Conventional wisdom used to dictate the bond market would tank when the nation's central bank applied the brakes on the economy by lifting short-term interest rates. Yet the bond market rallied when the Federal Reserve Board raised short term interest rates for the last time in 1994.
That, according to Gary P. Brinson, chief investment officer at Brinson Partners Inc., Chicago, was because investors looked beyond the immediate impact of the interest rate hike and reckoned the Fed's action would create a better, more stable environment for long-term interest rates.
This reaction by investors is precisely what Robert E. Lucas Jr., a University of Chicago economist, predicted in his rational expectations theory. And it was his ground-breaking work on this theory that garnered him the Nobel Memorial Prize in Economic Science last week.
The 58-year-old economist theorized that government efforts to jump-start the economy through interest rate cuts often fail because investors learn to anticipate those actions, and react accordingly. That, in turn, cancels any potential benefits. In other words, while lower interest rates might have a salubrious effect on bond prices in the short term, that effect is all but wiped out by higher inflation in the long term. Conversely, bond investors are likely to perceive interest rate hikes as beneficial because they keep inflation in check.
"Both the stock and the bond markets behave in ways that support and lend evidence to the credibility of the rational expectations theory," Mr. Brinson said.
As economists go, Mr. Lucas was not a household name when he won the Nobel Prize last week. But his work "has a fairly pervasive influence" on the way investors react to events, Mr. Brinson commented.
Thus, Mr. Lucas' award-winning theory explains why investors frequently shrug off large write-offs by companies that depress earnings, and push the stock price up, instead of down, Mr. Brinson noted.
"That is in anticipation that the immediate effect of the write-off and the poor earnings will create a better environment going forward," he said.
John Lonski, senior economist at Moody's Investors Service in New York, concurs.
He predicts that on Oct. 17, investors will brush aside a sharp drop in General Motors Corp.'s third quarter 1995 earnings compared to the automaker's performance a year ago, because that drop will not reflect a deterioration in the company's earning power.
Instead, investors will probably figure out that GM's earnings seem paltry compared to a year ago only because last year's third quarter earnings were boosted by a one-time tax credit.
"What you are doing is saying, 'So what,'*" Mr. Lonski said. "Investors will be trying to look through what may be an unsightly year-over-year drop in corporate earnings at face value," Mr. Lonski noted.
Economists familiar with Mr. Lucas' work also note the influence of the "efficient market hypothesis," on his rational expectations premise.
The efficient markets hypothesis - that the capital markets are very efficient at processing information and incorporating that information into the prices of securities - grew out of the 1960s work of the economist Paul Anthony Samuelson, an economist at the Massachusetts Institute of Technology, and gained acceptance after the publication more than 20 years ago of an article by University of Chicago business professor Eugene F. Fama in the Journal of Finance.
"The essence of Lucas' view is that the only things that matter in life are the surprises. The rest can all be handled by simple extrapolation," commented Merton H. Miller, Mr. Lucas' colleague at the University of Chicago. Mr. Miller won the Nobel Prize for economics in 1990.
Mr. Lucas was not available for comment.
Mr. Lucas' rational expectations theory also dismissed the notion proposed by British economist John Maynard Keynes that the stock market works like a casino. Keynesian theory says people pick stocks not because of the stocks' fundamentals, but because they expect others see those stocks as winners, explained Michael J. Brennan, an economist at the University of California, Los Angeles.
In contrast, the efficient markets hypothesis states that the capital markets are very efficient at digesting information and price securities taking into account all available information, explained Clifford W. Smith, a professor of finance at the University of Rochester.
"Mr. Lucas was influenced by the efficient markets theory which was very strong at the University of Chicago," Mr. Brennan observed.
But not everyone is sold on Mr. Lucas.
Robert A. Brusca, chief economist at The Nikko Securities Co. Ltd., New York, said Mr. Lucas' theory states "the markets are right. And, the markets are." But Mr. Lucas' theory does not explain how wrong the markets can sometimes be at anticipating events. One example he mentioned: the 508 point drop on Oct. 19, 1987.
"What did we know that day that we didn't know the day before? There really wasn't anything we learned," Mr. Brusca said.
