Asset pricing is in a Kuhnian crisis. And it has been since 1992.
The asset pricing theory that one would read in doctoral textbooks is the consumption CAPM, and the theory in MBA textbooks is the class CAPM. Alas, we know the CAPM fails in the data, and the consumption CAPM performs often worse than the CAPM.
Where do we go from here?
A prominent answer in the prior literature is the joint-hypothesis problem. There could be nonmarket risk factors absent in the CAPM. However, what counts as a risk factor is controversial.
The joint-hypothesis problem is a specific example of the Duhem-Quine thesis in philosophy of science. The thesis says that when we test a specific hypothesis, we are in effect testing a whole web of beliefs underlying its development.
In the context of the CAPM, a long list of assumptions, including metaphysical presuppositions, has been made in its derivation. Where exactly do we pin the blame for the model’s failure?
I blame the metaphysical presupposition of the consumption CAPM that the marginal investor is the marginal agent who determines asset prices. More specifically, I blame the assumption of homogeneous expectations (beliefs) for investors in the CAPM and the existence of a representative investor in the consumption CAPM.
Ontology is a branch of philosophy that studies the fundamental structure of reality.
Consider the following two possible worlds. Which world do you think is closer to the mind-independent reality we are living in?
Possible World 1:
At the end of each September (fiscal yearend) of calendar year t, all shareholders of Apple Inc. elect a marginal investor, who represents the best interests of all shareholders. The marginal investor then marches into Tim Cook’s office in Cupertino and dictates to Tim the cost of equity for Apple Inc. in the next fiscal year. After receiving the cost of equity, Tim and his management team then work out Apple’s operating, investing, and financing decisions for the next fiscal year.
Possible World 2:
Tim Cook and his management team do whatever they want to maximize the shareholder value to the best of their abilities. While paying attention to external capital markets, they already have a sense of what their cost of equity is likely to be. Some shareholders will approve what the management is doing and buy and hold Apple shares. Others who disagree can feel free to leave by selling their shares. Unless facing a major decline of Apple’s share price, Cook and his team continue to do whatever they feel is the right thing to do.
If you find Possible World 1 absurd, keep in mind that is exactly the ontology presupposed in the academic finance literature, often without us consciously aware that we are doing so.
Thus when teaching capital budgeting in corporate finance and equity valuation in accounting, we take the cost of equity as a free parameter. We then tell students to take a course on investments to pin down the parameter with a factor model. (Though curiously, most empirically efficacious factor models are built on firm characteristics, not investor preferences. Although the 3-factor model is dead, the CAPM is deader.)
Thus in the theoretical asset pricing literature, we have the metaphysical presupposition “Asset pricing is all about the pricing kernel” declared as incontrovertible truth. This decree ensures an ill-founded hegemony of the consumption CAPM over the investment CAPM.
Thus in the empirical asset pricing literature, the joint-hypothesis problem only covers missing risk factors, while leaving the question why we should waste more time on the pricing kernel (risk factors) to begin with unanswered.
Possible World 2 is the ontological foundation of the investment CAPM, which it shares with corporate finance and accounting. Alas, for the most part, the latter two fields have largely ignored their own impact on cross-sectionally varying expected returns (asset prices).
Possible World 2 is much closer to our reality. While still germinating in my brain, I am gradually arriving at the philosophical position that the corporate manager, not the marginal investor, is the marginal agent (causal power) that determines the asset price of the manager’s own equity.
It is conceivable that a venture capitalist can bully his way with the manager of a private equity or a microcap public equity. (I say “his” because most bullies I have encountered in life are male.) But I doubt Tim Cook can be bullied by anyone.
All in all, the fundamental structure I have in mind is a powerful manager on one side and a diffuse assemblage of shareholders, who are best at bickering among themselves, on the other. Which side do you think is more causally powerful for the asset price of the manager’s own stock?
If my carving of the fundamental structure of finance is more accurate than that of our forefathers, then we should clear the rubbish (at least substantially revise) what we call equilibrium asset pricing theory (i.e., the consumption CAPM) from our textbooks.
Partial equilibrium theories remain valid from the demand side, but general equilibrium theories fail. There is just no such entity called the marginal investor.
I accept the importance of behavioral biases in partial equilibrium theories of investors, both retail and institutional. But I remain dubious about their impact on equilibrium asset prices. Imposing behavioral biases on the marginal investor to do equilibrium asset pricing commits the same aggregation fallacy as the consumption CAPM.
All in all, our current edifice of equilibrium asset pricing theory is built on sand, shifting sand. The causal power called the marginal investor simply doesn’t exist in reality. Time to rebuild our edifice on the causal power that does exist, i.e, the corporate manager, via the investment CAPM.
Corporate finance and accounting colleagues of the world, unite! You have nothing to lose but your chains forced upon you by fallacious asset pricers.
In my recent interview with Jack Forehand and Justin Carbonneau, I discuss the related scientific debate within asset pricing.
The demise of empiricism.
The clash between the 3-factor model and the q-factor model is a clash between two philosophies of science and two visions for the future of asset pricing. And an epic struggle for its soul.
The 3-factor model is a product of empiricism. This philosophy of science dates back to David Hume in the 18th century, arises as logical positivism of the Vienna Circle in the 1930s, and modifies as logical empiricism in the 1950s and 1960s.
Empiricism is built on the verification principle, which insists that all scientifically meaningful statements must be verifiable (testable) with our senses, facts, and data. The verification principle emphatically rejects metaphysics, including theories of causation beyond Hume’s constant conjunctions (correlations).
After reaching its heyday in the 1960s, philosophers today generally regard empiricism as defunct. Most tellingly, the verification principle itself is not verifiable, meaning that it is itself an unfalsifiable metaphysical presupposition. Oops. As far as philosophy goes, this defect is insurmountable... All in all, theory is indispensable.
In asset pricing, empiricism has also crashed to the ground, albeit only recently.
The 6-factor paper states (2018, p. 237): “We include momentum factors (somewhat reluctantly) now to satisfy insistent popular demand. We worry, however, that opening the game to factors that seem empirically robust but lack theoretical motivation has a destructive downside: the end of discipline that produces parsimonious models and the beginning of a dark age of data dredging that produces a long list of factors with little hope of sifting through them in a statistically reliable way (my emphasis).”
Seriously? The beginning of a dark age? Isn’t it really the end of the dark age ushered in by the 3-factor paper in 1993? The q-factor model published in 2015 has ended the dark age. And the 6-factor paper merely confirms the end of the dark age via a form of doublespeak.
The creation of the q-factor model is an imaginative, retroductive, and iterative fusion between asset pricing theory and asset pricing empirics. The q-factor model asks: What the fundamental structure of capital markets must be like for us to observe asset pricing anomalies? The starting point is theoretical (transcendental). After I identify the causal powers of investment and profitability in 2005, it then takes another 10 years to put the empirics together. Contrary to Hume’s induction, the scientific inference is retroduction (closely related to abduction, i.e., inference to the best explanation).
Far from Hume’s empiricism, the philosophy of science embodied in the q-factor model is Roy Bhaskar’s critical realism. In addition to the domain of the empirical (observed events, the only reality accepted in empiricism), critical realism also allows the domain of the real (causal powers, causal structures, and causal mechanisms).
All in all, theory plays an important, if not major, role in science. About time to take causation seriously in asset pricing.
If the 3-factor model is like the alpha variant of Covid-19, the 5-factor model would be the delta variant, and the 6-factor model the wimpy delta+. While Covid-19 infects our lungs, the 3-factor virus eats our brains and turns us into zombies, who refuse to dig any deeper than observed events and even actively deny the need of doing so. As evidenced by the quote above from the 6-factor paper about "popular demand," the 3-factor virus has turned our beloved science into a dystopian Oceania.
The q-factor model is like the Pfizer vaccine. It borrows the factor form from the 3-factor virus but neutralizes its rotten, poisonous core of defunct empiricism. And the expected growth factor is our booster.
I have no conflicts of interest to declare. My only objective in life is the pursuit of scientific knowledge. The state of Ohio couldn’t care less about whether my results come out one way or another. And I couldn’t care less about any investment company’s assets under management.
Truth is fragile. Freedom is not free.
To protect ourselves from the delta surge, please consider taking the vaccine to ensure a brighter future.
Please see my latest interview below with Jack Forehand and Justin Carbonneau on my recent adventure into philosophy of science in the context of scientific debates within asset pricing.
I had much fun today discussing "Dissecting Green Returns" (Pastor, Stambaugh, and Taylor 2021) at the webinar hosted by the Jacobs Levy Equity Management Center for Quantitative Financial Research at the Wharton School. The webinar is available at this Wharton link, which contains Rob's presentation and my discussion.
Because the webinar is available only through 12/2/2021, I have posted a remake of my discussion on YouTube (slides):