Now in Chapter Three, Nassim Taleb talks more about Robert Shiller 1981 paper in which he attempted to mathematically explain how society processes information.
Nassim Taleb writes, “Shiller made his mark with his 1981 paper on the volatility of markets, where he determined that, if a stock price is the estimated value of ‘something’ (say the discounted cash flows from a corporation), then market prices are way too volatile in relation to tangible manifestations of that ‘something’ (he used dividends as proxy).”
In essence, Shiller claimed that the efficient market hypothesis (EMH) does not work. He explained that price volatility rarely reflects stocks’ fundamentals. In fact, stock prices often overreact either in response to real news or to no news at all. According to Shiller, “rational expectation” of the volatile relationship between prices and information are often not met, which means that, “Markets [have] to be wrong.”
Now, the EMH claims that prices generally process quickly all available market information but in a manner that is generally unpredictable, which is why abnormal returns should be virtually impossible. Of course, Shiller spoke against one of the biggest mantras in the world of high finance, which landed him in a world of trouble.
Robert Shiller was criticized the most by Robert C. Merton, who focused on Shiller’s rather rough methodology, an example of which was using dividends for cash flows instead of earnings. Merton was a “great defender” of market efficiency, which turned out to be rather ironic since that same Robert C. Merton later on founded a hedge fund with the mandate to exploit market inefficiencies and which so gloriously imploded after the “little black swan problem.”
Taleb concludes, “Things are not getting any better these days. At the time of writing, news providers are offering all manner of updates, ‘breaking news’ that can be delivered electronically in a wireless manner. The ratio of undistilled information to distilled is rising, saturating markets.”
