The World this year

Syria’s use of chemical weapons in an attack that killed hundreds of people thrust the country’s civil war to the top of the agenda in Western capitals. But the resolve by some governments to punish the Assad regime with an American-led missile strike crumbled after the British Parliament surprisingly rejected such action. Russia brokered a deal, backed by the UN and America, under which Syria is destroying its chemical stockpile. The war rumbles on. The UN estimates that three-quarters of Syria’s population will need aid in 2014.

Civil strife enveloped Egypt whenMuhammad Morsi, its Islamist president, was ousted by the army after days of street protests against his government that were bigger than the anti-Mubarak demonstrations in 2011. A crackdown on the Muslim Brotherhood led to more bloodshed; most of its leaders were imprisoned.

Pakistan’s election marked the country’s first civilian transition of power at the end of a full five-year term. Nawaz Sharif returned as prime minister; he had last held the job in 1999. Bombings and mayhem continued unabated. At least 50 people were killed on the day that Mr Sharif held a press conference with David Cameron, Britain’s prime minister, that discussed security issues.

Although less frequent than in previous years, American drone strikes against militants in Pakistan were bitterly condemned by its government. Drone technology was also more widely talked about elsewhere for other purposes, such as distributing aid to rural areas and delivering packages. Iraq had its worst year for sectarian violence since 2008, with over 8,000 people killed.

The nutcracker

 A new governing coalition was formed in Italy, headed by Enrico Letta of the centre-left Democrats, after an election in which a quarter of Italians registered their discontent by opting for a new party led by a comedian. Mr Letta got on with the serious business of trying to reduce public debt. The fun ended for Silvio Berlusconi when he was booted out of the Senate, after having been definitively convicted of a crime for the first time.


 Cyprus became the fourth country in the euro zone to get a full bail-out, though only after an anxious week in which it had to resubmit a plan to restructure its banks. Ireland became the first country to exit its bail-out programme.

Pope Benedict shook the Catholic church by stepping down, the first pope to retire in 600 years. His successor, Pope F rancis, an Argentine Jesuit, shook the church further by saying it should worry less about sexuality and by moving to reform the Vatican.

Dell rebooted its business by agreeing to a $25 billion offer from its founder, Michael Dell, to take it private, but not before rebellious investors submitted a counterbid for the computer-maker. Dell’s was the largest buy-out since the start of the financial crisis in 2007.


China’s new leadership under Xi Jinping announced the boldest set of reforms for decades. These included more market pricing and a promise to abolish labour camps. China also further relaxed its one-child policy, in place since the 1970s, by allowing parents to have two children if one of the parents is an only child. In 2012 $2 billion-worth of fines were imposed on families that broke the one-child rule. China tried to stamp its authority on its region by imposing an air defence zone over a swathe of the East China Sea that covers islands contested by Japan. Japan and America ignored China’s demand that it should be notified about flight plans by sending aircraft into the zone without warning. In December China accused Japan of “malicious slander” for suggesting its zone was threatening stability.


Edward Snowden provoked a debate about government mass-surveillance programmes when he leaked classified documents about the activities of America’s National Security Agency. The extent of the snooping angered many, though Mr Snowden was accused of putting the security of America and its allies at risk. Some of those allies, including Angela Merkel of Germany and Dilma Rousseff of Brazil, were furious that their personal communications had been monitored.

Typhoon Haiyan unleashed some of the strongest winds ever recorded at up to 315kph (195mph), leaving at least 6,000 people dead in the Philippines.

Israel’s general election returned Binyamin Netanyahu to power. After two months of tortuous negotiations he formed a broad coalition government and appointed Tzipi Livni, who leads the Hatunah party, as chief negotiator with the Palestinians.


Joyful and triumphant

Among other big elections, Angela Merkel’s Christian Democrats won a third term in Germany and formed a grand coalition with the centre-left Social Democrats. She is the only leader in the euro zone to have been re-elected since the start of its debt crisis. Australia went through three prime ministers over the course of the year; the centre-right Liberals, led by Tony Abbott, won an election. Michelle Bachelet became Chile’s president again; her first term ended in 2010. Malaysia’s ruling Barisan Nasional coalition had its worst election showing since 1969; it still formed a government. And Uhuru Kenyatta was declared the victor in a presidential election in Kenya. His trial at the International Criminal Court on charges of orchestrating the ethnic violence that followed Kenya’s 2007 election begins in February.


In Bangladesh the collapse of a building that housed clothing factories killed 1,100 workers. They had been ordered to return to work despite warnings about cracks in the structure. It was South Asia’s worst industrial disaster in 30 years.

G3

The economies of the G3 – the US, Euro Area, and China – are collectively growing at 3.7% in

the current quarter relative to the same quarter last year, according to the Now Casting 

growth monitor. And G3 growth in Q1 2014 will be 4.15% higher than in the same quarter 

last year.

Over the past month the picture for the US has improved, and this improvement has been only

partially offset by a slight weakening in the data for the Euro Area and China.

 

E Trading

There was a time not so long ago when equities traded on electronic exchanges and everything else traded on OTC markets. We used to hear people argue vehemently that electronic trading would not work outside of the equities world. The belief was that the central order book could not handle large trade sizes. Algorithmic and high frequency trading changed all that. We learned that large trades could be sliced and diced into smaller orders that the central order book could handle easily. With exchanges offering lower and lower latency trading, a big order could be broken into pieces and fully executed faster than a block trade could be worked out upstairs in the old style.

Slowly the new paradigm is expanding into new asset classes. The 2013 triennial survey shows that electronic trading has virtually taken over spot foreign exchange trading and is dominant in other parts of the foreign exchange market as well (Dagfinn Rime and Andreas Schrimpf, “The anatomy of the global FX market through the lens of the 2013 Triennial Survey”, BIS Quarterly Review, December 2013). The foreign exchange market has ceased to be an inter bank market with hedge funds and other non bank financial entities becoming the biggest players in the market.

The next battle ground is corporate bonds. Post Dodd Frank, the traditional market makers are less willing to provide liquidity and people are looking for alternatives including the previously maligned electronic trading idea. McKinsey and Greenwich Associates have produced a report on Corporate Bond E-Trading which discusses the emerging trends but is pessimistic about equities style electronic trading. I am not so pessimistic because in my view if you can get hedge funds and HFTs to trade something, then it will do fine on a central order boo

Jordan Belfort You can see why Leonardo DiCaprio wanted to play Jordan Belfort

The courts at the tennis club in Manhattan Beach are full, and the pool is overflowing with bikinis. It’s a brilliant summer afternoon, and over at the juice bar, drenched in sweat after hitting for an hour or so, Jordan Belfort and I are parked on stools and talking about his Big Problem. It’s plagued him since he was a child. Even in prison, he couldn’t make it stop.

“I can’t sleep,” he tells me as the waitress arrives to take our order.

“Oh my God!” she says with a gasp. “You look just like Jordan Belfort!”

Belfort looks confused. He doesn’t know what to do. He’s never been recognized like this before.

“Actually,” the waitress goes on, “we just looked you up on the Internet. You are Jordan Belfort!”

Then the gushing starts. She tells him what big fans she and her friends are of his books, that she follows his motivational-speaking career on the web. Juice Bar Woman is a bona fide Jordan Belfort groupie.

“Can I get a picture?” she asks, and soon her smartphone camera is clicking.

The spotting is incredible for many reasons. The city of Los Angeles and its satellite communities like Manhattan Beach make up the celebrity mecca of the universe, and among all the hot stars and not-so-hot ones who can be spotted around here, the name does not quite register. Jordan Belfort? And Jordan Belfort is also a convict, one of a particularly loathed class—a white-collar crook who duped innocent investors to finance an insatiable greed. Belfort was convicted of scamming more than $100 million throughout the nineties to finance a hedonistic paradise. Stratton Oakmont, the firm he started, became a kind of cult. “It should have been Sodom and Gomorrah,” Belfort would later write. “After all, it wasn’t every firm that sported hookers in the basement, drug dealers in the parking lot, exotic animals in the boardroom, and midget-tossing competitions on Fridays.”

Belfort’s background in finance was limited. After dropping out of dental school, he sold frozen lobsters and steaks door-to-door; one of his first experiences in sales came from hawking ices as a kid. He proved to be a great talker and fearless mimic, modeling himself after his hero, Gordon Gekko, the ruthless corporate raider in Wall Street, a favorite film, and assumed what he called “a devilish alter ego.”

It was a truly epic scam, in which he used his powers of persuasion to screw investors and then train a small army to do the screwing for him. But eventually, Belfort sank his own empire. He spent some of his fortune on megamansions, only to have the government seize them. He purchased his own helicopter, only to almost crash it on his front lawn while flying it stoned. He owned a 166-foot yacht built for Coco Chanel, only to tell the captain to steer it into a storm and nearly kill himself, his friends, and his crew before the ship sank in the Mediterranean. Even with the hundreds of prostitutes he claimed to have hired, Belfort struggled to perform. He was taking so many drugs that his penis, as he writes, had taken the form of a “No. 2 pencil eraser.”

It was in prison that Belfort discovered his talents were transferable. His cube mate, or “cubie” (at his facility, there were no cells), was Tommy Chong of Cheech and Chong fame. Chong laughed so hard at Belfort’s stories he pushed Belfort to write them down and get them published. Employing the same zeal that made him a financial-industry tycoon, Belfort set out to become a writer. In prison, he studied Tom Wolfe’s Bonfire of the Vanities, taking notes on character development, dialogue, tone. He then applied the Wolfean techniques to his own tales, writing two memoirs that detail his quest for fortune and approval.

And, now as then, people cannot get enough of Jordan Belfort. He’s using the same skills, working the same stories, only this time, the gig is entirely legal. His ruthless rise and self-destructive fall was ripe for a big Hollywood production. Leonardo DiCaprio signed on to play Belfort, with Martin Scorsese directing. After many snags in production, The Wolf of Wall Street will finally be released next month and in time for Oscar season.

Back at the tennis-club juice bar, Belfort still can’t believe it: Leonardo DiCaprio playing him? During production, Belfort even coached DiCaprio personally on the stages of a ’lude high (“tingle,” “slur,” “drool,” “amnesia,” and on), with Belfort rolling around in DiCaprio’s living room. He laughs about it now, but before he went to prison, Belfort had become a kind of neurotic, Long Island version of Scarface. “I was in the midst of a cocaine-induced paranoia that was so deep I’d actually taken a few potshots at the milkman with a twelve-gauge shotgun,” he writes in his first book. After that, he nearly killed himself. “It looked beautiful, a purple pyramid,” he writes of morphine pills piled up in his hand. “I threw them back and started chewing.” The drugs. The greed. That always empty feeling. The Big Problem.

“From the time he was born, he never really slept,” Leah Belfort, Jordan’s mother, tells me in the kitchen of their two-bedroom apartment in Bayside.

“He can’t sit still,” Max Belfort, his father, says.

“We’d come into the room, and he’d be watching his fingers,” Leah says about Jordan’s infant years. “I’d say to Max, ‘He’s not sleeping. He must be dumb. What kind of dummy are we raising?’ ”

In the kitchen, the appliances look plucked from a fifties time capsule, and framed recipes for gefilte fish and matzo-ball soup hang above us on the wall. The product of Bronx tenements and night-school master’s programs, Belfort’s parents represent the immigrant dream of hard work and ambition. Max and Leah are both accountants, but Leah decided to choose another profession after retirement. She went to law school in her sixties, graduated from St. John’s University, and still does pro bono legal work. With a home that appears so steady, part of the Belfort mystery is how a nice Jewish boy like him could destroy himself with such gusto.

Consider the following list of ingredients he packed inside “a brown leather Louis Vuitton shower bag” on a trip to Czechoslovakia, according to his memoir: “a half-ounce of sinsemilla, 60 pharmaceutical Quaaludes, some bootleg uppers, some bootleg downers, a sandwich bag full of cocaine, a dozen hits of ecstasy, and then the safe stuff: a vial of Xanax, a vial of morphine, some Valiums and Restorils and Somas and Vicodins, and some Ambiens and Ativans and Klonopins, as well as a half-consumed pack of Heineken and a mostly consumed bottle of ­Macallan’s to wash things down.”

In his memoirs, Belfort describes his parents as pushy and overbearing. He calls his dad “Mad Max” and fears his chain-smoking, vodka-drinking fury; Leah appears as a Jewish mother on steroids, demanding he start studying for medical school from the cradle. Both Max and Leah have read most of their son’s memoirs. Max and Leah are at least proud that he didn’t let the misery go to waste: Teaching himself to write and turning his gonzo tales into page-turning books, they believe, are great accomplishments.

“It’s an enigma, really,” Max says about his son.

“I wanted to deny he was my child,” Leah says.

“That time we found him growing pot in the closet,” Max says. “Very, very entrepreneurial. He said it was a school project, right?”

“He said, ‘I’m going to get an A.’ He was trying to buy me off with the grade,” Leah says. “I said to him, ‘I’ve been manipulated by better than you!’ Then Max came home, and you gave it to him.”

“A lot of lectures,” Max says, shaking his head again.

Leah says, “He always wanted to be part of the older kids, and all the big boys were taller. Much taller than he. And all the girls were much taller. He tried to build himself up with a bodybuilder, but that didn’t make him taller!”

“Yeah, all those girls were taller than him.”

“Maybe that’s one of the reasons he tried to compensate,” Leah says.

“Like Mayor Bloomberg, right?” Max says.

“Or Napoleon!” Leah says.

“My chief insecurity is that I was a late bloomer,” Belfort tells me. “I didn’t go through puberty until later in the curve. I didn’t feel confident in high school. Ninety percent of my focus was hot girls. I thought if you got rich, you’d get the girls. A lot of guys think that. And it’s true—it worked for me. It worked really well. When I really hit it, I had all these gorgeous women throw themselves at me. But the problem with that stuff is, it doesn’t really change you.”

Belfort has the salesman’s look: a flash of white teeth, tan skin, all of which radiate a youthfulness that’s impressive considering his age (he turned 51 this summer) and former drug habit. “A testament to the regenerative qualities of the human liver,” he likes to say of himself, with a heavy Long Island brogue.

It’s another tennis morning for us, and this time we play at the private court of Jeff Tarango, his personal tennis guru. Tarango is not any tennis instructor. The former pro and commentator has been rated one of the top over-40 players in the world.

“Obsessive-compulsive talent,” Tarango says of Belfort. “He’s not autistic, but he could be. He just can go into that tunnel.” Belfort is so committed to improving his tennis strokes that he and Tarango play together every morning. Belfort wanted to play on weekends, too. His sessions are tutorials. Behind the baseline, Belfort props up his smartphone to videotape himself in action; later, at night, he’ll study his technique in bed with his fiancée, Anne Koppe. His intensity can be overwhelming, but it’s all part of his recipe for success, a life philosophy he’s now hit the road with in his new incarnation as motivational speaker for hire. “I believe in total immersion,” one of his creeds goes. “If you want to be rich, you have to program your mind to be rich. You have to unlearn all the thoughts that were making you poor and replace them with new thoughts—rich thoughts.”

After hitting balls, I trail him back to his home. He drives a Mercedes SL convertible and lives in an oceanfront mini-mansion on Manhattan Beach. I follow him through the garage and up the spiral steps into an expansive living room where the doors and windows are open to the view of the Pacific and the warm breeze comes and goes just so.

“Making money is so easy,” Belfort tells me. “It really is. It’s not hard to do.”

Belfort’s actual net worth is something of a mystery. He earned more than $2 million for the books and film rights (“I thought they were fucking crazy,” he says about actually getting published), five figures for speeches he gives, along with income from investments he’s made in Australia.

“I did really well with the mining industry,” he says. “I made some hits. Iron. Ore. Stuff like that.”

But he can’t keep it all. According to a judge’s order, half of everything Belfort earns must go to the $110 million he is obligated to pay back to the more than 1,500 investors he fleeced. It’s a hefty order to fill, and according to the government Belfort has been negligent in his payments. Belfort denies he’s hiding money from the government—a skill he once perfected on Wall Street—and currently the parties are working toward a resolution. Belfort says he’s not making a nickel off his story and has signed over all proceeds and profits to the government.

“I wanted to be above reproach with the whole thing,” he tells me. “I didn’t want people to think, Oh, he’s making money on the movie, on his crime. Like, ‘I don’t want the fucking money! Keep the fricking money!’ ”

“They never even call me,” he says, sounding insulted.

Waiting for Belfort in his living room are two assistants, both of whom seem to possess his requirements for employment.

“Let’s just say Jordan has a type,” one says.

Belfort’s lair here is like a high temple of the Shiksa Goddess. He laughs off his propensity for long blonde hair, blue eyes, and buoyant bosoms.

“I’m not going to lie,” he says as we make our way onto the deck. The water is sparkling on the crashing surf in front of us, and errant sounds of a volleyball game pass in the breeze. One assistant brings out a pair of cold beers, sandwiches, and chips.

Belfort spreads out on a lounger, his sunglasses shielding his eyes.

“I always felt if I had more, then I’d feel good,” he says. “I think the more I had, the worse I felt. We all have these holes, right? The problem is, there’s some ways we plug those holes that are sustainable. Going out and fucking twenty whores every night—it was fun when I did it, but that’s not really sustainable.”

Toward the end of his first book, Belfort describes his need for validation: how he and a friend are swimming in a pool, but the friend never comes up for air. Belfort pulls the friend out of the pool and proceeds to perform mouth-to-mouth resuscitation. Finally, the friend shows signs of life—by vomiting the hamburgers they were eating into Belfort’s mouth. When the medics arrive, one tells Belfort, “You’re a hero.”

“What a delicious ring those three words had,” Belfort writes. “I desperately needed to hear them again, so I said, ‘I’m sorry, I missed what you said. Could you please repeat that?’” Belfort then approaches his second wife (“with her loamy loins and brand-new breasts”) and “tried to find just the right words that would inspire her to call me a hero.”

No dice.

“Unfucking believable!” he writes. “She didn’t call me a hero!”

Belfort’s business model itself seemed based around ego-boosting. Instead of hiring seasoned stockbrokers or anyone with experience, he recruited naïve twentysomethings who would adhere to his ruthless sales creed: Buy or die. To motivate these young and wealth-hungry aspirants, Belfort would arrive to work in the same white Ferrari Testarossa that Don Johnson used to drive in Miami Vice and deliver not one but two boardroom speeches to them each day.

“From a moral perspective, he was a reprehensible human being,” says Greg Coleman, the FBI special agent who made the case against Belfort. A specialist in financial frauds and money laundering, Coleman has been an agent with the Bureau for more than twenty years. “Admiration would be the wrong word, but from the perspective of manipulating the market, he’s one of the best there is,” Coleman says of Belfort. Coleman also specializes in the behavioral sciences, giving talks inside the FBI on the psychology and interior motives of criminals.

“In a single word, it’s attention, a craving for attention,” Coleman says. “I think it’s the issues that cause the insomnia, not the insomnia that causes the issues.”

Coleman spent six years investigating Belfort. From the outset, what bothered Coleman most, he says, is that Belfort put so many of his friends and family members at criminal risk. When he started laundering money in Switzerland, for instance, Belfort cajoled his wife’s aunt, a retired schoolteacher in London, to be the front for bank accounts into which he illegally funneled millions to hide from other regulators chasing him. “There’s a difference between influence and manipulation,” Coleman says. “He’s a great motivational speaker, and he manipulated everyone around him with a Svengali-like trance.” After his arrest in the fall of 1998, Belfort, then 36, faced a sentence of more than two decades in prison. He did not protest the charges and take his case to trial. He did not keep his mouth shut and spare others.

“He cried like a baby,” Coleman says.

Wearing a wire, Belfort worked with Coleman and other federal officials to make cases against his partners and associates. By cutting a deal, Belfort hoped to persuade a judge to cut the lengthy sentence awaiting him and spare himself heavy prison time. Working with the government, Belfort also proved he’d mastered the art of being liked. Dan Alonso, a former federal prosecutor who handled Belfort’s case, was so impressed with Belfort’s speaking ability that he invited him to the Manhattan district attorney’s office, where Alonso is now a top official, to have Belfort give a speech to prosecutors. (“He’s a salesman,” Alonso tells me of Belfort’s performance, “and he sold himself well.”) Alonso and others lauded Belfort’s efforts during the investigation, and he only served two years and four months in prison. “A slap in the face,” Coleman says of Belfort’s punishment. Coleman was so upset with Belfort’s sentence he considered moving out of the unit that handles white-collar crime. “At the very least, he should have done a year for every year I investigated him,” Coleman says. That Belfort is now a celebrity, immortalized by his books and a performance from Leonardo DiCaprio, galls him.

“Crime pays,” Coleman says.

But Coleman can’t get enough of Belfort either. Agent and cooperating witness stay in touch, going out to dinner every so often when their schedules allow. “He tells a good story,” Coleman says of Belfort.

“He’d come back from playing tennis, and I’d crack up, man, because we’re in fucking jail,” Tommy Chong says.

“I was shocked,” Belfort says. “Everyone’s playing tennis and basketball. The Latins have their music blasting. I was like, Wow, this isn’t so bad.”

We’re at Chaya, the Asian-fusion restaurant in Venice, for a prison reunion. The dining room is roaring, and under the chandeliers and stagelike lighting, waiters pass plates of shishito peppers and soy-glazed black cod. Chong, then jammed up for selling bongs over the web, and Belfort, serving out his white-collar sentence, got close in prison. They shared their meals and stories, like the prison chef who cooked, in a microwave, delicacies that included fresh squirrels he’d trapped. “The Quaalude stories are my favorite,” Chong says.

Belfort recalls a night where he spent $1,000 on a rare ­Quaalude pill and vowed to savor the high. “I stick my finger down my throat. I wanted to get all the frickin’ food out of my stomach. Then I take a fuckin’ enema, shove it up my ass. I want to be completely clean, from top to fucking bottom.”

Across the table, Chong’s wife, Shelby, is cackling with laughter.

“He has to do everything the best,” she says. “Perfect. Number one.”

And the story goes on, just as Belfort tells it in the book: about learning that the Feds are following him while completely stoned, then driving out to use a pay phone at the local country club, only to fall backward and crash on the floor in his ’lude binge.

“I’m lying on my back and see the ceiling has cracks in it,” Belfort says. “I’m like, Why are the Wasps not paying for their ceiling? What a troubling thought that they don’t fix the ceiling in this Wasp heaven—maybe they’re running out of money. I try to stand. I can’t stand! I curl myself into a little barrel and fucking roll myself down the steps. I do the prayer to Jesus. Even an old Jew. Jesus, please God, just get me home one last time.”

“I love this!” Shelby says. The more Belfort reveals, the more laughs he gets. Especially in the story’s dénouement: totaling seven cars at one mile an hour

Banging into a car! Banging into a car!” Shelby howls. “Oh my God! Oh my God!”

“Was he the gold mine?” Tommy Chong asks. “Was he the gold-mine writer?”

“You do such a good setup,” Shelby says.

“You learned that from the early selling,” Chong says. “How to sell.”

Finally the conversation lands on his lack of sleep. Belfort tells us he’s seeing a psychologist now, trying to come up with a cure for his insomnia.

“Why can’t you sleep?” Shelby asks him.

“I hated going to sleep as a kid,” Belfort says. “I almost trained myself to fight sleep, and it eventually became a pattern.”

Shelby is confused.

“You make your real life so scary,” she says. “How could sleep be scary?”

The night is warm and clear. After dinner, I drive with Belfort back toward Manhattan Beach in the Mercedes. Top down, we pass the tattoo and taco shops on Lincoln Boulevard in silence. Finally, he breaks it.

“Did you like the stories?” he asks.

The stories were great, I tell him. He’d told them so well. It was the truth. Once he got rolling, all the laughing was infectious. He truly was a talent.

Belfort smiles to himself. For a minute, the compliment has perked him up, but the feeling soon fades. As the stoplights on Lincoln Boulevard pass by, I look back at him. He looks pale and deflated.

“Honestly, it’s just so exhausting,” he says.

Final ARTICLE ON PRIZZE

At the University of Chicago, there are two professors of economics named Eugene Fama.
The first — let’s call him Fama the Younger — started in the 1960s. He developed a profound insight about the markets. This Fama observed that over the short term, equity markets behave randomly. The day-to-day, week-to-week trading action has no rhyme or reason. Indeed, the random walk of markets makes them effectively impossible to predict in that time frame.

Why was this? Fama reasoned that the pricing mechanism of markets — what you or I would call trading — efficiently reflected all known information about stocks. Buying and selling created an “informational efficiency.” If there were any significant details known about a company, someone would discover it eventually and act on that information. Hence, all known data that exist about a company are reflected in its stock price. The Efficient Market Hypothesis, as Fama called it, meant that stock-picking was a futile exercise. He described the details in a 1965 paper titled “Random Walks in Stock Market Prices.”
The relevance to finance was soon obvious: Most investors are better off owning the entire market, rather than guessing which stocks might do better or worse. We can quibble with some of Fama’s reasoning. It turns out that prices are not all that rational and frequently deviate from known data — but Fama got the big concept right: Markets behave unpredictably in the short term.
For this, Fama is thought of as the intellectual father of indexing. The entire concept of passive investing in indexes grew around his insights. His work became hugely influential, and remains so to this day. If you own a Standard & Poor’s 500-stock index, you do so because of Fama the Younger’s observations.
Had he stopped there, Fama the Younger probably would have flown to Sweden to pick up his Nobel Prize money decades ago.
But the years went by, and Fama kept coming back to his hypothesis. He pushed it to all manner of odd places. So the Nobel committee was confronted with the problem of Fama the Elder — the second Eugene Fama. That professor built on his own work. The influence of his insight imbued the Elder with prestige far beyond what his latter flawed work should have generated. It allowed him to expand his efficient-market thesis. That, dear readers, is where our boy ran into trouble.
Fama the Elder took the idea of efficient markets to an illogical extreme. He made a leap of faith based largely on the earlier flawed analysis that led him to the correct conclusion that markets behave randomly. Because markets reflect all known information in their prices, Fama rationalized, most of the rules and regulations related to securities were unnecessary. Even worse, he reasoned, they were counterproductive because they interfered with the price discovery process.
Insider trading rules? We don’t need them! Why would we, when even nonpublic information known to insiders is reflected magically in stock prices! Indeed, we can eliminate nearly all of the rules that have been developed since the Great Depression to regulate investing and trading. After all, Fama argued, with all information reflected in the price, these rules are superfluous.

Over the next three decades, Fama the Elder exerted enormous influence. The professor shaped financial theory. He influenced generations of economics and business students nationwide. And his hypothesis swayed senators, Federal Reserve chairmen, even presidents.
This created a bit of problem for the Nobel committee working on the Sveriges Riksbank Prize in Economic Sciences. If the first Fama can rightfully be called the father of passive investments, then the second Fama is in many ways the intellectual father of the financial crisis. His thinking laid the groundwork for deregulations that had a terrible impact.

Consider the grand experiment just before the financial crisis: The Commodity Futures Modernization Act of 2000 turned derivatives into a unique category of financial instruments. They did not mandate any disclosure, they were not obligated to be traded on any exchange, and underwriters were not required to hold reserves against potential losses. The theory was that the risks would be reflected, somehow, in the price.

The repeal of Glass-Steagall was another deregulation that could be traced to Fama. Glass-Steagall acted as a firebreak between Wall Street and Main Street. When that firebreak went away, it did not cause the crisis, but it allowed its spread.
Even then-Federal Reserve Chairman Alan Greenspan fell prey to the errors of Fama’s hypothesis. Fed Gov. Ed Gramlich had brought the subprime mortgage lenders and securitizers to the Fed chief’s attention as predatory lenders with the power to destabilize the mortgage markets. Greenspan called them “financial innovators” who should not be burdened with regulation. As detailed by the Mortgage Lender Implode-o-meter, 388 of these firms went down in flames, ravaging the credit markets. Despite all of this, Fama the Elder went so far as to say, “I don’t know what a credit bubble means.”
You can see the quandary this created for the Nobel committee. On the one hand, Fama is the father of modern indexing; his influence — from the development of exchange-traded funds to retirement planning — cannot be overstated.
Fama the Younger’s work was insightful and created an immense benefit for investors. But Fama the Elder’s work was almost as bad as the earlier work was good. The premise was deeply flawed. People were not rational, profit-maximizing machines — they were emotional, error-prone actors who often operated against their own best interests. Information efficiency was a nice concept, but it simply did not work in the real world.
The Nobel committee resolved this problem quite elegantly.
Unbeknownst to Fama the Elder, he had an adversary 1,000 miles away. On the ivy-covered campus of Yale, a young man decided that the efficient-market hypothesis made no sense. Professor Robert Shiller’s data overwhelmingly showed that markets were at times as irrational as the humans who traded them. His 1989 book on market volatility found that price fluctuations in speculative markets were not rational and did not reflect all known information. Price action moved so much more than future dividends changed that something else had to be at work. That factor was human behavior.
Bubbles formed, prices detached from reality, then just as soon came back to Earth. This was hardly informational efficiency. After the 1987 crash, Shiller remarked, “The efficient-markets hypothesis is the most remarkable error in the history of economic theory.” Indeed, much of Shiller’s work over the next 20-plus years was railing against the hypothesis’s obvious failings. Warning of the tech bubble late in 1999 and then of the housing bubble in 2006 served to cement Shiller’s reputation, as well as his views that markets were irrational. Sometimes prices had nothing whatsoever to do with the available information — except the insight that people occasionally went crazy.
So the Nobel committee could recognize Fama the Younger, awarding him the prize for his work on unpredictability. But it could distance itself from the silliness of Fama the Elder, by having the Younger share the award with Shiller.
And that is how the most astute critic of the efficient-market hypothesis helped its creator win a Nobel Prize in economics.

From Business Insider i agree to it

Yale University professor Robert Shiller was one of three people to win the 2013 Sveriges Riksbank Prize in Economic Sciences (also known as the Nobel Prize in Economics). Shiller is already a god among economists. He famously predicted two of the biggest bubbles of all time: the dot-com bubble and the housing bubble. Both times, he published an edition of his book Irrational Exuberance, which described and predicted each respective bubble.
The theme of this year's award "Trendspotting in asset markets," and the Nobel committee pointed to Shiller's work in forecasting intermediate-term moves in asset prices.
"He found that stock prices fluctuate much more than corporate dividends, and that the ratio of prices to dividends tends to fall when it is high, and to increase when it is low," said the Nobel Committee. "This pattern holds not only for stocks, but also for bonds and other assets."
Shiller regularly updates his data and makes it available for free online.
He is responsible for two charts, that everyone in finance follow very closely.
The first chart is of the cyclically-adjusted price-earnings (CAPE) ratio. CAPE is calculated by taking the S&P 500 and dividing it by the average of ten years worth of earnings. If the ratio is above the long-term average of around 16, the stock market is considered expensive. Shiller has argued that the CAPE is remarkably good at predicting returns over the period of several years.
As you can see, the CAPE ratio reached insanely high levels during the dotcom bubble.

Yale

The second chart is of a long-term look at home prices adjusted for inflation.
During the early 2000s, home prices took off, forcing Shiller to publish the second edition of Irrational Exuberance.
As you can see, homes are not great assets if you're looking for real returns.
"Housing traditionally is not viewed as a great investment," he told Bloomberg's Trish Regan earlier this year. "It takes maintenance, it depreciates, it goes out of style. All of those are problems. And there's technical progress in housing. So, new ones are better.
"So, why was it considered an investment? That was a fad. That was an idea that took hold in the early 2000's. And I don't expect it to come back. Not with the same force. So people might just decide, "Yeah, I'll diversify my portfolio. I'll live in a rental." That is a very sensible thing for many people to do."

Yale

No one will argue that Shiller wasn't deserving of the Nobel prize. If anything, it was long overdue.

Nobel fever

According to Google Scholar, Fama and Jensen (1983) is Fama’s third most cited paper, yet it isn’t mentioned at all in the scientific summary put out by the Economic Sciences Prize Committee of the Royal Swedish Academy of Sciences, which, if I remember correctly, sometimes does mention work that is not directly related to what the prize is being awarded for. In this case it is particularly tragic because Fama’s corporate governance papers are very good, and considered by some* to be much better than his asset pricing work. (A phrase which rhymes with “feta pining” is sometimes whispered in connection with the latter.)

I am talking about a pair of papers published back to back in the same issue of the Journal of Law and Economics in 1983; this is the other one. They are joint work with Michael Jensen, who is well known for his later corporate governance work and who is also the Jensen of “Jensen’s alpha” (these guys were generalists, of sorts). Go read them right now. They are very good, there is no math, I have linked to ungated versions, and their explanation is probably clearer than mine.

Both problems are about the separation of ownership and control, a feature seen in most organizations, both for-profit and non-profit. The academic study of organizations dates back to at least 1889, or even 1776, but who still reads Adam Smith?

If the owner of an enterprise exercises full control over its operations, as is the case in a sole proprietorship with few or no employees, there is no agency problem: the manager–owner can be trusted to make whatever decisions will maximize his profit (or whatever he is maximizing, when it is not a for-profit firm), and will even make appropriate tradeoffs between the short term and the long term.

In the real world, that’s not practical. Despite what Adam Smith might have preferred, modern firms (both for-profit and non-profit)—or even the commercial partnerships in the Middle Ages that Weber studied—are too large to be owned by one person or even a family and too complicated to be managed by a large group of stakeholders. If contracts could be perfectly specified and made contingent on every eventuality, there wouldn’t be a problem: the management contract would specify what the manager has to do no matter what happens, and the contract would be written to maximize profits. Of course this is even more unrealistic than thousands or millions of shareholders collectively making all the decisions of a firm.

Fama and Jensen’s analysis starts with the role of residual claims. Some claimants on a firm are promised fixed amounts that they will receive when the cash flows are paid out. For example, a bank or a group of bondholders that makes a loan to a business will only receive the amount that was actually borrowed, plus interest. The firm might go bankrupt, but hopefully in all probability the bank will simply be paid what it was promised. This means that by and large, they won’t care too much about the firm’s management decisions. Only the residual claimants, who in a typical corporation are the shareholders, need to fret about the firm’s management from day to day. In turn, they will bear most of the risk associated with the firm’s operations, and also receive the rewards if the firm is better managed than expected.

At a granular level, the agency problem is about making decisions. Fama and Jensen split up the decision process into decision management, which involves initiating decisions (coming up with the idea) and implementing decisions (actually doing the work), and decision control, which involves ratifying or approving decisions and monitoring that they are carried out faithfully. We now end up with three roles: residual claimant, decision management and decision control.

Some undertakings are “noncomplex”: the necessary information can be concentrated in a few people. Examples include small firms, as well as large firms with relatively simple decisions such as mutual funds and other mutual financial firms. In noncomplex organizations it can be optimal to combine decision management and decision control to economize on decision costs, but then you would have the foxes watching the henhouse. Who looks after the interests of residual claimants? The answer is that when decision management and decision control are combined, you would often restrict residual claims to a small group of people who either are managers or trust them, for example family members and close business associates. Partnerships and small corporations with stock transfer restrictions examples of what Fama and Jensen call “closed corporations”. The tradeoff is that you reduce the possibility of risk sharing and some efficiency is lost that way.

In more complex organizations, decision management would be separated from decision control. The information necessary to make decisions may be diffused among a lot of people, who would each be responsible for initiating and implementing decisions in their little area, but a few people—the managers, who would also be the residual claimants or close family members or business associates—could handle decision control, ratifying and monitoring the decision managers.

In large corporations with a lot of assets, you need more residual claimants to share risk, which in turn makes it impractical for all the residual claimants to participate in monitoring, and the agency problems associated with combining decision management and decision control are worsened. For such organizations, Fama and Jensen hypothesize, decision management and decision control will tend to be separated. In the largest corporations, this separation is complete, and residual claimants have almost zero participation in decision control.

Fama and Jensen also survey a variety of organizational forms that have different tradeoffs between the three roles and ways in which separation is achieved, for example with expert boards and through the market for takeovers. In financial mutuals, a large body of customers are also owners, and decision control is delegated to a professional board of directors, but an additional control function exists in the ability of each residual claimant to quickly and easily terminate his or her claims by redeeming the claim.

In nonprofit organizations, there are no residual claimants as such, which Fama and Jensen justify as a means of reducing the conflict between donors and residual claimants. Who would want to give a donation what will ultimately end up in the pockets of residual claimants? The solution: eliminate the latter. In US nonprofits, decision control is typically exercised by a board of directors that consists of large donors.

In the Roman Catholic Church, control is not exercised by donors (parishioners), but by the church hierarchy itself, and ultimately the Pope, with almost no separation between decision management and decision control. The solution is vows of chastity and obedience that bind the hierarchy to the organization, in exchange for lifetime employment. Fama and Jensen go on to claim that Protestantism is a response to the breakdown of this contract, and that “the evolution of Protestantism is therefore an example of competition of among alternative contract structures to resolve an activity’s major agency problem—in this case monitoring important agents to limit expropriation of donations.”

NOBEL economics

I cant resist writing for this year economics prizes Bob, Gene , Hans. I have read Shiller most and one of the reason to learn finance  , Fama is found in text books too often and Hansen is a pioneer in technical economics ( econometrics). Well , I would be talking mostly of Bob Shiller then Gene but Hansen work is too technical for me to talk about as his model for volatility is praised by pioneers in Econometrics but the truth is that  i am too young to seriously talk about their innovative  work .
Bob did (with Grossman and Melino) some of the best and earliest work on the consumption model, and his work on real estate and innovative markets is justly famous.  But, space is limited so again I'll just focus on volatility and predictability of returns which is at the core of the Nobel. 

Source: American Economic Review

The graph on the left comes from Bob's June 1981  American Economic Review paper. Here Bob contrasts the actual stock price p with the "ex-post rational" price p*, which is the discounted sum of actual dividends. If price is the expected discounted value of dividends, then price should vary less than the actual discounted value of ex-post dividends.  Yet the actual price varies tremendously more than this ex-post discounted value.

This was a bombshell. We Indian students were small in numbers to read it but those who knew Shiller enjoyed reading him  It said to those of us watching at the time that we pupils in this side of the world were missing the boat. Sure, you can't forecast stock returns. But look at the wild fluctuations in prices! That can't possibly be efficient. It looks like a whole new category of test, an elephant in the room that the Fama crew somehow overlooked running little regressions.  It looks like prices are incorporating information -- and then a whole lot more!  Shiller interpreted it as psychological and social dynamics, waves of optimisim and pessimism.
Read the citations in the Nobel Committe's  "Understanding Asset Prices." John Campbell's list is three times as long and distinguished.  

So, in the end, what do we know? A modern volatility test starts with the Campbell-Shiller linearized present value relation

Here p=log price, d=log dividend, r=log return and rho is a constant about 0.96. This is just a clever linearization of the rate of return -- you can rearrange it to read that the long run return equals final price less initial price plus intermediate dividends. Conceptually, it is no different than reorganizing the definition of return to

You can also read the first equation as a present value formula. The first term says prices are higher if dividends are higher. The second term says prices are higher if returns are lower -- the discount rate effect. The third term represents "rational bubbles."  A price can be high with no dividends if people expect the price to grow forever.

Since it holds ex-post, it also holds ex-ante -- the price must equal the expected value of the right hand side. And now we can talk about volatilty: the price-dividend ratio can only vary if expected dividend growth, expected returns, or the expected bubble vary over time. 

Likewise, multiply both sides of the present value identity by p-d and take expectations. On the left, you have the variance of p-d. On the right, you have the amount by which p-d forecasts dividend growth, returns, or future p-d. The price-dividend ratio can only vary if it forecasts future dividend, growth, future returns, or its own long-run future. 

The question for empirical work is, which is it? The surprising answer: it's all returns. You might think that high prices relative to current dividends mean that markets expect dividends to be higher in the future. Sometimes, you'd be right. But on average, times of high prices relative to current dividends (earnings, book value, etc.) are not followed by higher future dividends. On average, such times are followed by lower subsequent long-run returns.

Shiller's graph we now understand as such a regression: price-dividend ratios do not forecast dividend growth. Fortunately, they do not forecast the third term, long-term price-dividend ratios, either -- there is no evidence for "rational bubbles." They do forecast long-run returns. And the return forecasts are enough to exactly account for price-dividend ratio volatility!

Starting in 1975 and continuing through the late 1980s, Fama and coauthors, especially Ken French, were running regressions of long-run returns on price-dividend ratios, and finding that returns were forecastable and dividend growth (or the other "complementary" variables) were not. So, volatility tests are not something new and different from regressions. They are exactly the same thing as long-run return forecasting regressions. Return forecastability is exactly enough to acount for price-dividend volatility.  Price-dividend volatility is another implication of return forecastability-- and an interesting one at that! (Lots of empirical work in finance is about seeing the same phenomenon through different lenses that shows its economic importance.)

And the pattern is pervasive across markets. No matter where you look, stock, bonds, foreign exchange, and real estate, high prices mean low subsequent returns, and low prices (relative to "fundamentals" like earnings, dividends, rents, etc) mean high subsequent returns.

These are the facts, which are not in debate. And they are a stunning reversal of how people thought the world worked in the 1970s. Constant discount rate models are flat out wrong.

So, does this mean markets are "inefficient?" Not by itself. One of the best parts of Fama's 1972 essay was to prove a theorem: any test of efficiency is a joint hypothesis test with a "model of market equilibrium." It is entirely possible that the risk premium varies through time. In the 1970s, constant expected returns were a working hypothesis, but the theory long anticipated time varying risk premiums -- it was at the core of Merton's 1972 ICAPM -- and it surely makes sense that the risk premium might vary through time.

So here is where we are: we know the expected return on stocks varies a great deal through time. And we know that time-variation in expected returns varies exactly enough to account for all the puzzling price volatility. So what is there to argue about? Answer: where that time-varying expected return comes from.

To Fama, it is a business cycle related risk premium. He (with Ken French again) notices that low prices and high expected returns come in bad macroeconomic times and vice-versa. December 2008 was a recent  time of low price/dividend ratios. Is it not plausible that the average investor, like our endowments,  said, "sure, I know stocks are cheap, and the long-run return is a bit higher now than it was. But they are about to foreclose on the house, reposess the car, take away the dog, and I might lose my job. I can't take any more risk right now." Conversely, in the boom, when people "reach for yield", is it not plausible that people say "yeah, stocks aren't paying a lot more than bonds. But what else can I do with the money? My business is going well.  I can take the risk now."

To Shiller, no. The variation in risk premiums is too big, according to him, to be explained by variation in risk premiums across the business cycle. He sees irrational optimism and pessimism in investor's heads. Shiller's followers somehow think the government is more rational than investors and can and should stabilize these bubbles. Noblesse oblige.

How are we to resolve this debate? At this level, we can't. That' the whole point of Fama's joint hypothesis theorem and its modern descendants (the existence of a discount factor theorems). "Prices are high, risk aversion must have fallen" is as empty as "prices are high, there must be a wave of irrational optimism." And as empty as "prices are high, the Gods must be pleased." To advance this debate, one needs an economic or psychological model, that independently measures risk aversion or optimisim/pessimism, and predicts when risk premiums are high and low. If we want to have Nobels in economic "science," we do not stop at story-telling about regressions.

John Campbell  (Interestingly, Shiller was John's PhD adviser and frequent coauthor) wrote such a model, in "By Force of Habit". It uses the history of consumption and an economic model as an independent measure of time varying risk aversion. Like any model that makes a rejectable hypothesis, it fits some parts of the data and not other. It's not the end of the story, but it is, I think, a good example of the kind of model that can  make progress.

I am a little frustrated by behavioral writing that has beautiful interpretive prose, but no indpendent measure of fad, or at least no number of facts explained greater than number of assumptions made. Fighting about who has the more poetic interpretation of the same regression, in the face of a theorem that says both sides can explain it, seems a bit pointless. But an emerging literature is trying to do with psychology what Campbell and I did with simple economics. Another emerging literature on "institutional finance" ties risk aversion to internal frictions in delegated management.

That's where we are. Which is all a testament to Fama, Shiller, Hansen, and asset pricing. These guys led a project that assembled a fascinating and profound set of facts. Those facts changed 100% from the 1970s to the 1990s. We agree on the facts. Now is the time for theories to understand those facts.  Real theories, that make quantitative predictions (it is a quantiative question: how much does the risk premium vary over time), and more predictions than assumptions.

If it all were settled, their work would not merit the huge acclaim that it has, and deserves. Rather than attempting a comprehensive overview of Shiller's work, in this post I would like to focus on "Radical Financial Innovation," which appeared as a chapter in Entrepreneurship, Innovation and the Growth Mechanism of the Free Market Economies, in Honor of William Baumol (2004).

The chapter begins with some brief but powerful observations:

According to the intertemporal capital asset model... real consumption fluctuations are perfectly correlated across all individuals in the world. This result follows since with complete risk management any fluctuations in individual endowments are completely pooled, and only world risk remains. But, in fact, real consumption changes are not very correlated across individuals. As Backus, Kehoe, and Kydland (1992) have documented, the correlation of consumption changes across countries is far from perfect…Individuals do not succeed in insuring their individual consumption risks (Cochrane 1991). Moreover, individual consumption over the lifecycle tends to track individual income over the lifecycle (Carroll and Summers 1991)... The institutions we have tend to be directed towards managing some relatively small risks."

Shiller notes that the ability to risk-share does not simply arise from thin air. Rather, the complete markets ideal of risk sharing developed by Kenneth Arrow "cannot be approached to any significant extent without an apparatus, a financial and information and marketing structure. The design of any such apparatus is far from obvious." Shiller observes that we have well-developed institutions for managing the types of risks that were historically important (like fire insurance) but not for the significant risks of today. "This gap," he writes, "reflects the slowness of invention to adapt to the changing structure of economic risks."

The designers of risk management devices face both economic and human behavioral challenges. The former include moral hazard, asymmetric information, and the continually evolving nature of risks. The latter include a variety of "human weaknesses as regards risks." These human weaknesses or psychological barriers in the way we think about and deal with risks are the subject of the behavioral finance/economics literature. Shiller and Richard Thaler direct the National Bureau of Economic Research working group on behavioral economics.

To understand some of the obstacles to risk management innovation today, Shiller looks back in history to the development of life insurance. Life insurance, he argues, was very important in past centuries when the death of parents of young children was fairly common. But today, we lack other forms of "livelihood insurance" that may be much more important in the current risk environment.

"An important milestone in the development of life insurance occurred in the 1880s when Henry Hyde of the Equitable Life Assurance Society conceived the idea of creating long-term life insurance policies with substantial cash values, and of marketing them as investments rather than as pure insurance. The concept was one of bundling, of bundling the life insurance policy together with an investment, so that no loss was immediately apparent if there was no death. This innovation was a powerful impetus to the public’s acceptance of life insurance. It changed the framing from one of losses to one of gains…It might also be noted that an educational campaign made by the life insurance industry has also enhanced public understanding of the concept of life insurance. Indeed, people can sometimes be educated out of some of the judgmental errors that Kahneman and Tversky have documented…In my book (2003) I discussed some important new forms that livelihood insurance can take in the twenty-first century, to manage risks that will be more important than death or disability in coming years. But, making such risk management happen will require the same kind of pervasive innovation that we saw with life insurance."

Shiller has also done more technical theoretical work on the most important risks to hedge:

"According to a theoretical model developed by Stefano Athanasoulis and myself, the most important risks to be hedged first can be defined in terms of the eigenvectors of the variance matrix of deviations of individual incomes from world income, that is, of the matrix whose ijth element is the covariance of individual I’s income change deviation from per capita world income change with individual j’s income change deviation from per capita world income change. Moreover, the eigenvalue corresponding to each eigenvector provides a measure of the welfare gain that can be obtained by creating the corresponding risk management vehicle. So a market designer of a limited number N of new risk management instruments would pick the eigenvectors corresponding to the highest N eigenvalues."

Based on his research, Shiller has been personally involved in the innovation of new risk management vehicles. In 1999, he and Allan Weiss obtained a patent for "macro securities," although their attempt in 1990 to develop a real estate futures market never took off.