So the stock market is irrational. So what?
Michael Kinsley has a new piece in Slate this week purportedly offering "proof that the stock market is irrational." As the someday-to-be-author of a book tentatively titled The Myth of the Rational Investor (due out early next year, if I get cracking on the rewrite), I ought to agree with him. But I just can't bring myself to. Maybe it's because he unfairly disses my buddy Milton Friedman. Or maybe it's because, after dumping on the stock market for 900 words, he offers no plausible alternative.
Kinsley bases his argument on the current boom in private equity, and the fact that the private equity guys are almost always able to resell the companies they buy for more than they paid for them. The details are different, but the principle is the same. Private investors buy a company from its public stockholders. They have a letter from an investment bank saying the price is a fair one. They usually have the support of management, or they actually are the management. The public stockholders have little choice. But time and again--surprise, surprise--the investment bank turns out to be wrong. The company is actually far more valuable! (And any bank that can't be counted on to get this wrong will not be in this profitable line of work for long.) Soon, the company is sold at a large profit, either to another company or back to the public. So far, so indisputably true. And Kinsley is right to say that this state of affairs casts some doubt on the efficient market hypothesis, the theory that the stock market always accurately reflects all available information about the companies traded on it. If the market is efficient, he asks, how can the same company sell at three different prices depending on who happens to be doing the buying and selling? Actually, you can make an efficient-markets argument to explain the price discrepancy, as scholar Michael Jensen has been doing for the past quarter century: Private-equity-owned companies (a.k.a. leveraged buyouts) avoid a lot of the conflicts between owners and managers that plague publicly traded companies. The owners (the private equity guys) are clearly in charge, and therefore their companies are run better, and worth more. Kinsley allows that this might be true, but then argues: [I]f these deals aren't a swindle, then the stock market itself is a swindle. It does not maximize value for its working- and middle-class investors. The stock market leaves money on the table waiting for "private equity" to swoop down and pick it up. Furthermore, Milton Friedman was wrong, and the other famous economist who died this year, John Kenneth Galbraith, was right: The free market in corporate shares doesn't produce well-run companies. I wasn't aware that Friedman had ever claimed that it did. He was not a believer in the efficient market hypothesis, at least not in the extreme version of it that held sway at the University of Chicago Graduate School of Business (and a lot of other business schools) in the 1970s and 1980s. As he put it to me a couple of years ago: We all know the market is not efficient in a descriptive sense. But that doesn't mean that the efficient market is not the best approximation if you don't have anything else to use. And that's really the key. In our current system of stock-market-driven capitalism, corporate insiders make out like bandits, investment banks skim millions for themselves, and private equity firms profit repeatedly off the mispricing or mismanagement of public companies. Yet, somehow or other, stock market investors have made more than 10% a year since 1926. That doesn't necessarily mean they will in the future--but I also wouldn't be surprised if a lot of the private equity deals being closed these days go sour, too. There's just too much money flowing into the sector for all of it to be invested wisely. Over time, though, private equity will continue to serve as a useful alternative to the inevitably conflicted management model of the publicly traded company. And without the public equity markets, the private equity guys would never be able to cash in. It's a symbiotic relationship. Is it also a messy, wasteful way of doing things? You bet. Got a better alternative? Galbraith never did, which is why he will go down in history as a brilliant critic with few constructive economic ideas of his own (Thorstein Veblen with much better table manners) while Friedman's legacy lives on in policies and institutions that affect our lives every day. As for Kinsley, he's still the cleverest political pundit of the past couple of decades (in print, not so much on Crossfire). But he had a seriously wrongheaded piece about stock option accounting in Slate a few years ago, and now this. Maybe it's time for him to take his business commentary private. (This should, of course, dramatically increase its value, enabling him to charge much more per column when he takes his opinions public again in a couple of years.) "We all know the market is not efficient in a descriptive sense. But that doesn't mean that the efficient market is not the best approximation if you don't have anything else to use."
This was also Hayek's view -- and you can find him saying the same thing in rather similar language. Hmmmm.... u imply that 10% a year since 1926 is a good deal. I guess that if my father were alive and if he had actually had $100 to invest in the market in 1926 right after he arrived in North America and wouldn't have to contend with a depression and a half-dozen wars, his $100 would be worth the princely sum of $204,000 today. Of course, he did have those minor economic hiccoughs, not to mention dying in 1961 from tobacco-induced lung cancer. That did put a crimp in his economic prospects, if you know what I mean.
The market will always be messy, that's almost the definition of a market. What it doesn't have to be is unethical, irresponsible and predatory. Burdensome regulations such as Sarbanes-Oxley help a bit to level the playing field but it is going to take something far, far more radical to make the markets more than a tool for the few well-connected or very clever to enrich themselves at the expense of the many who actually work for a living. Seems the private equity companies evaluate many public companies, and then buy only the ones they think can turn around at a profit, therefore the high success rate.
Not a better idea but at least an improvement would be a strengthening of the laws against "acquisition fraudulent conveyance." That topic is a little arcane to explain here, but if the laws were stronger it would reduce the ability to over-leverage the LBO's and at least moderate and improve the situation by eliminating the most corrupt LBOs. I can explain it if you like, but it takes a lot of words.
An acquisition fraudulent conveyance occurs when the company takes on more debt as a result of the LBO, which debt usually liens on the assets, than it could reasonably expect to pay off out of its post-LBO cash flow. If the LBO is found to be a fraudulent conveyance "equitable subordination" is the result; that means the LBO lender is junior to the unsecured creditors. Lenders typically make this test when making LBO loans. But the statute of limitations are too short in most jurisdictions and proving the fraudulent conveyance is difficult especially for a bankruptcy trustee who may not have a lot of assets to use in the effort. Tightening the law here would tend to reduce the amount the buyout could borrow and the percentage of time the acquired companies later went bankrupt. Corporate governance is not a solved problem. Management sometimes faces a conflict of interest. Michael Kinsley is right on this.
A stockmarket is nothing more than an algorithm (today implemented on computers) to match offers and bids for shares (aka supply and demand). As a neutral processing algorithm, a stockmarket is inherently incapable of being a fraud. Although there is noise in stock prices, as Kinsley points out, the noise does not have the serious consequences claimed. It is quite possible to invest successfully in the stock market. Moreover, the stock market plays a central role in the allocation of capital. It works, and there is no known alternative that works. That's why Kinsley's carping on this is pointless. A properly run stock market is an activity that is purely voluntary and consensual on the part of all players. None of the players seems be complaining that the stock market in itself is a fraud. If Michael Kinsley thinks the stock market IS a fraud, he can refrain from participating. This would seem to leave all participants satisfied. Unless ... Michael Kinsley feels he needs to protect the capitalists from themselves. (With some kind of tax?) Perfect stock prices will never be available to us (i.e., stock prices that accurately give the discounted value of the future stream of dividends). One problem is lack of agreement on the discount rate. Another problem is that perfect stock prices would constitute an accurate prediction of future events. An accurate prediction of future events is logically problematical. The reason is that people will use the information to alter their behavior, and thus will alter the object of the forecast. Suppose a perfect stock market existed. A company could look at its stock price and see if it was going to be a success. If the stock price indicated success, everyone could take a year off, because the prediction is known to be valid regardless of any behavior on the part of the staff. Clearly, a stock market that perfectly prices stocks would be a twilight-zoneish logical contradiction. This fact helps excuse actual stock markets for not being perfect. This article by Kinsley may be a joke. He ends up looking leftish, yet the outpouring of opposing comments effectively neutralizes the influence of his article, protecting any investments Kinsley himself has in the stock market. You gotta hand it to him: he has a sense of humor. This could also be one of those Japanese koan thingies, where you're supposed to solve a very puzzling problem. (E.g., What is the sound of one hand clapping?) Kinsley is a radical thinker who puzzles about the validity of our basic institutions, such as the stock market. Kinsley would be able to figure this kind of thing out, but why bother? Just write up the opposing view and read all the comments that come out -- providing the correct answer to the koan. Kinsley is subtle, but remember, he jokes around a lot. Why don't you just come out and say equity markets are rigged in favor of the richest 5% of the population? It is hardly a secret that those people control/hoard 90% of the nation's wealth.
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