The Price is Right?

“Rather the correct response is to address the market failure directly by imposing tighter environmental regulations.”

That is one way, certainly. But isn’t the real aim to internalize those costs which are currently external the market price mechanism? And regulation isn’t the only way to do that, tax also works (Pigou etc). Of course we could say that tax is a regulation, but for clarity shouldn’t the aim of what we’re trying to do be emphasised (internalising the externality) rather than one possible method by which we do so (regulation)?

From an entirely lay point of view “the best possible estimate of the value of the asset” opens to the retort “well, what other methods are there?” “Best possible ” is very different from “right”. A valuation can be not very good and still the best possible just as, say, a medical treatment can be not very good and still the best possible at our current state of knowledge.

Perhaps this is still me not getting it but if I were coming entirely anew to the subject, with JQ’s explanation as the only one I had (which I believe is the point of the book, the intended readership, no?) that is the point I would want answered. OK, so the EMH isn’t correct: but what is better than it? Even if it is not correct, is it still the “best possible”?

Given any possible set of investments, market participants can estimate the value of those investments by considering the likely immediate impact on the stock prices of the companies concerned, or the likely return in an Initial Public Offering (IPO).

I’ve read this several times and I’m still struggling. The impact of what on the companies concerned? The possible new investments? I’m guessing that you have in mind something like a rights issue, which is intended to fund some new venture which is in the set of possible investments. So we’re talking about investment in the economist’s sense: building an oil-rig or something like that. Then you seem to be saying that the marginal cost of equity capital to the firm, which can be derived from the impact of the rights issue on the share price, is in some sense a measure of the marginal return from the new project. But I’m reading between the lines and drawing on hazy memories of Copeland and Weston’s textbook, which I haven’t read lately. I think that sentence and the paragraph it comes from could do with a re-write. Endless confusion is caused by the fact that economists understand investment to mean additions to the stock of (usually physical but sometimes human) capital whereas to most people it just means buying securities. You might try making the point by telling a story or citing an actual example, if you can find a suitable one, of a company announcement and its effect on the share price.

Otherwise, a good post which goes some way towards meeting the concerns raised in earlier threads.

I’m puzzled by your discussion of the discount rate.

If different investors have different preferences for money now vs. money later, doesn’t this mean that there is no single “right” price, even if everyone agrees on the statistical distribution of the future income stream?

I can see how this could work if all investors were trying to maximize the amount of money they will have at some point in the distant future – then, the discount rate is observer-independent and determined by the best available investment strategy. But if some investors want or need to spend some of their gains in the near future, what then?

It might be worth giving “Tobin’s Q” a mention. Investment (i.e. new purchases of equipment etc) depends on Q. Q = Market value of Capital over Replacement Cost. When Q exceeds 1, market is implying that some new investment is worthwhile. Eventually the new investment drives Q back to 1. It’s a simple and old idea but it resurfaces in much more complicated contexts. Needless to say, EMH is critical in Q giving the right signal to real investment decisions.

John: can you direct me to any work on how general equilibrium/incomplete markets fit into this picture?

Concretely, suppose we have an economy with two sectors, one of which has very low transaction costs (call it the financial market) and one of which has very high transaction costs (call it the real estate market). Historically, it seems that real estate bubbles can trigger stock market bubbles (that’s certainly the conventional wisdom wrt Japan in the 1980s, say). But on the other hand, it seems like if you’ve got enough ability to hedge in the financial sector, you can ameliorate real estate bubbles. But I don’t see immediately how to figure out which effect wins, and when.

John, I don’t know what you mean by “non-specialist readers,” or exactly who your target audience for this book is, but these sentences:

“Given efficient markets, economic analysis suggests that the discount rate should be determined by the socially efficient allocation of the aggregate risk for the economy as a whole among individual consumers. This gives rise to a model of the determination of the prices of capital assets called (perhaps unsurprisingly) the Capital Asset Pricing Model, or CAPM. Economists who want to stress the point that the asset prices are ultimately determined by the preferences of consumers sometimes make this explicit and refer to CCAPM, the Consumption-based Capital Asset Pricing Model. ”

are going to be absolutely incomprehensible to 99% of non-finance people. Even for people with a background in economics, this paragraph doesn’t follow obviously from the previous graf, or from a conventional understanding of what fundamental investors — the ones who are presumably trying to get a stock’s price right — are thinking when they value a stock. I’d really revise this substantially before putting it in the book.

I’ve been thinking about this post, since it went up, partly because it coincided with a couple of comments I wrote at Economist’s View and elsewhere, trying to clarify a bit the EMH and its shortcomings. The attempt helped me appreciate how difficult is the task you’ve set for yourself.

I’m reminded a bit of Archimedes, thrilling to his own insight into the power of the lever, proclaiming, “Give me a place to stand, and I will move the world.” It’s hard to tell if you have a good grip on your lever, and even harder to tell if you’ve found a place to stand.

Finding a consistent point-of-view, in which your reader can feel secure enough to join you and rely on you as a trustworty narrator would seem to be critical to the success of your venture. Unless you intend to discard the whole of economic thought, modes of reason, and accumulated evidence, you have to have some method for drawing a bright line between sound and proven economics, on the one hand, and clever, possibly promising hypotheses and distillations gone awry, on the other. The reader needs explanations that start with solid foundations, on dry land, and that clearly indicate when and where the intellectual journey crosses into water and slippery sand, where an unexpected tide might carry one out to sea to drown.

Since The Definitive Truth has not yet been discovered, you are denied the easy convenience of a god’s-eye view of these disputations, where you know all the correct answers. If you were to take up, say, the gold standard, you might claim something akin to the historian’s conceit in knowing the end of the story, and be entirely correct in adopting contempt for a radical fringe of latter-day goldbugs. But, these issues remain somewhat unsettled, even if we all hope that some learning from error is taking place (and your own work may aid in fully realizing that); key questions remain unanswered, even if some answers can be safely rejected.

I’d suggest that the tried-and-true Hegelian narrative of thesis, antithesis, (failed?) synthesis might help to establish a progression of ideas and explanations: in the beginning, there was Graham-Dodd fundamental analysis. That gives you the opportunity to briefly explain the concept of present value. Then, financial economics established several important null results, that called the value to the investor of fundamental research into question, and suggested that risk was the key factor to be managed. Again, this narrative course would give you an opportunity to review the fundamental problem, while indicating clearly where the solid intellectual firmament had been surveyed.

It is still a difficult problem, both to indicate how things went wrong as ideas derived from EMH were translated into market investor practice and into ideology and public policy. But, at least the reader would have a sense of when economists waded off into the deep water with a defective life preserver. And, a reader without an MBA would have at least a few pages with explanations of sound and proven reasoning, without resort to poetic use of inexplicable jargon, before having to deal with the intellectually daunting task of appreciating how a simple, seminal idea was squeezed until it yielded poison.

I’m in agreement with KD at #4. That whole paragraph is completely devoid of meaning to me. More broadly I think this is a fine draft, but the language could be simplified and cleared up a tiny bit.

Isn’t there some value when discussing the EMH in talking about the expected value gained by a purchase or a sale? Isn’t the “right” price the one at which the value gained or lost in a transaction is as close as possible to zero? Or is this wrong, or simply confusing the issue?

Linguistic Nit-Picks:

“But, an EMH advocate will say, the answer is not to try and change financial markets, for example by promoting socially responsible investments.”

This is a silly pet-peeve, but one tries to change things, one does not try and change things.

Finally, I’m sure you meant to say “stocks and other assets” rather than “stocks and other asset prices “.

As this thread is kind of closed, I feel I can be excused for posting what’s become a rather long coda.

Re: regulation/tax as ways to deal with externalities – surely neither of these are market solutions since, for one thing, they both require centralised decisions and estimates. The market way would presumably be via alienable rights not to be subjected to pollution – at which point of course you get into transaction costs and issues relating to non-rivalness and non-excludability.

Agree that all mentions of EMH need to specify the version (on a Goldilocks model, I’d call them the too-weak-, too-strong- and just-right- EMHs. As this suggests, the JR-EMH is the main concern.)

I’d also suggest being more explicit in distingishing:
1. The JR-EMH itself, taken as going some way beyond the bare unpredictability thesis, and including important presuppositions and assumptions (What exactly does it say? Is it consistent, contentful, true, non-vacuous, based on evidence?)

2. Theoretical consequences of the JR-EMH (are various economists right about them given (a) a correct, and (b) their own, interpretation of 1?)

3. Practical/policy/strategic implications of the JR-EMH and its theoretical conseuqences (are various polemicists right about these, for similar (a) and (b)?)

Some observations on ‘Price as best guide to value’. Not a deductive argument, and (at the risk of deterring the reader on grounds of quality as well as quantity) a bit grope-y:

A. The JR-EMH supposedly entails that price is the best possible guide to value. (And interpreted so that it didn’t have that entailment, what use would it be?)

B. This tends, rightly or wrongly, to be taken to imply that price is at least a very close approximation to value.

C. That presupposes that there is a quantity called value, independent of the price actually paid in any transaction. And if not, then this supposed consequence of the JR-EMH would tend to become trivial: at the extreme, ‘x approximates y (and, btw, x is y)’.

D. I suppose that such economic value is to be assessed ultimately by reference to human benefit (preference, whatever). In valuing firms one would I suppose take some set of facts about the firm’s actual operations and calculate its net impact on humanity. (The free-market approach defaults to the belief that profit/loss accurately gauges that impact, though explanations are kept available in the bottom drawer for why, in any paricular case you care to challenge, that simplistic idealisation doesn’t actually apply – obviously!)

E. Let’s suppose we could get a comprehensive set of the ‘fundamentals’ so conceived (perhaps things useful for producing [things useful for producing…] things of human benefit) and hold preferences constant or otherwise account for them. We have some kind of measure of value.

F. It is implausible that past values in this sense should generally fail to be a reasonable guide to future ones. It is much less plausible that all relevant information about the past (and the predictions derived from that information, e.g. about mergers, likely success of new products, whatever) should fail to be a very accurate guide to future values.

G. So why are prices a random walk? The speculative (future-price-regarding) element in price determination is my bold conjecture. This obviously ties in with the JR-EMH setup (when inside info a la the TS-EMH is not at issue): First, it’s assumed that future prices are worth trying to predict – i.e. the aim is buy low sell high. Second, traders compete to get ahead and don’t act identically, but all of them are identically rational, and in the same informational position (EXCEPT they are ignorant of each other’s plans, beliefs, intentions, assessments etc. If they weren’t, there wouldn’t be any sense to competing at all. That’s a rough approximation but I’ll leave it there.) And BTW, the ‘random walk’ entails that all (non-insider) speculation is in fact gambling.

H. If the JR-EMH and its ancillary presuppositions are correct, then each trader has the information needed to determine the right price – no-one is privileged – and indeed all traders do converge on that price. But they cannot determine the future prices. The JR-EMH supposes that the same is basically true of value.

I. But (F) why woud you be able to predict current value so much better than future value? I would suggest the reason that this seems to be the case is again speculation. The thesis that price closely tracks value, combined with the fact that there is a speculative element to price decisions, basically forces the implicit thesis that there is a speculative element to value, too.

J There is a possible problem there because speculation is specifically about in including prices as determinants of value, when value is being used as a measure of ‘right price’. It’s not a common or garden circularity issue, because the prices are future prices rather than the current one. Also, they are mediated by expectations – it is the expectation of those prices that act to determine current prices. There are complications there, but still – if price tracks value, then it seems pretty odd that value should be determined with reference to future price.

K. The method of valuation suggested (on behalf of the JR-EMHer) in the OP seems to do this, because ‘resale value’ is actually in effect resale price. This could be eliminated by taking the risk- (and time preference-?) adjusted income stream from the stock into perpetuity (regardless of the ‘perpetuity’ issue, I don’t really understand what these adjustments would entail – but I don’t think I need to for these purposes.)

J. The method of making investment decisions seems to me to suffer from a similar but different problem: if price tracks value, why would one try to imagine the likely impact on price in order to decide the likely value? There is an air of bootstrapping here – I’m reminded of the advice ‘imagine a really clever person, and do whatever they would do’. If you are assessing the value, why do it via the price, which presumably based on the same considerations as would be involved in assessing value, but going on in other peoples’ heads?

Obviously, ‘IIUC’, ‘in my opinion’, ‘it seems to me’ and other humility-caveats should be inserted at all appropriate points.