EFF: There never was one. The "puzzle" comes out of a simplified economic model that says the average spread of the equity market return over the t-bill return has been too high, given the risk of equities. It is easy to show that this argument is silly. Thus, the returns from equity investing are quite risky. As a result, if the high average stock return of the past is the true long-term expected return, the high volatility of stock returns nevertheless means that getting a positive equity premium (of any size) is highly likely only for holding periods of 35 years (an investment lifetime) or more. Given this result, the historical equity premium does not seem too high.

EFF: All the evidence I know says that market predictions are unbiased. It's understandable, however, that hedge fund managers are immune to this evidence since it's a threat to their existence.

EFF/KRF: We are not experts, but know enough about the academic research to be skeptical of the signals suggested by casual observers. The academics who study this find that the best leading indicators are not very powerful. It is hard to say when the recession will end until it has.

From an investment perspective, the market is always doing its best to incorporate information about future business conditions in current prices. As a result, other signals about the end of the recession are not likely to help you forecast the market.

EFF: The term "systemic risk" is less than 20 years old. It has become a scare term that governments use to justify bailout actions detrimental to taxpayers.

"Too big to fail" is an especially perverse use of the systemic risk scare tactic. I think the policy rule should be "too big not to fail," that is, big losers among financial firms get shut down first, to signal other big financial firms that "too big to fail" bailouts are over, so the firms will behave more responsibly in the future.

EFF/KRF: There is no single right answer to this question. If there were one answer, it would have to be the market portfolio of domestic, international, and emerging stocks, since that is the only portfolio that can be held by everyone. Different tastes and circumstances, however, push investors away from the market portfolio and the optimal deviations vary across investors. For example, perhaps because of exchange rate uncertainty, people tend to overweight their domestic market. Similarly, some investors are happy to increase their expected return by tilting toward small stocks, while others prefer to reduce their risk by tilting toward large caps. It is important to diversify, but there is no single optimal mix.

EFF/KRF: No. Although the expected market return probably increased over the last year, this is the result of greater uncertainty about future returns and perhaps an increase in the overall level of risk aversion. If your client's circumstances warrant a reduction in risk, an increase in expected return that is caused by an increase in risk is not a good reason to stay in the market.

EFF/KRF: In our research we calculate the E/P ratio for a portfolio just as S&P does, dividing the aggregate earnings of the firms in the portfolio by the total market equity. It is easy to see the logic if you imagine merging all of the firms into one giant conglomerate. The new firm's earnings and market equity are just the sum of the individual firms' earnings and market equity.

EFF: Wins and losses from market timing bets are both just unpredictable chance outcomes, and good luck is, of course, better than bad luck. The problem with market timing is that you may be out of the market in periods of strong returns.

KRF: There is a large academic literature on whether market returns are predictable. The general conclusion is that it is impossible to predict the market return with any confidence... "A Comprehensive Look at the Empirical Performance of Equity Premium Prediction," by Amit Goyal and Ivo Welch (Review of Financial Studies, 2008), is a good summary of the evidence.

EFF/KRF: Inverted yield curves are often observed at the front end of recessions. But there's no evidence that they predict stock returns, which also tend to predict (decline in advance of) recessions. Your client's implicit premise is that bond market investors predict future economic activity better than stock market investors. The evidence says that both markets are moderately good at predicting future economic activity, and inverted yield curves are not reliable predictors of stock returns.

EFF: It gives investors a good estimate of what a financial institution is worth. It has more flexibility than commonly realized, especially for illiquid assets, where best estimates of value can be used.

KRF: There is not enough empirical evidence to be sure who is right about this issue, but we can guess. Those against marking to market argue that the transaction prices for securities sold under duress do not reflect their true value. If you and I both own relatively illiquid assets and you choose to sell yours quickly at a fire sale price, mark to market accounting may force me to write down the value of my assets to your transaction price. Unless I also plan to sell my position quickly, this undervalues my position. The critical question, however, is whether your transaction price is more accurate than the model value I would use if I am not forced to mark to market. My guess—and this is only a guess—is that the observed transaction price is typically more accurate than the model. In other words, marking to market would improve the accuracy of my balance sheet.

EFF: Half of my 1964 Ph.D. thesis is tests of market efficiency, and the other half is a detailed examination of the distribution of stock returns. Mandelbrot is right. The distribution is fat-tailed relative to the normal distribution. In other words, extreme returns occur much more often than would be expected if returns were normal.

EFF: Theoretically, derivatives increase the range of bets people can make, and this should help to wipe out potential inefficiencies. Whether this actually happens is a difficult, perhaps impossible, empirical question. The "problem" is that markets seemed rather efficient before Black-Scholes (which initiated the derivatives industry), so there wasn't much for derivatives to do.

EFF/KRF: When overall market volatility increases, idiosyncratic (security-specific) volatility also tends to increase. For example, market volatility is currently quite high, and the dispersion of the cross section of stock returns (which is idiosyncratic volatility) is also unusually high. Diversification has no effect on the volatility of the overall market, but it reduces the effect of idiosyncratic volatility on a portfolio's return. To put it differently, active investment is a riskier strategy when volatility is high because active portfolios are, almost by definition, poorly diversified.

In short, diversification is now more important than usual.

EFF/KRF: In the past, other countries have had recessions that the U.S. has not shared. But the U.S. is big, and every U.S. recession has been global. Thus, the global aspect of the current U.S. recession is characteristic of past U.S. recessions. Every past recession has ended. This one will too.

EFF/KRF: As far as I can tell, the government bailout of AIG has gone largely to prop up its $2 trillion of credit default swaps. The fear of the Treasury and the Fed is that if AIG is forced to default on its credit default swaps, the "insurance" they provide to the value of bank assets will disappear, the value of the assets will fall, and lots of big banks will be insolvent. I agree that this is likely to be the eventual outcome, in other words, the Fed and the Treasury will eventually say "uncle" and let AIG and the bad banks fail. I think this is what they should have done from the beginning, and if they had we would be in better shape now. The stockholders and the bondholders of AIG and the failed banks will lose big time, but this will allow the banking sector as a whole to emerge in a stronger state. (See also my little paper "Bailouts and Stimulus Plans.")

EFF/KRF: Even in good times, economic systems are often changed dramatically by political decisions. (Think about South America over the last 30 years.) Capitalism is always under threat in the U.S., and the threat is higher when the legislative and executive branches are both in the control of liberal Democrats, who seem to be big admirers of the European system of high social welfare expenditures and "managed" (or better, mismanaged) capitalism. Unfortunately, the current political period may result in stagnation of the sort that other managed capitalist economies (Japan and most of Europe) have experienced. But we hope the pioneering free enterprise spirit of the U.S. can quickly reassert itself.

EFF/KRF: Government intervention affects the market in two ways. First, it affects the level of expected future profitability, which has direct effects on stock prices. Second, government intervention and uncertainty about the government's future actions change the risk of expected future profits, which affects stock prices by raising or lowering the discount rates for expected future profits, and thus raising or lowering expected stock returns. Our view is that the rhetoric and sweeping initiatives of the new administration have lowered market expectations of future profitability, and the uncertainty about government policies has increased the risk of expected future profits. Both effects have contributed to the lower stock prices we have seen as the policies of the new administration have unfolded. If the market has it right (that is, if the market is efficient) all this is built into current stock prices, and expected returns are higher going forward. (See also the answers to Expected Return in a Bad Economy, Expected Return and Stimulus Efforts, Hedging Inflation with Bonds.)

EFF/KRF: Short-term high grade bonds are a good hedge against inflation. If hedging inflation is your overriding goal, short-term high grade bonds are the route for you. (Gene has been saying this for about 40 years.) But don't expect much in the way of a real return. Short-term bonds maintain purchasing power, but they don't enhance it, since the real returns they produce are quite low (for example, less than %1 per year on T-bills). In other words, if you don't take much real risk, you can't expect much real return.

EFF/KRF: The recent sharp decline in prices suggests that the market does not think the actions of the government (including the stimulus plan) are, in aggregate, good for the economy. If you think the market has it right, then expected stock returns are high, for the reasons outlined above. If you are more pessimistic than the market about the effects of government actions, then (at least on this score) you think prices are too high, which means expected returns are low. Conversely, if you are more optimistic than the market about the effects of government actions, then you think prices are too low, which means expected returns are quite high. Keep in mind, however, that the empirical evidence says you are on thin ice when you decide your forecast of the future is better than the market's.

EFF/KRF: The market has declined sharply in response to rough times and forecasts of future rough times. The decline in market prices combines two effects: (i) lower current and expected future profits, and (ii) higher discount rates for the expected future profits. The discount rate, in turn, has increased because uncertainty about future profits (in other words, risk) has increased and, apparently, because investors have become more risk averse. Higher discount rates for expected profits translate into higher expected stock returns.

EFF: This is a market efficiency question. If firms facing extreme financial difficulty are properly priced to take account of the risks they face, there is no reason to avoid them, unless you don't like the risks.

KRF: Whenever you think about a proposition like this, you should ask yourself, "What do you know that the market doesn't?" Does the market know the firms are facing extreme difficulty? If so, your best bet is that the price is right. This does not mean that the price is always right, or even that the market always incorporates all publicly available information. Sure the price of a distressed firm may be too high, but it is equally likely it is too low. To decide how the market has erred in a specific case, you have to know more than the market or you need a better model than the market. Although most investors seem to think they have the expertise to beat the market, an enormous amount of empirical evidence says this is a very high bar.

EFF/KRF: Active management is always a zero sum game, before fees, expenses, and trading costs, regardless of market conditions. If there are active winners, they win at the expense of active losers. And active management is always a negative sum game after costs. This is an algebraic condition, not a hypothesis. We call it equilibrium accounting.

Moreover, our research on individual mutual funds says that it's impossible to identify true winners on a reliable basis, even if one ignores the costs that active funds impose on investors. Funds that seem to be winners, based on past returns, were probably lucky rather than smart. After costs, that is in terms of returns to investors, there is no game to play; there is no evidence of managers with enough information to cover costs, other than on a purely chance basis. And there is no evidence that this depends on market conditions. If you are interested, see our paper Mutual Fund Performance.

In short, passive management and passive investing always make sense.

EFF: This is a market timing question, and there is no evidence that anyone can predict markets or the duration of market episodes. Unfortunately, the same is true for business cycles. The average length of contractions during the post WW II period is about a year. But since there are so few observations on contractions, this historical evidence is not much of a guide.

KRF: This question has several interpretations. Perhaps the simplest is, "How long will prices continue to fall?" Since we are never certain what stock prices will do next, we cannot be sure they have stopped falling, but there is no reason to expect the market to go down over the next year, month, or even day. In fact, the historical evidence suggests that, rather than being negative, expected stock returns are unusually high in recessions to compensate investors for the additional risk they bear during these turbulent periods.

The question can also be interpreted as, "Gosh, we've lost a lot of money in the market. When will we get it back?" There is bad news and slightly better news here. First the bad news. Much of the drop in prices is permanent and reflects the reduction in profits firms have suffered and will continue to suffer as a result of the recession. This reduction is real and will have a permanent impact on firm values and security prices.

The good news -- if you want to call it that -- is that part of the price drop is probably temporary. Just as bond prices must fall when interest rates go up, if some combination of greater uncertainty about economic conditions and an increase in aggregate risk aversion increases expected stock returns, stock prices must fall to accommodate the higher expected returns. And this part of the losses is temporary; we expect to recover the price drop through higher future returns. Of course, the increase in expected returns we are talking about is not free. Any increase in expected stock returns is likely attributable to an increase in market risk and possibly an increase in risk aversion.

EFF: The evidence that short-sellers actually know something about market prices is weak. And even if they do, they only push prices more quickly to lower equilibrium levels, so they have little effect on the returns of long-term investors.

EFF/KRF: Perhaps, but you would have to put a high probability on deflation. Severe downturns in business activity do not always result in deflation. For example, during the depression of the 1930s, some countries experienced deflation and some experienced hyperinflation. There is lots of talk currently about deflation, but the huge commitments the Fed has made recently seem to be pushing toward higher inflation.

EFF/KRF: When market volatility goes up, cross-country and cross-asset-class correlations tend to go up. When market volatility is normal, events that are specific to countries, asset classes, or individual firms are a larger part of total volatility and correlations are low. When market volatility increases relative to other sources of volatility, the common variation becomes a larger part of total volatility and correlations go up. This effect has been particularly apparent recently because volatility has been extraordinarily high.

EFF/KRF: There is no evidence that market timing in response to economic events enhances expected returns. The market tends to lead economic activity. Stock prices tend to fall in advance of recessions and rise in advance of economic upturns. To time markets successfully, you have to come up with better forecasts of economic activity than those already built into stock prices. We don't know anyone who can do this.

Moreover, investors who try to time the market by selling after news of a recession is already in prices are probably reducing their expected returns. Although realized returns are too volatile to make strong statements, there is some evidence that expected stock returns are relatively high during recessions and low during expansions. One can avoid the higher risk of stocks during recessions, but apparently only by passing up higher expected returns.

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: 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: 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.