Finance Basics, part 7
Point number seven is that even though the equity markets are efficient, that doesn’t mean they’re also rational. We have to understand that there is an enormous amount of noise in the equity market, and share prices are affected by many more factors than bond prices. It is very difficult to pick stocks consistently to beat the market, but that doesn’t mean that those equity prices are set rationally. It is a conundrum that although it is well known that in an efficient market, asset prices fluctuate randomly, this can also happen in an inefficient market: Randomness per se or, alternatively, the difficulty of beating the market, doesn’t in and of itself prove market efficiency.
The basic problem is that sometimes we get bubbles in the stock market. Some academics will go though amazing contortions, rather than face the obvious truth that security prices are set by individuals operating in capital markets and that individuals both individually and collectively sometimes make mistakes, huge mistakes. The central problem is that it is incredibly difficult to form a correct valuation of the equity market. Unlike the bond market, where prices always revert to the bond’s principal value at maturity, there is no “anchor” for equity market values. As a result, equity values can drift off from fundamentals for a long period of time without any certainty of a short-term reversion to their “true” values. So even though the prices are still set in an “efficient” market, and it is difficult to make money, it is not necessarily true that the prices reflect the underlying fundamentals.
To some extent the foregoing remarks are time-dependent and reflect the run-up in the Internet and technology stocks in the late 1990s and their subsequent collapse. With hindsight it is clear that prices were considerably in excess of fundamentals and that the equity market wasn’t rational. However, it was still extremely difficult to take advantage of these opportunities in terms of making money by speculating against the market. Why this is the case has been one of the most controversial topics in finance for the last hundred plus years. This is partly because we have had bubbles in stock markets going back to the Amsterdam tulip mania and the South Seas Company bubble in England in 1720, where famously Sir Isaac Newton lost his fortune and declared, “I can calculate the motions of the heavenly bodies, but not the madness of people.”
Classically trained economists tend to believe that speculation offsets bubbles, so that they can’t exist. If prices get above the fundamentals, then shrewd speculators step in and sell to reap huge profits when prices revert to their fundamental values. If this were true, we would have expected to see professionals selling at the top of the stock market bubble. However, it turns out that this was not the case. Those who should know the most about the value of their companies, the companies themselves, repurchased a record amount of stock in 2000 right at the top of the market!
In 1936 John Maynard Keynes pointed out that professional investors do not speculate in the manner described in classical economics. As he argued:
They [professional investors] are concerned, not with what an investment is really worth to a man who buys it “for keeps,” but with what the market will value it at, under the influence of mass psychology, three months or a year hence.
Keynes himself was a very successful speculator, as well as the most brilliant economist of the 20th century, and was under no illusions as to how financial markets worked. However, even he would have wondered at some of the implications of the Internet bubble. Michael Lewis, the author of Liar’s Poker, pointed out that an Internet company, NetJ.com, had filed statements with the Securities and Exchange Commission with the confession, “The company is not currently engaged in any substantial activity and has no plans to engage in any such activity in the foreseeable future.” The company had $127,631 in accumulated losses and so little money on hand that the directors would have had to chip in themselves to pay any filing costs to raise capital. The only snag was NetJ.com had a market capitalization of $22.9 million!