9
Apr

The State of Small Business Lending: Innovation and Technology and the Implications for Regulation

The State of Small Business Lending: Innovation and Technology and the Implications for Regulation

by Karen Gordon Mills and Brayden McCarthy

Overview — New online fintech competitors have entered the small business lending space, filling a gap in small-dollar loans. More than 70 percent of small businesses seek loans in amounts under $250,000 and more than 60 percent want loans under $100,000. Gaps in regulation of the alternative small business lending market create issues of oversight and concerns about predatory lending. The paper first describes the current market for small business lending, including the new disruptors, and presents strategic alternatives for existing banks to partner with fintech entrants and compete in the new environment. The authors then describe the current regulatory environment with its large number of agencies, each with overlapping authority and mandates, and provide a set of recommendations for regulatory activity that will protect borrowers and investors in this space. These recommendations address concerns about systemic risk while trying to avoid dampening innovation that is filling the gap in small business access to credit.

Author Abstract

Small businesses were among the hardest hit in the Great Recession, accounting for more than 60% of the total jobs lost. The economic crisis was one focused on the banking sector, which is one reason for the disproportionately high impact on America’s small businesses, which tend to be heavily credit dependent. While some aspects of the economy have recovered in the years since, small businesses have struggled, primarily due to a lingering credit gap that is the result of banks being less likely to make the smaller dollar loans—those less than $250,000—that small firms (more than 70%) seek. A rapidly growing financial technology (fintech) sector has quickly stepped in to fill this gap, and incumbent banks are exploring a variety of partnership strategies with the new entrants. Yet, while the much needed increase in sources for financing has been welcomed by small businesses, these innovative fintech lenders have sparked concerns around transparency and the high costs charged to borrowers. These concerns are exacerbated by a “spaghetti soup” of regulators, where no one federal entity has oversight, and protections around small business borrowing slip through the cracks. This paper takes a detailed look at the current state of small business lending, the causes for the persistent low-dollar loan gap, the solutions being driven by innovative fintech lenders, and the key concerns around oversight and regulation. The objective is to provide regulatory recommendations that will protect small business borrowers and not dampen the innovation that has proven so promising for filling the gap in small business access to credit.

9
Apr

The Small Business Administration is a Model for How to Drive Economic Growth

The Small Business Administration is a Model for How to Drive Economic Growth

Responding to a recent editorial in the Washington Post, Karen Mills argues that the Small Business Administration is an effective public-private partnership model that fuels economic growth, access, and opportunity for all Americans.

by Karen Mills

A recent Washington Post editorial suggested that the United States Small Business Administration (SBA) is, in many ways, a remnant of days gone by. The arguments implied that small businesses that make up our nation’s “Main Street” sector are not particularly important to the US economy and that the government should not be in the business of helping some small businesses and not others.

The editorial writers reinforced their view of SBA by pointing to President Obama’s proposed reorganization of federal economic agencies in 2012. However, that reorganization was aimed not at reforming or eliminating SBA programs. Rather, it was an ambitious plan to make it easier for constituencies, like small businesses, to access the programs and services that are in place to help them.

“The SBA is perhaps the perfect prototype for a Trump administration agency: a public-private partnership driving valuable outcomes to a critical (but often neglected) part of the economy”

A look under the hood at SBA, however, reveals a small but important agency. In fact, the SBA is perhaps the perfect prototype for a Trump administration agency: a public-private partnership driving valuable outcomes to a critical (but often neglected) part of the economy, all at a low cost to taxpayers.

Gallup and other surveys show high support for small businesses. However, programs that support small businesses are not popular for superficial reasons. Instead it’s because small businesses touch the lives of every American in ways that are not only tangible, but also, in fact, consequential.

Half of the people who work in America either own or work for a small business. And small businesses have created 60 percent of all net new jobs since 1995. Four million Main Street businesses—including neighborhood restaurants, dry cleaners, and local grocery stores—form the backbone of communities across America and they are responsible for about 40 million jobs. And, as Mercedes Delgado and I show in research released earlier this year, small business suppliers—locally and across the country—contribute importantly to American innovation and growth.

Small businesses are actually the foundation for economic growth and, with that, critical to policy that purports to care about the average American. In fact, if we consider what Americans expect from their government, small business should have a voice in all of the key decisions facing the next president’s administration, from Dodd-Frank reform to the anticipated overhaul of the Affordable Care Act.

If you ask small business owners what they need to grow and thrive, they will talk about lower taxes, less burdensome regulation, and—what I spent four years working on as the head of the SBA and what I continue to write about today—access to capital.

SBA’s flagship loan programs are made through more than 3,000 banks, where the private sector picks “winners and losers” and the government provides a guarantee in areas where the bank wants to make a loan but needs some credit support. This allows women-owned small businesses, minority-owned small businesses, and others in underserved geographies to get credit even if the private sector market is not fully providing access.

As my co-author Brayden McCarthy and I detail in research released last month, the credit gap in small-dollar loans—those under $250,000, which is the size that 76 percent of small businesses say they need—is very real. While new private sector players like online lenders can help in this segment, they will certainly not replace the SBA. A well-functioning, low-cost agency—that expands access to credit to small businesses across America with an overall loss rate under 5 percent—should be viewed as a huge asset, as it most certainly was when I joined the agency in 2009 at the height of the credit crisis.

SBA’s loan guarantee programs were actually a mechanism that helped unlock capital to small businesses at a time when most banks had stopped lending to small businesses altogether. In fact, SBA’s guarantee brought many banks back to small business lending, helping resuscitate this critical sector of our economy right where it was needed, on our nation’s Main Streets.

The effectiveness of SBA programs also explains why during my time at the SBA, we hosted more than 150 delegations a year from countries around the world who wanted to use the agency’s programs for small business assistance in their own country. The Chinese visited nine times. And, David Cameron’s U.K. government borrowed from the SBA’s contracting efforts, setting an even higher small business contracting goal than ours here in the United States (25 percent versus our 23 percent) and achieving it in less than two years.

Yes, the government reorganization proposed by President Obama would have consolidated small business in one place (his proposal would have put parts of the small business activities from the Departments of Agriculture, Treasury, and Commerce under a newly aligned SBA department), but the principles of those programs would have remained the same – give small businesses the access to capital, counseling, and contracts they need to grow and create jobs works well and, in the current structure, gives taxpayers a pretty good bang for their buck.

Making government work better is a goal everyone can get behind. To get there we should consider SBA as an effective public-private partnership model that increases US economic growth and helps create access and opportunity for all Americans.

9
Apr

Precautionary Savings in Stocks and Bonds

Precautionary Savings in Stocks and Bonds

by Carolin Pflueger, Emil Siriwardane, and Adi Sunderam

Overview — What drives real interest rates? The question is important because of unusually low interest rates across the developed world. This paper provides new empirical evidence for one broad driver of real interest rates: investors’ time-varying demand for precautionary savings.

Author Abstract

We document a strong and robust relation between the one-year real rate and precautionary savings motives, as measured by the stock market. Our novel proxy for precautionary savings, based on the difference in valuations between low- and high-volatility stocks, explains 37% of variation in the real rate. In addition, the real rate forecasts returns on the low-minus-high volatility portfolio, though it appears unrelated with measures of the quantity of risk. Our results suggest that precautionary savings motives, and thus the real rate, are driven by time-varying attitudes towards risk. We rationalize these findings in a stylized model with segmented investor clienteles and habit formation.

9
Apr

Vanguard, Trian And The Problem With ‘Passive’ Index Funds

Vanguard, Trian And The Problem With ‘Passive’ Index Funds

Index funds are the major shareholders in many large- and medium-sized public companies, but their passive investment nature offers few checks on those companies’ executives, says Luis Viceira.

by Michael Blanding

On August 31, 2016, many investors celebrated the 40th birthday of one of the world’s most successful financial instruments: the mutual index fund, created by Vanguard founder John C. Bogle.

Index funds, which automatically track an index of stocks such as the S&P 500, lowered the cost of investing, especially for smaller investors, and ultimately created greater returns than most professionally managed mutual funds could deliver. That has made index, or passive, funds wildly popular: For the 12-month period ending May 2016, according to the Wall Street Journal, $409 billion was invested in index funds while $310 billion exited actively managed funds.

But have they become too popular? Researchers and analysts are increasingly concerned that managers in companies with a large number of passive fund investors can too easily operate outside the scrutiny of engaged shareholders.

“Do we need to get shareholders more engaged? What shape should the separation of management and ownership take in the twenty-first century?”

“We are now in a situation where index investors are the major shareholders in most of the large- and medium-sized public companies in the United States,” says Luis M. Viceira, the George E. Bates Professor and senior associate dean for International Development at Harvard Business School. “That raises the question, who is exercising control in these corporations?”

In traditional mutual funds, powerful fund managers representing thousands or tens of thousands of individual investors are able to wield great influence on management teams of companies in their investment portfolios. By contrast, index funds almost run on autopilot—with no active investor analyzing companies, rewarding those that make good financial decisions and punishing those with shaky corporate governance.

“When you think of the factors that have made capitalism such a successful model for economic growth, the separation between management and ownership, with the ability to disperse ownership and risk over many shareholders that comes with it, is one of them,” says Viceira.

Healthy corporate governance, such as the presence of engaged independent board members and other measures, is vital for this separation to work well. “But if management is not under shareholders’ control,” continues Viceira, “it may act in its own best interest, and not on behalf of the shareholders. When investors become too passive, we might see inefficiencies at the corporate decision-making level kicking in.”

The question for today, he says, is whether the pendulum has shifted too far toward passive investing in a way that hurts the long-term financial performance of firms.

“Do we need to get shareholders more engaged? What shape should the separation of management and ownership take in the twenty-first century? These are hugely important questions playing out live right now,” he says.

The case of Vanguard

Viceira explores these questions in two recent case studies, including The Vanguard Group, Inc. in 2015: Celebrating 40. Co-written with HBS finance professor Adi Sunderam along with Allison M. Ciechanover (HBS MBA 2002), director of the HBS California Research Center, the case looks at the current state of Vanguard, which has a 78 percent share of the asset class it created.

Vanguard’s index funds have obvious appeal to investors, especially smaller ones. Their passive approach makes these funds less expensive to maintain than active mutual funds, and their operating costs as a percent of assets under management tend to decline with size. That translates to lower fees for clients.

“But there is a hidden cost,” says Viceira. “Index funds by definition don’t look at what is happening in the corporations they own.” That is less important when index funds are a minority of a company’s ownership—investors can count on more active shareholders to scrutinize the firm’s financials and engage with corporate management. “But when [index funds] become the largest shareholders, they need to take a stand,” he says.

And for the first time, this appears to be happening. Large index funds such as BlackRock and Vanguard have become aware that staying out of corporate governance is not in the best interest of their investors.

For example, Vanguard has participated in proxy votes at shareholder meetings. While it has mostly voted in accordance with recommendations by management, in some key areas it has parted ways. It has supported shareholder resolutions concerning governance and compensation issues 75 percent and 92 percent of the time, respectively. Vanguard has also met with some 1,000 executives from companies it invests in.

In 2015, CEO Bill McNabb signaled his recognition of the increased role Vanguard has to play in a letter to some 500 publicly traded companies, spelling out corporate governance principles that it would advocate. (See illustration.) BlackRock CEO Larry Fink followed in 2016 with a letter to chief executives of large US and European companies urging them to focus on long-term value creation, and for boards to actively engage with management in long-term strategic planning.

Vanguard Corporate Governance Principles

Source: Letter by F. William McNabb II to the independent leaders of the boards of directors, February 27, 2015, Vanguard.com.

“The letters from the CEOs of two main index investing companies suggest that index managers are fully aware of their significant influence on capital markets, as well as their responsibilities to their investors and to capital markets—and to the US economy more generally,” says Viceira. “After all, they are true long-term investors, as they stay invested in a company as long as it is part of an index, regardless of its performance.”

This is not the only way shareholders are reengaging with management to take more corporate control. Private equity investing allows investors to take a problematic public company private, fix those problems, and then take it public again. Says Viceira: “Investors in those funds benefit from that process, as they tend to buy the company at a discount from the market and sell it back later to the market for a premium once the company has been turned around.”

But private equity is not a tool that benefits small investors, who usually don’t have access to those funds. An alternative in more recent times is what Viceira calls “private equity in public markets.” In these cases, investment funds adopt processes similar to private equity firms but without taking a public company private. Their strategy usually involves identifying a company going through governance or management issues, coming up with a plan to fix those issues, and then making a large investment in the equity of the company to gain a voice on its board to exercise control and oversight, as well as advocate for change. Since the company remains public, smaller investors retain an opportunity to participate in any value creation or bail out if need be.

Will index funds become more engaged?

This evolving power relationship between largely hands-off investors such as index funds and investors focused on shorter-term management change is discussed in Viceira’s two-part case Trian Partners and DuPont, co-written with Dhruva Kaul and Peter Lee.

Investment management group Trian’s strategy is to invest in undervalued companies and work with management to restructure and increase value for the long term. (Trian defines itself as “highly engaged shareholders” rather than “activist investors,” seeing typical activist funds more focused on short-term value creation than on the long term.)

In the case of the diversified conglomerate DuPont, Trian identified a host of problems including a structure that generated excessive costs, suboptimal financial management, and an unsatisfactory history of capital allocations, acquisitions, and divestitures. But Trian’s $1.8 billion stake in DuPont was worth only 2.7 percent, making it easy for the management team to reject reform proposals.

So Trian, recognizing the growing power of index funds, tried to persuade three index investors in DuPont—Vanguard, BlackRock, and State Street—to support its management reform package. All three funds refused to go along, although the assent of just one of them would have tipped the balance in favor of Trian’s plan.

As Viceira, Kaul, and Lee describe in the second part of the case, however, even though Trian lost the battle, it eventually won the war. The close vote shook up DuPont’s complacent managers and shareholders, and the company, with the help of investors, eventually brokered a deal to merge with rival Dow and split the combined company into three stand-alone businesses.

“The case documents a fascinating dynamic between index investors, who are true long-term investors, and this breed of investment funds focused on creating value by promoting change at the corporate level,” Viceira says.

As the case illustrates, the reluctance of passive investors to join the fight delayed the effective restructuring. “Right now the index funds are saying [that they] are not here to directly intervene in boards,” says Viceira. “Instead, they are promoting better corporate governance, voting for rules that make boards better run, but they are not trying to have a direct influence on the decisions management takes.”

As passive investors become larger and larger owners of companies, however, the future health of these businesses may depend on those investors taking a more active role in determining the management of the companies they own.

In the near future, Viceira hopes to sponsor a conference at Harvard that will bring together index fund managers, institutional investors, long-term shareholder activists, and company directors and heads to engage in charting the course for what it means to be an engaged shareholder in the twenty-first century.

“There are serious questions about the future of dispersed ownership and the separation between management and ownership,” says Viceira. “The way we answer these questions may literally determine the future of capitalism.”

9
Apr

Rainy Day Stocks

Rainy Day Stocks

by Niels Gormsen and Robin Greenwood

Overview — Niels Gormsen and Robin Greenwood identify characteristics of stocks that an investor who is worried about bad times should buy— a “rainy day” portfolio. They also propose a simple methodology that places greater weight on performance achieved during bad times than performance achieved during good times, essentially evaluating returns under a risk-neutral probability measure.

Author Abstract

We study the good- and bad-times performance of equity portfolios formed on characteristics. Many characteristics associated with good performance during bad times—value, profitability, small size, safety, and total volatility—also perform well during good times. Stocks with characteristics signifying high liquidity, such as high turnover and low bid-ask spreads, perform well during bad times but otherwise underperform. We develop a simple but flexible procedure to recover a “risk neutral alpha” that recognizes a 1% return experienced during bad times as being more valuable than a 1% return generated during good times. We also show how an investor can build a “rainy day” portfolio that minimizes underperformance during bad times

9
Apr

The Persistent Effect of Initial Success: Evidence from Venture Capital

The Persistent Effect of Initial Success: Evidence from Venture Capital

by Ramana Nanda, Sampsa Samila, and Olav Sorenson

Overview — To understand better what channels might account for persistence in the fund-level performance of private equity firms, the authors examine the individual investments underlying fund-level returns.

Author Abstract

We used data on individual investments in the portfolios of venture capital firms to study persistence in their performance. Each additional IPO among a VC’s first five investments predicted a 13% higher IPO rate for its subsequent 50 investments. Roughly half of this performance persistence stemmed from investment “styles”—investing in particular regions and industries. We found no evidence of performance persistence stemming from a differential ability to select or govern portfolio companies. Rather, our results suggest that early success in venture investing yields better deal flow in subsequent investments, thereby perpetuating differences in the outcomes of initial investments.

9
Apr

Diversity in Innovation

Diversity in Innovation

by Paul A. Gompers and Sophie Q. Wang

 Overview — This study discusses a systematic and persistent lack of female, Hispanic, and African American labor market participation in the innovation sector, through both entrepreneurs and the venture capitalists that fund them.

Author Abstract

In this paper we document the patterns of labor market participation by women and ethnic minorities in venture capital firms and as founders of venture capital–backed startups. We show that from 1990 to 2016 women have been less than 10% of the entrepreneurial and venture capital labor pool, Hispanics have been around 2%, and African Americans have been less than 1%. This is despite the fact that all three groups have much higher representation in education programs that lead to careers in these sectors as well as having higher representation in other highly compensated professions. Asians, on the other hand, have much higher representation in the venture capital and entrepreneurial sector than their overall percentages in the labor force. We explore potential supply side explanations including both education attainment as well as relevant prior job experience. We also explore the correlation between diversity and state-level variations. Finally, we discuss how these patterns are consistent with homophily based hiring and homophily induced information flows about career choices. We end the paper by discussing areas for future research.

9
Apr

Patent Trolls and Small-Business Employment

Patent Trolls and Small-Business Employment

by Ian Appel, Joan Farre-Mensa, and Elena Simintzi

Overview — Patent trolls are organizations that own patents but do not make or use the patented technology directly, instead using their patent portfolios to target firms with patent-infringement claims. This paper provides evidence that state anti-troll laws have had a net positive effect for small firms in high-tech industries. There is no significant effect for larger or non-high-tech firms.

Author Abstract

We analyze how frivolous patent-infringement claims made by “patent trolls” affect small firms’ ability to create jobs, raise capital, and survive. Our identification strategy exploits the staggered passage of anti-patent-troll laws at the state level. We find that the passage of this legislation leads to a 2% increase in employment at small firms in high-tech industries, which are a frequent target of patent trolls. By contrast, the laws have no significant impact on employment at larger or non-high-tech firms. Anti-troll legislation is also associated with fewer business bankruptcies. Financing appears to be a key channel driving our findings: in states with an already established VC presence, the passage of anti-troll laws leads to a 19% increase in the number of firms receiving VC funding. Our findings suggest that measures aimed at curbing the litigation threat posed by patent trolls may play an important role in reducing both the real and financing frictions faced by small businesses.

9
Apr

Is China About to Overtake the US for World Trade Leadership?

Is China About to Overtake the US for World Trade Leadership?

 SUMMING UP. It’s better for the United States if China is an economic ally rather than a competitor for world trade leadership, James Heskett’s readers conclude.
by James Heskett

SUMMING UP: Does It Matter If China Assumes Global Trade Leadership?

There are a variety of reasons why China is not a threat to the global trade leadership of the United States. They include demographic disadvantages, an unwillingness to make Chinese markets more available to imports, and a reluctance to open up the banking system and promote the yuan as a global reserve currency. These were the conclusions of nearly all respondents to this month’s column.

Nevertheless, there was an undertone to the comments suggesting that a more productive way of thinking about the matter would be to concentrate on fostering a stronger trade partnership between the US and China rather than thinking about it primarily as a competition.

Janik Kersten commented that “China today is not yet taking part in all the institutions that we (the Western economies) installed, but slowly and steadily they will improve their trade ‘interoperability…’” Nevertheless, “the US will stay a country with a young and ambitious population benefiting from the flow of immigrants while China is rapidly growing old due to its one-child policy.”

George added that unless China opens up its own markets, it cannot be a credible champion for world trade. “Xi Jinping’s words are more of a PR stunt,” he wrote. Wildebeest added, “[A]ttempting to do meaningful work in China is basically a hassle from day one, top to bottom. Large companies often are willing to pay the price, small companies much less so.” Judy observed that, “Seems like China needs to become a member of OECD for it to become the leader in world trade.”

Liel reminded us that, “Global trade leadership will have to go hand in hand with allowing the yuan/renminbi to be a major reserve currency. And for that to happen, there will be a need to expose the banking system to free market forces… We will have to see if Prime Minister Xi is prepared (to expose) China’s shadow banking and rumored zombie banks to such a discipline.”

China should not be an economic enemy, Greg reminded us. “It would be better for the US to view China as a global partner rather than a competitor for global trade and resources… Dealing with Asia, and especially China, requires a more nuanced point of view because understanding of language, culture and business practice can be easily misunderstood… Ultimately, this will lead to better economic performance for both the US and China.” But ProfPaul views this as a long-shot. As he put it, “China remains committed to its own economic and political advancement at the expense of its trade partners. It has never expressed a compelling world view that would rally global citizens to its side… .”

Others were not ready to lose much sleep over the question. For example, Shadrick Shaili commented “China’s motive is to make the best out of any economy they have an opportunity to trade or deal with so that the benefits manifest in its people at home … In so doing, China seems to be taking over world trade.” Sat Goel added: “China has surplus trade with the world and the US has a deficit trade balance… As such, the US lost the race several years ago.” In the same tone, Salvatore posed a question for us: “Leadership in global trade is as fluid as leadership in the Kentucky Derby… So, sure, China could overtake the U.S. The more interesting question is, does it matter?”

So that’s it for this month. Does it matter if China assumes global trade leadership? What do you think?

For once, I’ll disclose a personal bias up front. In the early 1960s, I signed on as a member of a group that sponsored an ad in The Columbus Dispatch titled, “Trade With Red China.” Rather than advocate a position, the ad laid out the pros and cons of establishing a trade relationship between the United States and a largely isolated but feared China. Nevertheless, it got my name on a blacklist of faculty members attached to a letter from an alumnus to the president of The Ohio State University at the time, demanding a reprimand or worse.

How times change. Of course, a few years later, president Richard Nixon embarked on his momentous trip that literally changed the course of US-China relations and history. Little by little, trade relations between the two expanded. China, for a time, became a primary manufacturer of goods for US markets–economists estimate that up to 2 million manufacturing jobs shifted from America to China.

At one time, the Chinese government was taking obvious steps to hold down the value of its currency, triggering a chain reaction that some believe contributed to the Great Recession of 2008. Here’s their thinking: Although the depressed value of the yuan increased the cost of raw materials imported by China, it produced a huge flow of manufactured goods from China to this country. A large current account trade deficit for the US followed, with the resulting funds invested by the Chinese government in US Treasury bonds instead of going into increased consumption by Chinese consumers. This depressed global interest rates and encouraged what turned out to be imprudent borrowing (and lending) practices in the world’s largest economy.

Since then, labor costs in China have risen to the point where a great deal of the original kind of manufacturing performed there has moved to lower-cost countries. Currency manipulation is thought to have subsided. The current account trade imbalance has shrunk. Chinese consumers are being encouraged to spend more of it. And the leadership of the Chinese government appears to be adopting a new stance concerning free trade, one that appears to be at odds with core beliefs of China’s ruling Communist Party.

When President Xi Jinping spoke to the World Economic Forum in Davos recently, according to a report in The New York Times, “He championed free trade and open markets, setting the tone for the week.” The facts on the ground seem to support that position. China is overtaking the United States as a trade partner of Latin American countries, for example. The Chinese government/industrial complex (it’s hard to sort it out) is buying companies and investing in projects around the world. In the meantime, a populist and nationalist wave has produced a power shift in America. Whether it will lead to the threatened tariffs, border taxes, and renegotiated trade agreements (with an emphasis on bilateral agreements) mentioned by the new administration is still subject to debate. But the tone of utterances by those now in position to influence US trade policy is in distinct contrast to the position of free trade advocates in past administrations.

The biggest factor influencing world trade leadership is the relative health of the economies of the US and China. As Thomas Christensen put it in his book, The China Challenge, “before we worry ourselves about Chinese economic growth, it might be best to consider the implications of Chinese stagnation!”

So are the roles of the US and China in world trade reversing? If President Xi believes, as he says, in free trade, will he be in a position to deliver? In the meantime, is current US talk about renegotiating long-standing trade agreements along with tariffs and tighter borders just talk? Is Chinese world trade leadership on the horizon? If so, what will it mean for the rest of us? What do YOU think?

References:

Thomas J. Christensen, The China Challenge: Shaping the Choices of a Rising Power (New York: W. W. Norton & Company, 2015)

Alexandra Stevenson, “Global Elites See an ‘Abyss’: The Populist Surge Upending the Status Quo,” The New York Times, January 20, 2017, p. B2.

9
Apr

Bubbles for Fama

Bubbles for Fama

by Robin Greenwood, Andrei Shleifer, and Yang You

 Overview — Nobel laureate Eugene F. Fama has famously claimed that there is no such thing as a bubble, which he defines as a large price run-up that predictably crashes. Analyzing industry data for the US and internationally, the authors find that Fama is mostly right that a sharp price increase of an industry portfolio does not, on average, predict unusually low returns going forward. Yet the authors show that there is much more to a bubble than merely increases in prices; they show a number of characteristics that predict an end to the bubble.

Author Abstract

We evaluate Eugene Fama’s claim that stock prices do not exhibit price bubbles. Based on U.S. industry returns 1926–2014 and international sector returns 1985–2014, we present four findings: (1) Fama is correct in that a sharp price increase of an industry portfolio does not, on average, predict unusually low returns going forward; (2) such sharp price increases predict a substantially heightened probability of a crash; (3) attributes of the price run-up, including volatility, turnover, issuance, and the price path of the run-up, can all help forecast an eventual crash and future returns; and (4) some of these characteristics can help investors earn superior returns by timing the bubble. Results hold similarly in U.S. and international samples.