The Nobel Prize Is No Crystal Ball

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EUGENE FAMA LARS PETER HANSEN NOBEL PRIZE ROBERT SHILLER
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JASON ZW EIG CONNECT

University of Chicago Professors Eugene F. Fama (L) and Lars Peter Hansen (R) appear together at a news conference after winning the 2013 Nobel Prize in Economic Sciences for trend spotting in asset markets.
EPA

For investors, the main lesson from this weeks announcement of the Nobel Prize in economics should be humility about anyones market-forecasting abilityespecially your own.

This past Monday, the economics prize went to three researchers whose work seems to have little in common: Eugene Fama, a leading advocate of the theory that stock prices are efficient; Lars Peter Hansen, who probes predictive models for statistical weaknesses; and Robert Shiller, who argues that markets are more irrational than efficient. The Nobel

committee said these economists findings show that it is quite possible to foresee the broad course of [stock and bond] prices overthe next three to five years. If only it were that simple. Prof. Fama, a finance professor at the University of Chicagos Booth School of Business, was unavailable for comment this week. He has argued for nearly five decades that markets are efficientmeaning that you cant reliably predict, using publicly available information, which securities will have higher or lower returns than expected. On the other hand, with his longtime research partner, Kenneth French of the Tuck School of Business at Dartmouth College, Prof. Fama has identified several factors that appear to beat the market over long periods. Small stocks, value stocks (priced at low multiples of their net worth), momentum stocks (with recently rising prices) and quality (or highly profitable) stocks all have earned higher-than-average returns over the decades, according to Profs. Fama and French. Why these stocks tend to outperform isnt yet fully understood. But you should be wary of stock-pickers who claim to be able to beat the market buying such companies. Approximately 97% of fund managers havent demonstrated enough skill even to cover the expenses they charge, Prof. Fama has arguedmaking low-cost index funds, which dont even try to beat the market, the best bet. It will always be challenging to get sharp predictions as to what will happen in the future, Prof. Hansen, an economist at the University of Chicago, told me this week. Theres a tremendous amount of uncertainty [in financial data], and if there are predictable patterns in there, they are modest and very subtle.

Robert Shiller
REUTERS

Prof. Hansen has spent his career building complex mathematical models to measure economic variables. He has learned much about what works, but even more about what doesnt work. Theres a danger if you turn over policy and regulatory design to models that we dont yet have full confidence in, he says. Theres a big danger in pretending that we have a new set of knowledge that we can use in fine-tuning policies and markets. Prof. Shiller, an economist at Yale University, is best known for his book Irrational Exuberance. The first edition, in March 2000, warned that the U.S. stock market was dangerously overvalued. Over the next 2 years, stocks fell 44%. The second edition, published in early 2005, warned that the U.S. housing market was dangerously overvalued. He was right again. Still, Prof. Shiller doesnt believe that if you roll up enough data, it will turn into a crystal ball. For years he has calculated what has become known as the Shiller CAPE, or cyclically adjusted price/earnings ratio. That measure is the price of the S&P 500-stock index, divided by the average of its past 10 years of earnings, adjusted for inflation. The resulting number has averaged 16.5 since 1871. By the end of 1999, it was flashing furiously at 44.2, the highest level ever recorded. Today, Prof. Shiller says, CAPE is a plausible strategy for getting a rough sense of whether markets are fairly priced. It appears to work over the very long term, he says, but I dont

think you can know that its going to [work] tomorrow or even over the next few years. (At 23.5, the recent CAPE for the U.S. stock market is well above the historical average.) One lesson Ive learned from Prof. Shiller comes not from his work but his life. In college, he went on such long contemplative walks that he stress-fractured a bone in his foot. He told me years ago that the collective enthusiasm of fans at sporting events is alien to him. He still recalls, with a shudder, reading Aldous Huxleys novel Brave New World as a teenager. In Huxleys dystopia, babies are brainwashed with hypnopaedia and adults are doped into conformity with a drug called soma. I never wanted to get socialized like that, he told me. In 2003, Prof. Shiller said in an interview that he has kept a diary continually since I turned 12 years old. He added that talking in it to oneself creates a more idiosyncratic view. Such deliberate detachment from the crowd may be the best way to avoid getting swept up in the next bubble.

Behind the SEC's Pursuit of Mark Cuban

Regulation through litigation is no way to run a government agency.
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By LYLE ROBERTS
Nov. 17, 2013 6:03 p.m. ET

When Mark Cuban stood outside the federal courthouse in Dallas last monthafter a jury found him not liable for insider tradinghe noted that the Securities and Exchange Commission lacks "bright-line rules" and resorts to "regulation through litigation." Mr. Cuban, who owns the Dallas Mavericks basketball team, raises a very good point. In

pursuing insider-trading claims, the SEC often appears to be making up the rules as it goes along. This is not healthy behavior for government law enforcement. In SEC v. Cuban, the regulatory agency alleged that Mr. Cuban traded on material, nonpublic information when he sold his investment in the Internet-search firmMamma.com DPSI 3.27% in June 2004before the company announced a private offering of shares.
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Mark Cuban exiting federal court in Dallas after being acquitted of insider trading, Oct. 16. Bloomberg News

In its Nov. 17, 2008, press release announcing its lawsuit against Mr. CubanI represented him in the casethe SEC claimed that it was "fundamentally unfair for someone to use access to nonpublic information to improperly gain an edge on the market." Statements like this are misleading. Contrary to a popular misconception about insider trading, there is nothing wrong with a person trading on the basis of nonpublic information about a corporation. An entire professionthe stock market analystis predicated on the idea that investors can and should seek an informational advantage to better manage their investments. Trading based on an informational advantage is only illegal when it results in a fraud, and that only happens in certain narrow circumstances. In the classic case of illegal insider trading, where a corporate insider trades on material, nonpublic information about the company for his own benefit, this fraud requirement is easily satisfied. The insider owes a fiduciary duty to his company's owners, the shareholders, which he fraudulently violates when he trades (or deliberately tells someone else so that they can trade) without disclosing to the market the existence of the information. Where things get tricky, however, is when the trader is not a corporate insider. What if someone is just told (or overhears on an elevator or in the subway) material, nonpublic information about a company? If he proceeds to trade on the information, his liability under insider trading rules turns on whether he has breached a fiduciary or similar duty of trust and

confidence he owed to the source of the information (this is called the "misappropriation theory"). The original idea here was to prevent an attorney, for example, from obtaining information from a client and using it for his own benefit to trade stock. The way the SEC has applied the misappropriation theory, however, deliberately blurs the lines in an overzealous attempt to regulate "unfairness." The agency began in 2000 by creating a regulatory rule (Rule 10b5-2) designed to address how the misappropriation theory could be extended to exchanges of information between friends or family members. Under the rule, the required duty of trust and confidence is formed any time a friend or family member formally agrees to keep the information confidential. Soon thereafter, however, the SEC began citing Rule 10b5-2 in courts across the country as applying whenever any material, nonpublic information is exchanged and the recipient, regardless of whether he is a friend or family member, formally agrees to keep the information confidential. Recently, the SEC abandoned even that broad standard and essentially has argued that a wink and a nod (or even silence) to confidentiality when material, nonpublic information is shared is sufficient to hold anyone who trades on that information liable for insider trading. This is where Mr. Cuban comes in. He was a large investor in Mamma.com and, in an eightminute phone conversation in 2004, the company's then CEO, Guy Faur, provided him with information about an upcoming stock offering. The SEC argued that based on testimony from Mr. Faur concerning his understanding of the conversation, Mr. Cuban had agreed to keep the information confidential. The case ultimately collapsed. For starters, the court found that SEC Rule 10b5-2 was an invalid exercise of the agency's authority because a confidentiality agreementwithout any additional agreement not to trade on the informationcould not create the required duty. The jury found that Mr. Cuban had not, in fact, entered into the requisite agreements to keep the information confidential and not trade on it. The jury also made other findings in Mr. Cuban's favor, including that he had told the company that he would sell his shares. It also found that the information about the company's stock offering was not material, nonpublic information in the first place. The SEC's case was based on shaky law and shaky facts, but bringing it is no testament to the agency's fortitude. Instead, it functions as a warning to stock traders that the SEC will not hesitate to use its vast enforcement resources to bring test cases based on unclear rules.

Was Mr. Cuban supposed to know in 2004 that he would fall afoul of the misappropriation theory of insider trading, even though he had not expressly agreed to keep the stock offering confidential or not to trade on the information? It ended up taking him years of litigation and enormous legal bills to find out. As Mr. Cuban put it, he was glad that this happened to him because at least he had the ability to defend himself, but why isn't the SEC concerned about the "fairness" to other market participants without the same ability? In the wake of this case, the SEC needs to re-evaluate its insider trading program. Itor Congressshould clarify that under the misappropriation theory of insider trading, the required relationship of trust and confidence can be created by agreement only if someone who receives material, nonpublic information about a company agrees to keep that information confidential and not trade on it. These are standard terms in corporate nondisclosure agreements. There is no reason traders should operate under an uncertain legal regime that encourages the SEC to regulate through litigation, at a significant cost to the government, traders and the rule of law.

Johnson & Johnson to Pay $2.2 Billion to Settle U.S. Probes

Deal with Justice Department Regards Drug Maker's Selling of Antipsychotic Risperdal
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By JONATHAN D. ROCKOFF
Updated Nov. 4, 2013 8:27 p.m. ET

Johnson & Johnson JNJ -0.70% agreed to pay a total of $2.2 billion and plead guilty to a misdemeanor in a deal that would settle U.S. Department of Justice investigations into the marketing of antipsychotic Risperdal and other drugs. The deal resolves probes that prosecutors had pursued for nearly a decade into allegations that J&J had promoted drugs in the late 1990s and early 2000s for unapproved and sometimes harmful uses. The settlement ends years of often-difficult negotiations that at one point even pitted prosecutors in Washington, D.C., against federal prosecutors in Philadelphia.
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J&J 'displayed a reckless indifference to the safety of the American people,' Attorney General Eric Holder said at a news conference on Monday.Associated Press

Prosecutors accused J&J of encouraging Risperdal's use in elderly nursing-home patients suffering from dementia, even though such a use wasn't approved by health regulators and could prove life-threatening. The company was also accused of marketing Risperdal to certain boys, despite a risk it could stimulate development of breasts. J&J "displayed a reckless indifference to the safety of the American people," U.S. Attorney General Eric Holder said at a news conference on Monday announcing the settlement. "And it constitutes a clear abuse of the public trust, showing a blatant disregard for systems and laws designed to protect public health." J&J, of New Brunswick, N.J., said it had already set aside funds to cover the full cost of the settlement, and it had already paid out $200 million of the $2.2 billion as part of agreements reached in previous years. The company disputed many of the government's claims and said its settlement of civil allegations wasn't an admission of wrongdoing or liability. "We do not agree with all of the government's allegations and strongly believe some of them are not supported by the facts," J&J general counsel Michael Ullmann wrote to employees. The company settled, he said, "because it resolves complex and lengthy legal matters,

allowing us to continue focusing our full attention on delivering innovative health-care solutions for patients and their families." Under the terms of the settlement announced Monday, J&J's payment included a criminal fine of $334 million and forfeiture of $66 million. The company pleaded guilty to introducing a misbranded drug into interstate commerce, a plea that preserves J&J's ability to sell its products to Medicare and other government health programs. The settlement would also resolve investigations into the promotion of Invega, another schizophrenia agent like Risperdal, and the heart-failure drug Natrecor. The company also agreed to upgrade its compliance practices and submit to five years of monitoring by the Department of Health and Human Services' Office of Inspector General. The J&J deal is among the biggest reached between the Justice Department and a pharmaceutical company accused of promoting medicines in ways that lead to unnecessary spending by government health programs. Federal and state prosecutors have been pursuing the cases for several years, aided by company whistleblowers. Last year, GlaxoSmithKline PLC agreed to pay $3 billion and plead guilty to criminal charges involving the antidepressants Paxil and Wellbutrin and the diabetes drug Avandia. In 2009, Pfizer Inc. agreed to pay $2.3 billion to resolve a drug-promotion criminal investigation. Under federal law, drug makers can market medicines only for uses approved by the U.S. Food and Drug Administration, though doctors can prescribe drugs for unapproved, or offlabel, uses. Risperdal is a pill treating the symptoms of mental illnesses such as schizophrenia, bipolar mania and irritability in autistic patients. The medicine had been J&J's top-selling drug with $2.2 billion in sales in 2007, the year before it lost U.S. patent protection. Prosecutors alleged that J&J's Janssen Pharmaceuticals unit promoted Risperdal to elderly patients suffering from dementia, despite no approval for that use. Prosecutors also alleged that J&J's "ElderCare" sales force pushed Risperdal for use in these elderly patients, and sales representatives' bonus awards failed to distinguish prescriptions for schizophrenia or the unapproved dementia use. In 2005, the FDA required the label warn that elderly patients suffering from dementiarelated psychosis were at a higher risk of death.

Prosecutors also alleged that J&J promoted Risperdal for use by boys suffering from mental disabilities despite knowing that use could raise levels of a hormone stimulating breast development. J&J faces more than 160 personal-injury lawsuits in state courts in Philadelphia filed by users of Risperdal alleging it caused their breasts to grow, according to Stephen Sheller, one of the lead lawyers in the Risperdal whistleblower and breast litigation. The company is fighting most of the lawsuits but has settled some others. Executives at J&J recognize that the federal settlement "represents solid ammunition for all the litigants in the civil cases out there,'' one person familiar with the situation said Monday. J&J had been negotiating for years to resolve the government investigations. At one point, J&J and prosecutors in Philadelphia had tentatively agreed to a $1 billion settlement of the Risperdal claims, but prosecutors in Washington, D.C., scuttled the proposal as too small, The Wall Street Journal has reported. The rejection prompted the sides to fold in other probes into the deal. Devlin Barrett and Joann S. Lublin contributed to this article.

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