KRF: It is not obvious that financial regulations were weakened during the last few years. This claim seems to have been the product of a Presidential election in which both candidates were running against the incumbent. In fact, one could easily point to important new laws and regulations such as Sarbanes-Oxley to argue that market regulation increased. As more tangible evidence, the SEC's budget increased from $377 million in 2000 to $906 million in 2008. It is certainly true that different regulations could have reduced the magnitude of the current turmoil, but that is like saying a different portfolio allocation could have produced higher returns.

EFF/KRF: The market turmoil is caused by some combination of (i) quickly fluctuating changes in expected cashflows (future profitability), and (ii) variation in investor risk aversion that leads to variation in expected returns (the discount rates for expected cashflows). Both responses can be rational. In short, a change in volatility, by itself, says nothing about market efficiency. Of course, it is interesting to ask why the volatility of expected cashflows and expected returns increased so much, but that requires a much longer analysis.

EFF/KRF: There is often a two or three year gap between the first draft of a paper and publication in a top finance journal. Most financial economists post their working papers on SSRN.com and, because the publication process is so slow, that is where they look for the latest research. Most papers on SSRN are available for free.

Ours are available here:

• Papers by Fama (SSRN)
• Papers by French (SSRN)

EFF/KRF: Any current situation is always somewhat unprecedented and somewhat old stuff. Large declines in stock prices occur several times during the last 80 years. The nearby plot of the volatility of daily market returns shows that the current high volatility also has precedents in 1987 and in the 1930s, and to a lesser extent in 2000-2002. Periods of business uncertainty (for example, the onset of a recession) are typically associated with stock price declines and increases in volatility.


Intra-Month Daily Volatility, S&P 500, July 1926 to October 2008

EFF/KRF: Stock prices would go down and T-bill prices would go up - the usual response of prices to changes in demand. Of course, when T-bill prices go up the yield falls. Similarly, a reduction in prices caused by a large number of investors moving out of stocks pushes expected returns up.

EFF: If the current high volatility makes you permanently averse to stock market volatility, and the inevitable variation in market volatility, you should get out. But you shouldn't have been in the stock market in the first place since fluctuations in volatility are the norm. If you eventually want to come back into the market, then you shouldn't leave. Bouncing in and out of the market is risky if your desired long-term asset allocation involves exposure to the market.

EFF/KRF: The volatility of gold prices (and of commodity prices in general) is much like that of stock returns. Gold is far from a safe haven.

EFF/KRF: Gary Becker (University of Chicago faculty member in economics and business and a Nobel Prize winner in economics) and Richard Posner (University of Chicago Law School professor and a US Appellate Judge) are intellectual giants of economics and law.  Whatever they have to say is worth a read.

EFF/KRF: The tools we develop in "Disagreement, Tastes, and Asset Pricing," published in the Journal of Financial Economics 83 (March 2007), 667-689, are helpful here. To keep the analysis simple, let's assume that (i) there is only one stock, (ii) I have $100,000 to invest, and (iii) for some reason, I want to own as much of the stock as possible. Compare two scenarios. In the first I cannot borrow so I just buy $100,000 of equity. In the second scenario, you are willing to lend me money to buy more stock. You are not crazy, however, so you limit my leverage to four to one. With $100,000 to invest I can borrow $400,000 and buy $500,000 of stock.

EFF/KRF: For diversified portfolios, quite well. For example, the model's market, size, and value-growth factor automatically pick up changes in the volatility of the three factors. Keep in mind, however, that the model is not designed to predict the return on the market (or on SMB and HML), so it cannot call market turns.

EFF/KRF: Yes, but not with lots of confidence. The market return tends to be lower when aggregate ratios like E/P and D/P are low, and vice versa. The economic logic is based on the same discount rate effect we use to explain the higher expected return on value stocks. The empirical evidence leans toward a positive relation between aggregate fundamental to price ratios and future market returns, but there is lots of uncertainty about the forecast.

EFF/KRF: Sorry, but there is no magic bullet here. Market events of the last few months underscore the risks of defined benefit plans to plan sponsors. As a result, we expect that DB plans will be even less popular among plan sponsors in the future.

EFF/KRF: There is always an issue about how to "properly" measure value. But all the work we have done says that at least for diversified portfolios, it doesn't much matter.

Alternative price ratios, like earnings/price and cashflow/price, work about as well as book/price, in terms of identifying value stocks and growth stocks. Every ratio has its problems because whatever fundamental one puts in the numerator has its own accounting issues. As a result, there are inevitable misclassifications of stocks, but they should wash out in diversified portfolios like ours.

We don't see any special problems with the book/price ratios of financial companies.

EFF/KRF: The IGM (Initiative on Global Markets of the University of Chicago Booth School of Business) web site has lots of good stuff from op eds to links to serious academic papers of the business school faculty.