Tuesday, July 16, 2002

stock market heresy Send this entry to: Del.icio.us Spurl Ma.gnolia Digg Newsvine Reddit

stock market heresy I used to work in capital markets, where I developed a heretical disbelief in the stock market. "Why," I'd ask anyone who'd listen, "should a share of MSFT stock be worth anything?" The initial answer I'd get involved dividends, in response to which I'd point out that Microsoft doesn't pay dividends and seemingly has no plans to start. Next someone would point out buybacks -- MSFT returns cash to the shareholders by buying back stock. But selling my stock back to MSFT is no more beneficial to me than selling it on the market (which I could do without a buyback, likely at close to the same price) -- the benefit (if there is one) is to those who keep the stock and "own" a larger share of the company. My friend Norm would then steer the topic to earnings. Imagine, he'd say, that Microsoft's future earnings have a net present value of $100B. Then Microsoft should be "worth" $100B, and so one share (out of a billion) would be worth $100. I'd grant him that under his circumstances, the whole company should be worth $100B, in the sense that someone would be smart to buy it for a price less than $100B and someone would be smart to sell it for a price above $100B. Nonetheless, I couldn't make the mental leap that my one share should be worth $100. After all, I couldn't drive to Redmond and demand my "piece" of the company. And when Microsoft reported $5B of earnings, there was no $5 check for me. In what sense, I'd ask Norm, was I really a one-billionth "owner"? After a while he came to agree that I really wasn't. And (here's the really heretical part) insofar as my share of stock doesn't represent any real ownership, there's no reason its market price should be related to the value of the company. In fact, except for the fact that people are willing to buy it from me, there's no reason it should be worth anything. (In contrast, gold can be used to make jewelry, grain can be eaten, Beanie Babies are huggable, etc...). What it boils down to is that, for the most part, the stock market operates on the greater fool theory:
[The b]elief held by one who makes a questionable investment, with the assumption that he/she will be able to sell it later to a bigger fool.
Now as long as most of the people in the market believe that a stock's value should be related to a company's earnings, there will be some connection. But it's a connection that rests solely on that belief. If everyone woke up tomorrow and decided that MSFT stock was only worth a dollar, then MSFT stock would only be worth a dollar. By way of analogy, the Hollywood Stock Exchange (which is interesting in its own right) offers ArtistStocks:
An ArtistStock™ represents a musical artist that is traded on the Music Market™. It's an ownership [sic] stake in a musical artist (solo, duo, or group) whose value will fluctuate based on market supply and demand. So, you should buy an ArtistStock if you believe its price will go up (meaning that other people will be picking it up) and sell if you think its price will drop (people are selling).
In this instance the misuse of "ownership" is much clearer, since the HSX is not even connected to the actual artists. And yet the Music Market makes its own attempt at fundamental analysis with the Spin Factor:
A high Spin Factor signifies a lot of hype and a potentially good investment.
Now, as far as I'm concerned, ownership of a share of, say, PJ Harvey is only superficially different from owning a share of MSFT. (It's true that the share of MSFT gives me 1 vote out of 1 billion in how the company is run -- but the practical value of this is zero.) Hence it is with a mixture of amusement and confusion that I watch stock market commentary. Currently, for instance, people are complaining that the stock market keeps going down, despite positive economic indicators. Larry Kudlow, for instance, offers the unjustified assertion that
today's market averages look to be nearly 40% undervalued.
To me this seems no different from asserting "Today's Beanie Market is 20% undervalued" or "Today's Top Ten ArtistStocks™ are 35% undervalued" or "Today's Pokemon Market is 30% undervalued." It amounts to a mass prediction of investor psychology. It's like trying to predict what's going to be fashionable next year, or which new TV show is going to be the "sleeper" of the season, or who's going to be elected President in 2008. Of course, people can guess and even clothe their guesses with statistical analysis to lend them a scientific veneer. And so many people are guessing that a few of them will build track records of "knowing what's going on." (Just as if you pair up 1024 people in a single-elimination coin-flipping tournament, one of them will flip 10 heads in a row. This does not make him a coin-flipping "expert.") But even track records aren't that important. Jim Glassman, who runs TechCentralStation, published a book in 1999 claiming that the Dow was heading to 36,000. (Incredibly, here's a fairly sensible Krugman article about the hypothesis.) But this hasn't affected his credibility -- he's still getting his predictions published today. (Similarly, biologist Paul Ehrlich, who has a track record of being spectacularly wrong when it comes to economics, is still approvingly cited as an "overpopulation expert.") So why do we listen to stock market "experts"? Well, Elizabeth is a stock market expert, so maybe she'll tell us. :) Update: the instapundit points to this CSM article listing a bunch of possible excuses for the "disconnect" between the market and the economy. This all reminds me of one of my favorite stories:
In Munich in the days of the great theoretical physicist Arnold Sommerfeld, trolley cars were cooled in summer by two small fans set into their ceilings. When the trolley was in motion, air flowing over its top would spin the fans, pulling warm air out of the cars. One student noticed that although the motion of any given fan was fairly random -- fans could turn either clockwise or counterclockwise -- the two fans in a single car nearly always rotated in opposite directions. Why was this? Finally he brought the problem to Sommerfeld. "That is easy to explain," said Sommerfeld. "Air hits the fan at the front of the car first, giving it a random motion in one direction. But once the trolley begins to move, a vortex created by the first fan travels down the top of the car and sets the second fan moving in precisely the same direction." "But, Professor Sommerfeld," the student protested, "what happens is in fact the opposite! The two fans nearly always rotate in different directions." "Ahhhh!" said Sommerfeld. "But of course that is even easier to explain."

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