Friday, September 23, 2011

Inefficient Market Theory

"If obfuscation clouds public debate and sidelines reform, many confidences that bona fide investors have in the capital markets may be irreparably harmed." - Mason Hawkins

The economy isn't operating at full strength but, as the excerpt below points out, it's sure not because of the consumer.

In the U.S., consumer spending makes up the bulk of gross domestic product. This Barron's article points out real consumer spending already exceeds its 2007 highs but...

"The sick man of the economy—and the original cause of the bust—is that broad category called "gross private domestic investment," meaning investment in plants, equipment, software, housing and inventories. Despite some gains, real gross private domestic investment is still more than 16% below its peak of fourth-quarter '07."

It turns out consumer spending is alive and well. What makes up 70% of gross domestic product has been surprisingly stable.

As the article points out, the problem is that job creation depends to a great extent on the remaining 30%. In fact, something like more than than half the jobs are created there.

So increasing the amount and effectiveness of "gross private domestic investment" is key. For a variety of reasons that seems to be where the trouble lies.

Corporate cash balances have grown to rather high levels as have excess reserves at banks. Fixing this so-called capital strike will likely come down to changing a bunch of factors over time, both systemic and psychological, that currently dominate the investing environment.

Creating certainty when it comes to putting capital at risk would certainly help. Policies that investors and businesses see as unfriendly is a part of the problem.

The memory of the recent crisis also contributes to the reduction in "animal spirits" no doubt.

To an extent, when it comes to an apparent capital strike, it seems fair to point to the uncertainties created by things like an aggressive regulatory environment and other government policies. Those are easy targets but definitely real factors when it comes to getting businesses to invest.

Yet, whether a direct contributor to the capital strike or not, we also need capital markets to get back to basics.

What seem like (or, in fact, are) less stable capital markets can hinder confidence. When that happens businesses and individuals, at least at the margin, naturally hunker down. The numbers above, of course, suggest it is investment by businesses that is taking the biggest hit right now.

One question worth asking: Have the substantial changes to capital market structure in recent years amplified some of what has always been inherently manic tendencies?

Capital markets exist to foster capital formation and allocation. That is their primary purpose or reason for being. I'd argue that role has become weakened in recent years.

I happen to think, when it comes to the essential role of transferring capital from investors to businesses, the evolution of capital markets to their current form has got to be a net negative and not a small one

These days, we have something that better resembles a casino where people, and increasingly computers, make rapid fire bets all day long with the main purpose seemingly an afterthought. This CNBC article points out:

- High frequency trading now accounts for something like 70 percent of volume
- The average holding period for U.S. stocks now: 2.8 months
- The average holding period for U.S. stocks in the 1980s: 2 years

Stock Market Morphs into Casino

Not good. Keep in mind that the average holding period was even higher, more like 4-8 years, from the 1930s to the 1970s.

In the past twenty years or so, a disproportionate amount of the emphasis in markets has become gambling and speculation in lieu of investment. The excessive and frenetic activity means frictional costs are unnecessarily high. It also means, with a disproportionate amount of "stock-renters" involved, the system operates more like a capital misallocation machine.

Inefficient and ineffective with mispricing the norm.

I think it is fair to say that renters*, at least compared to long-term owners of an asset, do not think nearly as much or as carefully about what something is worth, could be worth, and whether its potential being nurtured properly by those in charge.

We have too many rental oriented market participants involved these days.

It's, unfortunately, the triumph of gambling and speculation over investment.

First and foremost, capital markets should facilitate the allocation of capital from investors to businesses. As Mason Hawkins and his colleagues said in this letter, "markets do not exist as an end in and of themselves", their purpose is "transferring capital from investors to productive businesses that can provide a return on that capital".

Capital Markets: An Overshadowed Servant to Traders?

It seems we've become, in many ways, somewhere between neglecting the importance of high quality capital formation and allocation to downright being hostile toward it.

Adam

* How carefully is a rented automobile driven? Well, it's a completely different context, but the driver likely worries a whole lot less about the long-term viability of the underlying asset. Short-term renting changes behavior whether it's a car or a stock (part ownership of a business). If most participants are only willing to commit capital for days, minutes, and these days even seconds or less, what's the chance they are going to pay attention to whether the board of some company is doing its job? Equities aren't trading cards. They're partial ownership of some mostly rather useful assets. Those who think this situation doesn't impact the real economy and ultimately reduce wealth creation I have a nice, well-maintained, rental car to sell them.
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