Are the markets telling the truth?
The opening month of 2016 has been marked by sharp falls in asset prices, not just in financial markets but in commodities such as oil. The conventional wisdom is that the markets form a rational assessment of future prospects for the economy, and set prices accordingly. So if prices fall, we should be downgrading our forecasts for economic growth.
The underlying theory is that shares in any particular company only have value because of the future stream of dividends which the owner of the share will receive. If the outlook for the economy becomes gloomier, the expectation becomes that firms will not make as much profits, and dividend payments will be reduced. So share prices fall.
It sounds plausible. But in recent years, developments within economics have cast serious doubt on whether financial markets are rational in this way. A key player has been Robert Shiller, professor at Yale and winner of the Nobel Prize in 2013. The title of his first paper on the topic, published as long ago as 1981, summarises his argument: “Do stock prices move too much to be justified by subsequent changes in dividends?”
Shiller looked at data from the 1920s onwards, and showed that stock prices moved up and down to a much greater extent than did dividends. This excess volatility, as he called it, was confirmed when evidence going back into the 19th century was examined. If dividends are meant to determine prices, yet shares fluctuate much more, there is clearly something wrong with the theory. Although his article was published in the top ranked American Economic Review, it was originally widely regarded as a bit weird. Gradually, however, as events unfolded like the 20 per cent crash in share prices in a single day in 1987, his arguments became more persuasive.
Recent years have seen developments which reinforce Shiller’s point. In February 2015, for example, Brad Jones published an IMF Working Paper on asset bubbles. He points out that the value of globally traded financial assets increased from some $7 trillion in 1980 to around $200 trillion now. Even more importantly, banks no longer dominate the market. The value of assets under management of investment firms is now nearly as large as that held by the large global banks. People have become richer, are saving more, and look for companies to manage their money.
Jones argues that the incentives facing asset managers lends itself to herding behaviour and excess volatility in the markets. The tyranny of the quarterly report drives decisions. A fund simply cannot risk taking a view which is too contrary to that of the consensus. A manager may eventually be proved correct, but if in the short term loses money, investors will simply pile out of his or her fund.
Ironically, of course, large falls in markets still have the capacity to be self-fulfilling. By destroying the value of wealth, they reduce future spending. Still, it was another Nobel Laureate, Paul Samuelson, who famously remarked that “the stock market has forecast nine of the last five recessions.”
As Published in CITY AM on Wednesday 27th January 2016