Re: flow or stock?

[Clifford Poirot <cpoirot@xxxxxxxxxxx>]

Paul,

 

I think there are at least two parts to your message. In part I where you discuss the EMH,  I am pretty sure we do not disagree (though we seem to be talking past each other) on either its meaning, implications, or inapplicability. Just to be clear, I said that the EMH states that prices for financial assets must accurately reflect all known information, and only unanticipated information will change stock market prices. You elaborate on this theory and note that if it is true, then stock market prices must also accurately value real underlying asset prices. You rightly reject this idea, as do I, and I am not sure where you ever got the idea that I believed in the EMH.

 

If I understand you correctly, you are arguing people buy financial assets for speculative purposes only "to sell to a greater fool" as you put it. Suppose I accept your argument for the moment. Why would I think a financial asset would go up in value, or down in value. In other words, what would make me want to buy and what would make me want to sell. If I understand your past arguments correctly, you might argue it is essentially a beauty contest with bull believing the stock beautiful and bears seeing it as yesterday's movie starlet. To complicate matters, it is not just what I think of the stock's "beauty" it is also what I think others think that matters as well.

 

To which I say-all well and good-but what makes people think that others think....Is it entirely subjective? I would argue no-it is subjective interpretations of various sorts of "objective" information people receive that they interpret and process in numerous ways. Which is to argue that people look at the prospects for both short term and long term appreciation at least in part based on the financial health of the company (or factors that they think might affect the financial health of the company). As I pointed out to Barkley, I never have to receive a single dividend check. All I need to know is that the company has solid earnings prospects if not today, then I believe tomorrow. And I think it is pretty clear where I part company with the EMH-I do not believe this information can ever be complete and accurate or fully known in the present, and no one knows for sure what is going to happen tomorrow. But I can make reasonable distinctions between finanacial assets that I have reason to believe will be stable in long run returns and those that are speculative, and those that are mere Ponzi schemes.

 

As to the second part of your argument: I have never actually seen where Stiglitz makes the "noise trader as fool argument" though I can see why he might make that argument. I do not agree with it and that is not what I am saying. People speculate because they want higher returns and believe they can get it. They succeed enough that there is a fairly strong incentive to do so. Soros made an incredible amount of money off the "noise" associated with the British Pound. Using other people's money did not hurt him either.

 

Upon more careful thought, I might amend my previous argument and concede people can buy postage stamps or baseball cards for the same speculative motives people buy financial assets. I don't think this changes the point. They buy postage stamps because they believe the price will rise. But why do they believe the price will rise? Stamps, as you point out, do not give you a claim on the Post Office's assets. But as you point out, the Post office can indeed effect the value by issuing more stamps. So what? That does not change the fact that people make guesstimates about future values of financial assets based on a subjective belief about a company's long term financial prospects.

 

Growing liquidity does not change this. The loan and mortgage consolidators buy the loans because they see a potential for return. The sellers sell because they would rather make new loans, and sell them, thus getting the cash today and turning over their portfolio. I do not see how that changes the fact that people buy financial assets on the basis of expected future value and that expected future value (though often wrong) is based on how people interpret future prospects for performance.

 

Finally, we both lack hard data on how many people buy long term treasury securities for "Security". I doubt it is as out of fashion as you think. But let us ask why the price of 10 year bonds has gone up, and yields have plummeted. I say it is because people's expectations about the future and present earnings of stocks have gone down.

-----Original Message-----
From: Paul Davidson [mailto:pdavidson@xxxxxxx]
Sent: Saturday, August 03, 2002 8:30 PM
To: Clifford Poirot
Cc: pkt@xxxxxxxxxxxxxxxx
Subject: Re: flow or stock?

At 02:30 PM 8/3/2002 -0400, you wrote:

 

Paul Davidson

 Those who propagate the belief that stock prices reflect future dividend (or even income) flows is a reflection  that these "economists" have not yet been sable to slough the skins of the irrelevant efficient market hypothesis of mainstream economics.

[Clifford Poirot]

To argue that people buy financial assets on the basis of expected future returns (be it in the form of anticipated dividends, earnings or capital appreciation) is not the same as accepting the efficient market hypothesis-by a long shot. The EMH says all current prices reflect all known information, and only new information moves prices. The EMH assumes the information is correct, and that in the aggregate, any mistakes in anticipation cancel each other out. I would argue that people buy on the basis of expected future returns, but that for many reasons (including, but not limited to uncertainty) often wind up being wrong in their expectations, and that prices do not reflect all known information. So this is far from the EMH.

Sorry Cliff but you do not understand  the logically consistent efficient markets hypothesis.  As I said  in my answer to Barkley :

The efficient market hypothesis says that all these financial markets optimally allocate capital based on the expected future earnings (marginal product?) of capital. Remember Cliff, if the markets are efficient and people are rational (and therefore have rational expectations) the spot market price of titles to capital at any date  is equal to the discounted future earnings of the underlying capital goods -- and since rational expectations require subjective probabilities equal to objective probabilities-- these future earnings are the actual ex post earnings when tomorrow becomes yesterday!!"

If on average expectations are correct or as you put it " The EMH assumes the information is correct, and that in the aggregate, any mistakes in anticipation cancel each other out" then the spot market price of titles to capital at any date  MUST BE equal to the correct discounted future earnings of the underlying capital goods . That's why these markets are EFFICIENT for their price each day is correct in terms of  being  the capitalized present value of the ACTUAL future earnings of the capital assets they represent.

 If on any date the price does not reflect the correct present value , then the markets cannot be efficient.

Moreover if  as you say  The EMH assumes the information is correct, and that in the aggregate, any mistakes in anticipation cancel each other out.,
then one cannot explain bubbles , etc.  Stiglitz always has this problem with his asymmetric information approach to financial markets-- If you look up my article on "Volatile Financial Markets and the Speculator"  (which I gave to a plenary session of the Royal Economic society a few  years ago) -- it is on my web page I believe --you will see that Stiglitz gets himself into a logical inconsistency when he tries to explain speculation over the last two hundred years. 

Basically my argument is that if markets are efficient -- at least in the long run -- and those (from Peoria in Stiglitz's analysis) who are noise traders and think (erroneously) that they know more than the market  and speculate, then those noise trader "fools" should be wiped out by the efficient market so that they all die within a generation -- the Social Darwinist survival of the fittest of efficient market theory--and people learn not to be so foolish.  So how does Stiglitz explain the continuous --over centuries -- existence of noise traders!!  He quotes Barnum "There is a sucker born every minute!" as the explanation for the fact that efficient markets do not kill off all the noise traders within a generation.

But if that is true in financial markets it is also true in product and service markets and therefore markets will NEVER be efficient in the classical sense that only the best and most profitable things that people want are produced!!  In other words the whole efficient market theory for product markets is also nonsense.

I am amazed Cliff that you have not realized that the baloney of efficient markets -- and information  that textbooks and mainstreams regurgitate ad nausem -- is just that baloney.

When students present this argument I confront them with the following real world example.

 While I was at Rutgers a colleague of mine collected stamps as a professional occupation.  His collection was so valuable that he had to keep it in a safe deposit box at a bank. (Therefore he could not get any utility from looking at these beautiful pieces of paper as some mainstream colleagues argue when I present them with this example. Nor could many of these bits of paper even move a letter through the mails --since they were often cancelled -- and even if they could move a letter they could not be worth more than their face value.)   Yet he continued to buy and sell parts of his collection. Why?

These pieces of paper certainly did not represent a share of the future profits of the post office (That's a laugh since most postal systems lose money.)

Did these bits of paper represent the Marginal product of the post offices which issued them?  Or was it (as I have argued is the same for any liquid assets in a nonergodic system) the "buy to sell to the bigger fool theory"?

[Clifford Poirot]

Paul, I must protest this example as bordering on the invidious. Did your students really let this go unchallenged? Do you characterize stamps as a "financial asset"? Stamps are a rare commodity, and their rareness or uniqueness makes them valuable.

When you say rare what you are indicating is one of the two essential properties of all liquid assets  that Keynes discussed in ch. 17 of the GT -- an essential characteristic of anything that might be considered for trading in liquid markets have an elasticity of production = zero so that if the demand for this item rises, labor can not be hired to produce more of the  same item.  Keynes recognized that Old Masters and Land played the same role as liquid financial markets "historically" and i would only add  postage stamps (that are rare only because the postal service decides not to print any more of the same stamp--- and rarity disappears as soon as the postal service prints more as my  Dag Hammersjold stamp example illustrated.

 Your colleague may have been unable to derive pleasure from looking at stamps, but most collectors of anything rare value things due to their rareness. Nonetheless, they buy on the basis of anticipated future values-or-to obtain an opportunity to buy another item. When I collected baseball cards as a teenager, I placed on a disproportionate value on the Yankees. Yet I would trade Yankee cards if I thought it might bring me something equally as good-like say -Pete Rose. What made the value of Pete Rose (or Thurmond Munson, or Bobby Mercer...) high? It was anticipation of their current and future performance. The same with rookie cards.

 

Nonetheless, I was never able to parlay my minimal baseball card collection into tradeable liquidity (though others I knew were to a very limited degree).

If you cannot it is only because no one has organized an orderly market for resale-- See my many wrttings on liquidity where I explain what the characteristics are that permit one to organize such markets.

For example, the development of "securitization" in recent decades have converted many financial assets that were not liquid (because resale was difficult if not impossible) into liquid assets. In fact previously most commercial bank loans were not liquid and remained on the portfolio of the lending bank until the borrower repaid the obligation. At that point of time, bankers had to worry about the ability of the borrower to meet his debt service obligation.  But with securitization, banks do not hold the loans they make-- they bundle them and sell them to pension funds, mutual funds, etc and make their money on the fee for originating and servicing these loans!!   In my new book FINANCIAL MARKETS, MONEY AND THE REAL WORLD, I provide statistics to show that most commercial bank loans are resold within days of origination so that less than 20% of the new loans in any year remain in originating bank portfolios.  This has converted bankers from cautious lenders to "loan pushers" both domestically and internationally!

Such items are not the same as the purchase of financial assets.

See my comments on securitization of formerly nonliquid financial assets into liquid financial assets above.

Another example: In the 1970s the US postal system offered a  stamp for Dag Hammersjold (spelling may be wrong) a former UN official that had died..  After the end of the production run, a person in Peoria told the media that he had obrtained a sheet of these stamps where the picture was reversed --and the owner explained how  since this was so rare he expected to sell this for millions at a stamp collectors auction.  The U.S. post office found out about this as the TV media picked up the story , and they decided to print  sheets of the stamp with the picture reversed.  As soon as that was announced guess what happened to the value of the original sheet of misprinted stamps?

[Clifford Poirot]

And this is a perfect example of unanticipated information changing the value. Why did its price fall? Because now its anticipated future value had changed.

No it is an example of a high elasticity of productivity because the postal service had not yet destroyed the plates for printing the stamp thereby making sure the stamp would not be a "rarity" (in your terminology)

One final fact, several years ago (before the Clinton Administration started retiring the 30 year Treasury Bonds, statisitcs indicated that the duration that people held a 30 year Treasury was on average less than 180 days. In that case who cares about future stream of interest payments?

[Clifford Poirot]

Anyone who is buying and selling Treasury Bonds-because the decision to buy, hold or sell will be based on anticipated changes in bond prices and yields. Nonetheless, I would like to see these statistics. I'll make a guess that professional bond traders and bond funds held the bonds for short term purposes to trade in response to short term market movements, in an attempt to push fund yields up a few basis points (and also generate management fees). I would hazard to guess that the "average" investor who bought Treasury bonds for long term income and safety, held them for much longer.

Really -- that idea went out with John Galsworthy!!

Regardless, why would I buy or sell a bond if it was not in anticipation or in response to, actual or anticipated changes in yields.

The important thing to recognize is that if an orderly, well organized market for a durable (with low carrying costs) exists, people will hold it for speculative purposes primarily --

[Clifford Poirot]

To speculate: I thought that meant in anticipation of future yields or values?

Yes but you must be speculating that you KNOW better than the market what the correct future yields (in terms of present value) are going to be-- but your own statement "The EMH assumes the information is correct, and that in the aggregate, any mistakes in anticipation cancel each other out."

means that the market "knows" better than the speculators -- if the market is efficient -- and both the bulls and the bears are wrong!

And as I have argued in my just published book FINANCIAL MARKETS, MONEY AND THE REAL WORLD a liquid market is not an efficient market -- and, in a nonergodic  uncertain world, an efficient market cannot be a liquid market.

Do you see why?

Paul

Paul Davidson

Editor, Journal of Post Keynesian Economics

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University of Tennessee

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