Back when I was tall, I wrote a book about the Texas economy during the turbulent 1980s. It was organized around the notion that “the most important thing is what people think.” This concept certainly wasn’t novel. The idea that expectations drive human (and, hence, economic) behavior is a vital part of the analytical framework of economics, psychology, sociology, and philosophy. These disciplines, as well as mathematics and statistics, devote considerable attention to the subject of how our expectations are formed, with no real consensus beyond the fact that they’re a response in some fashion to current and past information.
I will now segue abruptly into the fundamentals of markets. (I’ll tie it all together later.) From the time of Adam Smith more than two centuries ago (and even earlier in practice), the principles of supply and demand have been slaves to accurate information. I feel quite certain that fleet-footed opportunists moving nimbly through the tents of traders along the Silk Road more than a millennium ago were arbitrageurs that brought prices into harmony over miles of burning sands. Pick up any basic economics text today, and it will tell you that access to reliable information is essential to the proper functioning of markets. Information is the rock which forms the foundation of modern markets, and it is no mere coincidence that the rise of complex global markets in recent decades has paralleled unprecedented advances in our ability to assimilate, transmit, and communicate information.
As a final awkward transition, there has been considerable path-breaking research in economics (including some landmark findings by recipients of last year’s Nobel Prize) regarding the concept of “information asymmetries.” This highbrow name is nothing more than a stilted, academic way of saying that markets can do strange things when buyers and sellers have different levels of knowledge. One of the most famous applications is the market for “lemons;” cars with ongoing problems manage to sell quite well simply because the buyer does not know as much as the seller.
Pulling these disparate, but valid, propositions together gives us a good indication of what is going on in today’s equity markets. As various major companies released ever more impressive financial reports, investors expected (quite rationally) that this pattern would persist. “What people thought” drove them to purchase large volumes of shares in these firms, thus pushing prices to stratospheric levels.
But, alas, the gains ultimately proved to be a veritable orchard of lemons. Through an impenetrable web of accounting sleight-of-hand and off-the-books chicanery, the sellers managed to maintain far more information than the buyers. The result is inevitable, whether in questionable used cars or seemingly superlative blue-chip equities, that buyers pay too much.
When this situation occurs, as of late, often enough to suggest that it is something systematic rather than a random event, it shakes the very foundations of the market. If information is viewed as unreliable, the rock begins to crumble. When expectations go awry because of the uncertainty of the economic world, there are winners and losers. While investors who don’t achieve desired returns are disappointed, if they perceive they have been part of a fair game, they are likely to play again. When they don’t believe the game is fair, however, investors often opt not to play at all. In such an environment, the stock market can remain in the doldrums despite a recovering economy. Sound familiar?
Fortunately, the problem lays the groundwork for the solution. Some additional regulation may be appropriate. One of the legitimate functions of government in a market economy is to establish the framework in which competition can thrive. Allowing the keepers and checkers of vital data to regulate themselves while taking additional lucrative assignments from those they are supposed to monitor may be an insurmountable obstacle to the proper functioning of the market. In reality, however, much of the needed discipline will be imposed by the actors themselves. We now have an explicit (we have always had an implicit) market for reliable information. Accountants with impeccable reputations will be rewarded; companies with “clean” records will be rewarded; and those who distort their true performance will be dealt with severely. This process, which is already underway, will continue until confidence is restored. Once that happens--and it shouldn’t take long given the efficiency of modern markets -- stock prices will again reflect the enormous long-range potential of the US economy.