Wow! Close your eyes and try to remember the roughest, bumpiest road you’ve ever traversed (in my case, it’s a close race between four-wheeling experiences in East Africa and Southern Mexico). Now imagine the scariest, rickety, wooden roller coaster you’ve ever seen. What would it be like if the roller coaster were mounted on the bumpy road? Go one step further. As you rattle and plunge along on this contraption, you’re not safely strapped in a padded seat. Instead, you are astraddle the meanest bull that ever entered a rodeo arena. Got the picture? That’s roughly what it was like on the stock market over the past week.
Some days the market collapsed; other days it rose at near record rates. The amazing thing was not the magnitude of the swings, dramatic though they were. The shock was the volatility from the opening bell to the banging of the gavel. Multiple swings of several hundred points in a single day were commonplace; in fact, they often happened in a matter of minutes. On Tuesday, I said to a colleague that I had not seen this much movement since the wild gyrations in 1987. Sure enough, when the day was over, the Volatility Index reached the highest level since that time. The fluctuations were far more radical than those observed when the markets reopened after September 11. The situation even has the Fed talking about lower interest rates despite definitive signs of economic growth.
The Volatility Index is a decent and very widely followed measure of swings in the market. It is calculated based on patterns in options trading in securities that track the overall market. It has only been around since 1993, but nerds like me can calculate it further back in time. The technical aspects of this measure, however, are much less important than one simple question—Why?
Since we haven’t dealt with a situation quite like this one before, all I can do is give you my opinion. As a general proposition, there is nothing inherently wrong with volatility. In fact, as markets improve their efficiency and process larger quantities of information more rapidly, volatility is an expected outcome that actually enhances profit opportunities. That is a basic law of markets (and mathematics and thermodynamics, for that matter).
The current market behavior, however, is different. With a general pattern of recovery and almost 90% of firms meeting or beating their earnings estimates, there is no rational reason for such widespread swings in value. It is simply not the case for cumulative future prospects of leading American firms, which is what the market should reflect, go up or down 5% in a single day when nothing extraordinary happens.
That the difficulty stems from the current credibility crisis goes without saying. The larger and more perplexing issue is the nature of the mechanism that causes it to happen. First of all, it doesn’t matter if a high percentage of companies make their numbers if nobody believes them. Academic studies have shown for years that even the best of markets tend to overreact to short-term information. At present, however, the very structure of the system is at issue. Without the basic underpinnings that we normally take for granted, the process that invisibly reconciles supply and demand no longer works. In effect, investors are set adrift.
When this phenomenon occurs, mass psychology replaces orderly market clearing. Overreactions become chronic, leading to selling frenzies followed by buying frenzies. Volumes accelerate to record levels (which they have), and the persistent tendency to exaggerate the importance of the latest bit of information is blown completely out of proportion. Even good news is at times greeted with negative reactions, as a firm in the spotlight for any reason is a potential target of the fickle and uncertain masses.
We have begun the process of rising confidence, but we are not yet there. We can take some solace in the fact that “this, too, shall pass,” from sheer exhaustion if nothing else.
Form Over Substance As I have repeatedly stated of late, the current crisis in financial markets is a source of genuine concern. It is not a passing reaction to a few bad numbers, an external shock, or disappointing earnings. In fact, the economic statistics are good, no major new threats have surfaced, and a number of companies have “beat the Street” in their performance. Even the irascible Mr. Greenspan is talking things up. The problem is at the core of the market itself—people don’t believe the numbers!
Having defined the problem, there is a political feeding frenzy to find solutions. The President is talking tough (although the market doesn’t seem to be listening), the Senate unanimously passed a bill, the House passed a weaker one (the leadership is trying to keep it weak but is facing mutiny among many members from both parties as it goes to a conference committee), and state officials around the country are putting their two cents worth in as well.
At the same time, there is a fierce lobbying effort behind the scenes to weaken the proposed restrictions; many trade associations are walking the fine line between appearing to support reforms and not alienating their members; and accounting boards and regulators are scrambling to prepare new guidelines.
The main source of controversy revolves around the treatment of stock options in corporate records. The reformers want to treat them as current expenses, thus reducing reported earnings and (at least theoretically) providing a more realistic picture of overall performance. Most corporations (probably temporarily—but they don’t know that yet) fear dire consequences from such a change and are resisting mightily (though quietly). There are a few exceptions. Coca-Cola and Bank One have decided to account for their options as expenses, and I suspect others will follow. The market is in a mood to reward disclosure, and that in and of itself is a powerful force.
The strange thing about this whole issue is that, despite the intensity of the battle, it is really much ado about nothing—a classic case of form over substance. The “substance” is the information itself; if it is fully and properly disclosed with no shenanigans, it doesn’t matter where you put it. The thing that the market does best is process information. If it has the right data, it will accurately assess and value firms with marvelous efficiency.
If the options are recorded as expenses, the market will instantaneously adjust to the fact that “new” earnings and “old” earnings are not the same thing. It will look to future prospects, not past numbers, in setting stock prices.
On the other hand, if the options are reported elsewhere, the market will assess performance with full knowledge of the effects of dilution (and analysts will most likely publish earnings with and without options included); investors will respond accordingly. Either way, the adjustments occur within a matter of nanoseconds, and the outcome is the same.
I like the idea of including options in expenses, but all the fuss is misplaced. If the market has the right information, the market knows what to do with it. The key is to get the substance right; the form is irrelevant.
A Summer of Discontent I was saddened by the passing of Ted Williams. Despite the unfortunate circus created by his family, the majestic presence of this baseball icon cannot be diminished. I missed his greatest years, as I was only seven when he powered the last pitch he saw through a gray mist and into the stands of fabled Fenway Park.
My boyhood was framed around the final years of Musial (my personal favorite) and some of the best of Mantle, Mays, Aaron, Koufax, Gibson, Rose, Killebrew, Clemente, Kaline, and Robinson (Frank and Brooks). It was the era prior to free agency, when even a superstar and household name was lucky to earn a six-figure salary and many players had to have another job during the winter to make ends meet.
As in many other sectors, the advent of organized labor and competition for talent has led to much higher levels of compensation, with multi-year contracts in the hundreds of millions of dollars becoming ever more common. At the same time, profits to the major league teams have risen and even minor league games are enjoying increased popularity.
As is also the case in other industries, however, the strife between labor and management has threatened the very viability of the system that brings prosperity to all sides. At present, there seems to be little hope of avoiding a work stoppage. The last one, in 1994, had a devastating effect on the game, with its comeback in the past few years being tied largely to individual achievements which captured the imagination—Cal Ripkin, Jr.’s quest for “Iron Man” immortality and the 1998 home run race that at times even managed to knock Bill and Monica out of the headlines.
Such events cannot be counted on to repeat themselves, and the timing of the current dispute could not be worse. Part of the unique appeal of the “National Pastime” is its link to heritage and patriotism. Ted Williams a war hero; Jackie Robinson a major figure in the quest for human dignity and equality; Babe Ruth the hope of America through the Great Depression. Even the national anthem first gained popularity at a World Series. The prospect of not playing on the anniversary of September 11 and potentially canceling a World Series a month later is not pretty.
People are gravely concerned with an apparent level of greed which led many major corporations to improperly represent their performance. This issue is dominating political and economic discussion at present, with many worried about the future of their lifetime savings and retirement security. Against this backdrop, there is likely to be little sympathy for owners and players in what is essentially a dispute between multi-millionaires and billionaires over how to carve up the monies provided by and large by folks of far less means. To top it off, the All-Star Game ended in a tie because the best (and most highly compensated) in the game were unwilling to play long enough to allow the game to be finished (14 pitchers appeared for 1 inning or less). In a twist of irony and a sign of the times, the Most Valuable Player Award was named in honor of Ted Williams, yet couldn’t be bestowed on any of the players in this “non-game.” Williams, Musial, and company often played the entire All-Star Game, with Stan the Man (who played in more than 20 of them) once ending it with a 12th inning home run.
One of the issues confronting the equity markets at present is the tendency for corporations to overemphasize short-term stock price movements at the cost of long-range prosperity. We have seen that phenomenon in spades in recent months. Baseball is in danger of a similar error. There are legitimate issues to be resolved (including franchise inequities between large and small media markets), but a work stoppage at this time may well dramatically shrink the pie from which the various slices are obtained. Although it won’t be easy, these matters can be worked out while the game goes on.
Although I’ve never been a big fan of umpires, one of their classic quotes is appropriate to this situation. “Play Ball!”
Lemons and Rocks 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.