Strikingly, once post-IPO lock-up restrictions on selling by corporate insiders ended, prices often fell sharply — perhaps partly because well-informed investors were able to communicate their knowledge to the market by shorting.
A growing number of economists have become adherents of "behavioural finance", which attempts to explain real-world deviations from the asset prices predicted by modern finance using the insights of human psychology. One example is that people often use a "representative heuristic" — that is, they use data from the recent past as a basis for predicting the future. Thus, when share prices have risen strongly in the recent past, perhaps for a good reason such as a fall in interest rates, investors may assume that they will continue to rise. They will therefore buy the shares, making their rise a self-fulfilling prophecy, at least for a while.
If current share prices reflect a belief that the returns on shares earned in recent years will be repeated in future, they are probably mistaken. The average share-price-to-profits ratio of American equities — as well as British and some continental European ones — remains high by past standards. Jay Ritter, an economist at the University of Florida, estimates that shares might reasonably be expected to earn around one percentage point more per year than the risk-free rate of interest. That would be far less than the average return on shares during the past 20 years.
In "Triumph of the Optimists: 101 years of Global Investment Returns", Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School also question whether future returns will match those of the recent past. The global post-war bull market in shares, they say, owed much to two trends that cannot be relied on to continue. First, the world enjoyed a long period of relative peace and prosperity far exceeding expectations at the end of the war. Second, equity holders increasingly diversified their portfolios, which led them to regard their shares as less risky and therefore more valuable.
Physics Envy
Why do so many people cling so hard to the notion of efficient markets? Andrew Lo, an economist at MIT, suggests that they may be suffering from a "peculiar psychological disorder known as 'physics envy'...We would love to have three laws that explain 99% of economic behaviour; instead, we have about 99 laws that explain maybe 3% of economic behaviour. Nevertheless, we like to talk as if we are dealing with physical phenomena."
There may be some truth in this. In 1947 Paul Samuelson, later awarded the Nobel prize for economics, set out to apply the principles of thermodynamics to economics. More recently, Bill Sharpe, another Nobel-prize winner for his contribution to modern finance, wrote an interesting paper on "Nuclear Financial Economics", drawing parallels with nuclear science. This work yielded some useful insights, but left a lot of question marks.
Emanuel Derman of Goldman Sachs, one of the growing number of former physicists working in investment banking, puts the financial world's physics envy into perspective. "There is no fundamental theory in finance. There are no laws." In finance, he says, you are playing against people, who value assets on the basis of their feelings about the future. "These feelings are ephemeral, or at best unstable."
The art (not science) of valuing shares may be getting harder because of changes in the nature of the economy, creating even greater scope for bubbles to form. When the bulk of a company's assets were physical and its markets were relatively stable, valuation was more straightforward. Now a growing proportion of a firm's assets — brands, ideas, human capital — are intangible and often hard to identify, let alone value. They are also less robust than a physical asset such as a factory. As Enron showed, a reputation for trustworthiness, and the market value resulting from it, can vanish in a moment. The dotcoms pushed this valuation challenge to extremes, often expecting investors to put a price on profits that would not be forthcoming for many years, and would be derived from business models and intangible assets such as brands that had not yet been created.
To Pop or Not to Pop
But back to Mr Greenspan. Messrs Smithers and Wright, having dispensed with market efficiency and established that asset bubbles are possible, next take issue with the Fed chairman's belief that central bankers are supposed to control only inflation, not asset prices. They argue that the downside of a bubble bursting — possibly some combination of depression and deflation — far outweighs the cost of raising interest rates to stop the bubble forming in the first place.
The Fed does take asset prices into account in its policymaking, but only in so far as changes in them are transmitted to demand in the economy and thus potentially affect the rate of inflation. The likely transmission mechanism is the "wealth effect". As share prices rise, people feel better off and spend more; as they fall, people feel poorer and spend less, reducing inflationary pressure.
In practice, Mr Greenspan has seemed to act on the wealth effect only after share prices have fallen. For instance, when prices tumbled after the collapse of LTCM, the Fed cut interest rates sharply, and shares started to recover at once. This has given rise to the notion of a "Greenspan put": just as an investor can set a floor for the price of a security by buying a put option, so Mr Greenspan will provide a floor for the stockmarket by cutting interest rates when it gets too low for his liking.
Reader Comments» Post a comment