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                                             The Nature of Markets

 

 

 

Globalization, the trade of natural resources, labor, and capital around the world, is a universalizing force. Economics is the study of universally rational human behavior. But economic logic, the study of equilibrium, requires no markets. The following essay introduces the reality of markets into the investment discussion and discusses navigating the 2008 environment.

 

 

Take for instance the simple economic tradeoff between two goods, in this case the classic consumer tradeoff between wine and bread. Behind this simple graph are significant assumptions about rational human behavior:

 

 

 

Information and Individual Choice

 

The neoclassical theory of choice assumes that a consumer has full information on every product and its effect on his welfare. In other words, he knows the world and himself perfectly.

 

 

 

Calculability and Optimality

 

A consumer is able to calculate an ordinal measure of his welfare, utility, and to maximize his satisfaction by consuming an optimal combination of goods within budget constraints, represented by the line ab. At current prices, he could buy eight bottles of wine or eight loaves of bread; however the consumer will maximize his utility by consuming an optimal bundle of wine and bread, in this example four bottles and four loaves.

 

Progress and Happiness

 

This graph can also illustrate the increase of consumer welfare by improvements in the means of production and distribution. Increased productivity will lower the prices of wine and bread, resulting in more utility. If you meet an economist, call him a hedonist. A recent Brookings Institute study reports that absolute levels of increased GDP per capita are related to increased levels of happiness. 

 

Whether applied to profit maximizing firms on the supply side or to utility maximizing individuals on the demand side, economics makes these key assumptions of rationality. The following discusses the personal dimensions of value investing and suggests the conditions that are conducive to rational 1 markets.

 

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Value investors are concerned with the principle of rationally calculated investment value, purchasing stock at a discount from its intrinsic value. What does being concerned with principle require? (At this point, our readers will probably note.) Being concerned with principle, one author states, requires a certain maturity and a knowledge of one’s long-term interests. That states perfectly, on the personal level, what value investing is all about. Think about Warren Buffet. How then does a value investor cope with turbulent markets? Falling markets unearth investment opportunities; it’s just that simple.

 

Our discussion about financial markets however proceeds further to the current credit crisis as an example. Real markets respond to events and swing (error-correct) around a valid, econometrically determined and rational equilibrium point. Thus, MIT economist Charles Kindleberger writes in Manias, Panics, and Crashes (2000 ed.), “It is much easier to agree that most markets behave rationally most of the time than that all markets do so all the time.” 2 We have shown that the U.S. stock market, the result of group behavior, error corrects moderately around a rational equilibrium when events are predictable. It can, however, respond wildly to large and unique events whose quantitative import is unclear, either good like the invention of the Internet or bad like large OPEC price hikes or present credit and foreign policy problems. People impute meanings to events, sometimes excessively under uncertainty.

 

At the level of society, what causes market turbulence? How to deal with it? Whereas societies are based upon values that are generally (we’re being very careful about this point) similar, markets are based upon values, perceptions, wants – an economist would say parameters – that are different. As an example, lenders rushing for liquidity. Markets can be highly turbulent when rapid change occurs. Our reasoning at this point necessarily goes beyond the quantitative into the analogical. Kindleberger writes in the language of medicine: describing the fever of speculation, contagion, and the pathology of high leverage. In a recent book, Richard Bookstaber (2007) uses the language of physics. Describing the panic of 1987, he writes:

 

The huge volatility of the market broke down all but the most fundamental relationships between the market securities. The usual day-to-day world where investors cared about subtleties like corporate earnings or analyst forecasts dissolved as the energy of the market was turned up. All stocks moved together; if it was a stock, it was sold. The market hardly differentiated between domestic and foreign, small cap or large. It was like plasma physics. As matter becomes hotter it becomes less differentiated…just a seething white-hot blur of matter. 3
 
             

 

 

 

 

 

 

 

 

 

 

 

No rationality and stable asset correlation factors there.

 

Although each economic downturn has its differences, Kindleberger elucidates certain stages in the pathology of crashing markets. We paraphrase and repeat from an earlier article.

 

Speculation begins when:

 

                            1)  There is an exogenous shock to the macroeconomic system such as 

                                 the outbreak or the end of a war, a bumper harvest, a crop failure,

                                 adoption of an invention with widespread effects... .

 

                             2) The monetary means of payment is expanded by the banking system,

                                  the development of new credit instruments.

 

                             3) Euphoria results in the overestimation of future profits, or we would

                                  say the underestimation of risk.

 

                              4) Excessive gearing (leverage) arises from cash requirements that

                                   are low relative to the price of the asset.

 

                              5)  As the number of firms and households involved grow large,

                                    speculation for profit leads away from normal rational behavior

                                    to what has been described as "manias."

 

                              6) The speculation detaches itself from really valuable objects

                                   and turns toward delusive ones.

 

                              7) At some stage, a few insiders decide to take profits and sell

                                   out. At the market top, there is hesitation as the purchases of new

                                   speculators are balanced by insider sales.

 

                               8) There ensues a period of financial distress, as it is perceived

                                    that there is risk to the overestimated profits and that markets

                                    cannot go higher. For the economy as a whole, there is the

                                    perception that a rush for liquidity may develop. The next

                                    stages may or may not happen.

 

                               9) Prices decline as the race is on to be out of real

                                    or long term financial assets and into cash.

                             

                              10) Prices fall to the point that people are again tempted

                                     to move back into less liquid assets, markets simply

                                     cease, or a lender of last resort such as the Fed succeeds  

                                     in convincing the market that there will be enough money                 

                                     made available to meet the increased demand for liquidity. 4

 

 

This model allows us to put the current subprime mortgage crisis in the context of previous crises. For step 5, fill in the originating subprime lenders’ failure to do the most elementary credit verifications that might “kill the deal,” as they shoveled money out the door 5. For step 6, fill in the funding creations of structured finance: the SIVs, CDOs, CDO2, CDO3, and so on.  However, all crises have their differences. The scope of this credit crisis is different from those previously because it now extends around the world from a town in Norway that invested in subprime CDOs to the canyons of Wall Street, involving the largest economy in the world, accounting for nearly 25% of the world’s GDP.  When people are uncertain of the values in markets, they simply cease to trade. Forget about return on investment when return of  investment is the major concern, and so on. Needless to say, seized up financial markets are not good for the real economy because of restricted credit flows.

 

In this environment, what is a value investor to do. The prescription of value investing is simple. When a stock has a high margin of safety (that is a current price sufficiently below the calculated equilibrium price) hold your nose and buy. Due to the many moving parts in this current financial crisis – deleveraging, globalization, government policy, developing recession in the real economy – that’s not what we’re going to do, exclusively.

 

When adding stocks, we’re going to establish initial stock positions during difficult market moments and then phase in when we think the general market has bottomed and is beginning to recover. That is how we’re going to apply the principle of value investing to present economic realities.    

  

               

              

Footnotes

 

 

 

                                            

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