional presence of bubbles, only. Believe is the key word. Remember the Holbrook Working story that I tell in class about bubbles. Gene's next email explained: Working showed plots of cumulative iid normal random numbers to his economist colleagues at Stanford. They quickly concluded that these were plots of specific commodity prices and identified the "obvious" bubble episodes. Given our asset pricing malaise, Market Efficiency is so powerful on short horizons, and so weak on long horizons. Given that it is so difficult to pin down a definite long-run equilibrium model for stock returns, I wonder whether there is any hope of ever deciding based on the/any evidence whether bubbles exist or long-run Market Efficiency holds. I wonder: will this always remain a faith-based issue? Perhaps Let me prod you again with my questions: Maybe our difference in perception is milder than I think. How many Microsofts among Internet firms would it have taken to justify the high prices of 1999-2000prices? I think there were reasonable beliefs at the time that the Internet would revolutionize business and there would be many Microsoft-like success stories based on first-mover advantages in different industries.

At this point, there was a brief conversation between John Cochrane (Chicago) and myself, in which John suggested (and I agreed) that it would help to define bubble. Gene was cc'ed. In the conversation, I suggested that Gene would be uniquely qualified to define what a bubble means, even if he does not believe in their presence.

From: Eugene Fama Date: 10/16/2002 12:18pm To: Ivo Welch, John Cochrane Here it goes. Bubbles are special cases of market inefficiency where cumulative returns differ predictably from equilibrium expected returns for sustained periods.
From: Ivo Welch Date: 10/17/2002 12:47pm To: Eugene Fama Hi Gene: I do not want to intrude on your time much further, so feel free not to answer. I looked up Holbrook Working, but could not find what you must be refering to. (answered above) I do not remember the story. Then again, I was in your class 18 years ago. Sheesh, has it really been so long... I think your Microsoft10 argument is not impossible, but it is implausible. This is for 2 reasons. First, if all these Internet firms were about to revolutionize businesses and able to defend first-mover advantages, I wonder why the old economy firms did not drop like crazy. Second, I cannot intuit the process by which independent new information came out that there would be no first-mover advantage, after all. That is, why was this justification that Lycos would become a new Microsoft so sensible in March 2000 and so insensible in September? Naturally, I need not see the entire way that markets function and what new information is arriving, but the process by which markets came to refute this idea of Microsoft10 dominance in many industries needs as much explanation as the one why they came to this idea in the first place. Would you allow me to post and/or forward some of your comments to students? Also, Dick Thaler wrote me an email that he would be curious. Is it ok? Gene granted permission for this page later. Regards, /ivo
From: Eugene Fama To: Ivo Welch, Jay Ritter, Richard Thaler Date: 10/18/2002 10:41am Loughran and Ritter (2002, Why has IPO prcing changed over time) report that during 1999-2000 there are 803 IPOs with an average market cap of $1.46 billion (Table 1). 576 of the IPOs are tech and internet-related (Table 2). I infer that their total market cap is about $840 billion, or about twice Microsoft's valuation at that time. Given expectations at that time about high tech and the business revolution to be generated by the internet, is it unreasonable that the equivalent of two Microsofts would eventually emerge from the tech and internet-related IPOs? Eugene F. Fama
From: Ivo Welch Date: 10/19/2002 12:24 To Eugene Fama, Jay Ritter, Dick Thaler Hi Gene: The bubble view is less based on the IPO Gross Proceeds, but on the aftermarket valuation. That is, it is not difficult to understand why Tech IPOs were priced so highly at initial sale; it is difficult to understand why the entire Tech sector was so high. In January 2000, I posted on my webpage the market caps of firms that I did not understand at the time: AOL=170 billion; Yahoo=$114 billion, Akamai=$30 billion, etc. Microsoft as a benchmark against the bubble is not correct, because it also rode the wave of Tech enthusiasm. Even Bill Gates and Steve Ballmer came out repeatedly claiming that they were worth a lot less. (Microsoft now has a market cap of $271 billion, despite continuous improvement in performance.) In fact, I might even believe that the entire market was exceedingly high at the time. It is just that the Tech IPOs were so far above what I considered reasonable that I felt it was here that one can reasonably claim the presence of a bubble; the same could not be said for the market. I agree: I have not proven the presence of a bubble, but neither have you proven the absence of a bubble *in this context*. So, I have to repeat myself: your view is not absolutely impossible, but appears highly improbable to me. Oddly, on the scale of Fama to Thaler, my own priors sit at about 85% Fama and 15% Thaler. I am a bit surprised, though, that your posterior is so unaffected, not so much by the price pattern, but by the price/fundamental pattern. I wonder if Newton would have been moved by Einstein-ian relativity. After all, 99% of what we see was explained by Newton alone. [The only thing that I dislike about this analogy is that if Thaler was Einstein, he would have claimed that he could see light bending around him everywhere ;-) .] Regards, /ivo

Jay Ritter later pointed out that Gene quotes $1.46 billion market cap on the first day of trading. I should not have ignored this figure, becayse in my emails, my concern was with the issue of explaining tech valuations at the peak of the market in March 2003 (Nasdaq briefly reached 5,000), not the IPO's "first day of trading" price.

Jay Ritter's email was not working during the initial conversation, so he weighed in later only.

From: Gene Fama Sent: Wednesday, November 13, 2002 4:42 PM To: (large number of people) Jay and Ivo: There is an interesting result implicit in your IPO review paper in the August JF. Any post-issue under-perfomance of IPO stocks does not benefit the IPO firms since under-performance is always measured relative to the closing price on the first day of trading (or the end of the first month). If one factors in the strongly positive first day returns, the long-term returns on IPOs are not low, by any measure. This is interesting because it seems to be evidence against the hypothesis that firms go public when they can get prices that are too high. Eugene F. Fama Robert R. McCormick Distinguished Service Professor of Finance
From: "Jay Ritter" To: "Eugene F. Fama" Cc: "ivo welch" Sent: Wednesday, November 13, 2002 6:54 PM Subject: Re: long-term returns on IPOs Gene-- If the degree of underpricing (as measured by first-day returns) is constant over time, then this is just another transaction cost of going public and thus is unrelated to the question of the timing of IPOs. So I presume that the issue is one of whether there is a correlation of IPO volume, underpricing, and long-term returns. Long-term returns can be measured in both an absolute sense (raw returns) or abnormal returns (relative to some benchmark). If it is the case that IPO volume is high when first-day returns are high and long-term returns (measured from the first aftermarket price) are low, then you are absolutely right-- if long-term returns measured from the offer price are uncorrelated with volume, then there is little evidence of timing ability. In fact, IPO volume and first-day returns have a very low correlation (see, for example, the numbers in Lowry-Schwert (2002 JF)). You are correct that, measured from the offer price to five years later, the raw and abnormal returns on IPOs are not noticeably low, once penny stocks are deleted form the samples. But there still seems to be some negative correlation of volume and long-term returns, although it is not an incredibly strong negative correlation. The exact numbers depend somewhat on whether the 1999-2000 bubble period is included. These years had incredibly high first-day returns and incredibly low long-term returns. The volume in 1999 and 2000 was not extreme, however. 1983, 1986, 1993, and 1996 all had higher IPO volume than 1999 and 2000, as measured by the detrended number of IPOs, if one assumes that IPO volume should increase by 2% per year to reflect the growth of the economy. Jay R. Ritter Cordell Professor of Finance P.O. Box 117168 University of Florida Gainesville FL 32611-7168

A final word: for me, the challenge for efficient market proponents is not only to explain why Tech stocks increased so dramatically from 1995 to 2000, but also to explain why their explanation stopped working in March 2000. The decline seemed rapid and not associated with a lot of new fundamental information. So, I am sure that it is possible to concoct such explanations, but I have yet to hear an explanation that I also find plausible. So, to this day, I still believe we experienced a bubble.

Jay R. also pointed out that the most reprinted article in the history of Fortune magazine was Warren Buffet's Fortune piece from November 22, 1999, in which he warned about the overvaluations of Tech stocks and Internet stocks---well before March 2000.

Ivo Welch