Re: Re pension funds

[Oliver Kamm <oliver.kamm@xxxxxxxxxx>]

James R. Olson, jr. wrote:

> The capital gains themselves are currently viewed as the income flow from
> stocks.  This is a large part of what makes the current bubble dangerous,
> and why I proposed that certain of those parties proposing sinking SS into
> the stock market are simply looking for more funds to sustain the bubble.

The capital gains are what accrue to the investor as a result of the firm's return on
its retained earnings. There's nothing speculative or unusual, still less dangerous,
about this. If a firm judges that it can generate a higher return for shareholders
than the shareholders can themselves, it will tend to have a low dividend payout
ratio. If its judgement is right, then future earnings will be enhanced, the book
value of the firm will increase, and, ceteris paribus, the stock market will reward
the firm for its investment decisions (i.e. provide the firm's shareholder with
capital gains).

I argued in a previous letter that, if that is the motivation for the proposal you
refer to, then it's misplaced, as an influx of funds has no effect on the price of the
stock market - stock prices are not set by shifts in supply and demand functions.


> Another problem with your pure rationality analysis of price setting in the
> market is the fact that prices are set by bid, which means that, no matter
> what rationale is used for making bids, the most optimistic bidder(s) sets
> the price.  This means that stocks are normally overpriced, except in a panic.

I'm not sure what a pure rationality model would look like, unless it be the view that
stocks are always priced exactly in line with their intrinsic values. Not even the
most hard-line supporter of the Efficient Markets Hypothesis believes this (the EMH,
though it has different forms depending on the information set being considered, is
usually thought of as the proposition that stock prices fluctuate randomly around
intrinsic values).

Stock prices aren't set by the most optimistic bidder, they're set by the arbitrageur,
who can operate on either side of the transaction. If a buyer wants to pay over the
odds, then arbitrageurs will compete among themselves for the opportunity to sell to
him at an inflated price - which will, of course, mean that the price thereby settles
back at something closer to the stock's intrinsic value.

> If you reject the bandwagon effect, there's no way to account for bubbles
> or panics, either.

Sure there is, though I would question your use of the term "bubble", which assumes
what it is you're trying to prove. If new information becomes available that causes
the consensus of investors to revise their judgement of the stock market's value
radically, then huge and rapid price movements will result. Consider what happened to
the UK stock market when sterling left the European Exchange Rate Mechanism - not a
bubble, but a rational response to new information.

Regards,

Oliver Kamm