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.