Re: ECON: Market efficiency: good or bad?
Fri, 2 Jul 1999 12:59 +0000

>As far as I'm concerned, speculators are a symptom, not the problem. The
>problem with the stock market is that it's far from a free market; for
>1. Insider trading laws prevent the spread of accurate information required
> for sane investment choices.
>2. Capital gains tax means that many people stay in a stock well after they
> would otherwise have dumped it, in order to avoid tax.
>3. Various laws encourage people to invest money in the stock market which,
> in a free market, they'd have put elsewhere.
>So all these restrictions encourage continual increases in stock prices and,
>not surprisingly, speculators jump in and take advantage of that. And
>politicians can use this to claim the economy is wonderful, all the while
>just creating a hideous bubble which will eventually collapse.

So I take it you guys believe that a stock is worth something different to what the next guy will pay for it?

Warren Buffett and indeed many fundamental investors believe in "intrinsic value," a true value that may change over time, but bears only a passing resemblance to its current market price. The logic can't easily be refuted. According to the time value of money, a stock "should" be worth the net present value of its expected stream of future dividends, discounted by an appropriate interest rate. The problem lies in what constitutes an appropriate discount rate (it will vary with the opportunity cost of the individual or the institution, since some can borrow at lower rates or invest at higher rates than others), and in what a particular investor's expectation of future dividends is. So actually, you end up not with a single intrinsic value, but a bell curve of possible intrinsic values.

The second complication comes as a result of what George Soros calls reflexivity. On the micro level, a company which investors think is capable of producing a healthy stream of dividends will find buyers for its stock. It can then invest its capital in businesses that will enhance even further its ability to produce big dividends. Or, banks will like its expected cash flow and allow it to borrow at lower interest rates. The converse applies as well: companies with weaker prospects have to pay higher interest rates and watch their share prices go down. Now, if investors and banks get it in their heads that a particular company has better prospects than they used to believe, they'll bid up the stock, and lend at lower rates, and the prospects of the company will indeed improve. So the virtuous or vicious spiral can start either way, with the company or with the market, and end up in the same place.

At the macro level, an investor without the discipline or the data to calculate his personal opinion of intrinsic value will rely on these facts -- intrinsic value lies somewhere in a range, and if it's rising it will likely continue to rise -- and aim to capitalise on the trend. He'll buy a rising stock because it's safe to assume it'll keep rising. The economics supports him.

Yes, stocks overshoot and create bubbles and panics. We know that just by looking around us. But the only alternative has decidedly un-extropian implications. The alternative requires us to assume that the true value of a stock (or any asset, for that matter) can be something different to what the next buyer says it is. Someone has to decide that an asset is "worth" a particular price, and be able to enforce that price. I say he (in most cases, a regulatory agency) has to be able to enforce it because, by pure market logic, there is more than one correct price, and investors will profit to the extent that the agency is willing to buy or sell at a price different to what the investors believe constitutes the appropriate level.

In some cases, such as the Malaysian ringgit during the past year, the enforcement takes the form of a withdrawal of the asset from the market. If you want to buy ringgit, you have to hold them for a year before you can sell them again. What's happening right now is that most investors here in Asia think that the ringgit is very undervalued, and they're buying it up in anticipation of a relaxation of capital controls. Suddenly, the game is moving against Malaysia -- they're selling their country too cheaply. Either they flood the market with newly minted ringgit and depreciate their currency, which hurts the country, or they let the currency float again, which means investors who bought ahead of the relaxation profit, which gives the investors profits which by rights should have accrued to Malaysia.

The market isn't always right -- as Soros puts it, it's almost always wrong. But it has such power that the "right" price moves towards the value the market puts on it every bit as much as the market price moves toward the right price.

I believe that asking whether market efficiency is good or bad misses the point entirely. The only "real" price is the market price; anything else is fanciful and more often than not will lose its investor money.

Okay, so how do we spread some equity through the market, when information disseminates unequally and speculators over- and under-shoot all the time? (I'll get to taxes in a minute.) Well, insider trading laws don't in fact slow the process of disseminating information; their purpose is to prevent people who know more from acting on it before the information is "adequately" disseminated.

Yes, there's a lot of grey area on what constitutes adequate dissemination. But the line has to be drawn somewhere, and if you wait until everyone in the world, or everyone who could possibly care, has the information before it can be acted on, you create such a disincentive to spread it around that you end up with one of two things. Either the market bcomes essentially void of this information, and prices never move at all, or more likely, you get a black market in information that transfers the profits to people who have figured out how to hoodwink the system.

As to speculators, let me note here that I've just watched them destroy Indonesia's hope, for five to ten years at least, of pulling itself out of the destitute status in which it's wallowed since World War II, and conferred similar if less-extreme fates for Thailand and perhaps Malaysia as well.

I'm no fan of speculators, nor am I an apologist for their actions. But realise that all they've done, individually, is to attempt to capitalise on reflexivity -- on the adjustment of market and fundamental expectations from one level to another. In aggregate, they've exposed underlying weakness in the systems -- massive corruption in the Asian cases (which investors and bankers, prior to the crisis, knew all about but were ready to ignore), and similar ones in half a dozen crashes and panics in the past ten years.

Finally, as to tax differentials altering the investment profiles of investors, you're right. Investors make decisions based on their after-tax returns. In this regard, a flat tax, with no preferential capital gains treatment -- perhaps no capital gains tax at all -- might might make sense. But America isn't the world. Foreign investors operating in different tax regimes will continue to find incentives and disincentives other than those available to American investors, which again will distort the market. You can't avoid it without *all* tax regimes being identical. (And don't think the foreign presence in US markets is inconsequential. Consider just one counter example: consider the 300-500 basis points extra the US government, and by extension all Americans, would have to pay on debt if Japanese investors had not financed such a large part of the deficit for the past 25 years.)

Can we solve this problem? Not by top-down initiatives, that's for sure. Capital markets are a complex dynamical system like any other. Any top-down set of controls ultimately fails.

The only possibility lies in bottom-up change -- that is, in an evolution in people's utility functions. Things have to become more and less important, to everyone. More money has to become worth less to people than no more money at some point. People have to have a trigger which at some point says, "okay, that's enough for now," they way they do with food or sex. Perhaps posthumans will have this. It's certainly not built into humans.