For a few exciting minutes on Thursday, the Dow-Jones Industrial Average was down a thousand points, with some major stocks momentarily falling to a penny a share. The basic story appears to be as follows. Initial strong selling in some stocks such as Procter & Gamble led the New York Stock Exchange to halt trading temporarily in a few stocks until specialists could sort out what was going on. But trading in those stocks continued on other exchanges, where as a result of their thinner books, orders to sell at any price went far down the list of existing buy bids. These lower prices triggered further automatic selling that sent some stocks all the way through the list of outstanding bids until encountering basement bids at one cent a share.
One popular meme is to attribute these fireworks to the existence of multiple trading venues that didn’t all get shut down simultaneously (e.g.,
WSJ or NYT). But I think we should also be taking a closer look at the folks who were sending the sell orders rather than just blaming the exchanges for carrying out the instructions they received.
Let me frame my discussion of Thursday’s drama in terms of two very different views of what your strategy might be for investing in stocks. One view was articulated by John Maynard Keynes on page 156 of his General Theory:
professional investment may be likened to those newspaper competitions in which the
competitors have to pick out the six prettiest faces from a hundred photographs, the
prize being awarded to the competitor whose choice most nearly corresponds to the
average preferences of the competitors as a whole; so that each competitor has to pick,
not those faces which he himself finds prettiest, but those which he thinks likeliest to
catch the fancy of the other competitors, all of whom are looking at the problem from
the same point of view. It is not a case of choosing those which, to the best of one’s
judgement, are really the prettiest, nor even those which average opinion genuinely
thinks the prettiest. We have reached the third degree where we devote our intelligences
to anticipating what average opinion expects the average opinion to be. And there are
some, I believe, who practise the fourth, fifth and higher degrees.
Is there an alternative interpretation of what gives a stock value, apart from what others think that others think it might be worth? Most assuredly there is, and the easiest way to understand that value is to contemplate buying a stock with the intention of never selling it, simply passing it on to your heirs, and from them to their heirs. Is the asset, if used in this way, of any benefit to you? Sure is, because even if you never sell the stock, you and your heirs can expect to receive a dividend payment from the company four times a year as long as the company stays in business. Those dividend payments will grow if the company’s earnings grow over time. Even for a stagnant company that sells exactly the same number of units each year, in an inflationary world the dollar prices of those goods (and therefore the number of dollars you receive in dividend payments) should grow over time.
The average dividend yield on stocks in the S&P500 at the moment is about 1.8%. The yield on a 30-year Treasury Inflation Protected Security is also about 1.8%. On one dimension, with equal yields stocks might seem more attractive than TIPS, since nominal dividends will grow faster than inflation. On the other hand, stocks are much riskier, because nobody knows for sure exactly how big those future dividend payments are going to be.
Historically, investors have demanded as risk compensation a significantly higher average real return from stocks relative to bonds than is reflected in the current equality of dividend and TIPS yields; the average dividend yield on stocks over the last 30 years was 2.8%. That means that if we return to average historical evaluations, stock prices would fall. I made this point from some related calculations last December. There I suggested that when Professor Robert Shiller’s long-term price-earnings ratio was above 20, it was time for caution. That ratio exceeded 22 at the April peak, but with last week’s correction is now just above 20. Here’s an update of the graph I discussed in December.
 |
Whatever your stand on how to evaluate the tradeoff between risk and return, if you take the above perspective that the value of a stock ultimately derives from the stream of dividend payments that it delivers to its owner, then when the stock price goes down, it becomes a more attractive asset for you to buy, whereas when the stock price goes up, it is something you should consider selling.
But, you might ask, isn’t is possible that other people know more about those future dividend prospects than I do, so if they’re selling, maybe I should sell too? It’s not just possible that others know more than I do, it’s a certainty. But, let’s suppose that one minute ago I was persuaded that ahead of us was normal dividend growth, and the next minute something caused me to change my mind and believe that dividends were about to go through a meat grinder like we experienced during the Great Depression of the 1930s. As I showed in illustrative calculations in March of 2009, that Armageddon-level revelation would reduce the rational price I’d be willing to pay for most stocks, in the sense that I’ve been sketching here, by about 25%. The news that actually arrives on a given day would of course have a vastly more modest effect on how your calculation should come out. If overall stock prices fall 10% in the space of a few minutes, you can almost be certain that it’s not because anybody’s rationally-calculated fundamental valuations have declined by that amount.
Alternatively, you might argue, if stocks were 10% (or more) overvalued on Wednesday, as indeed I’ve just suggested that they may well have been, then couldn’t a dive of the magnitude we saw in the intraday excitement on Thursday be perfectly rational? Maybe so. But the Wednesday close and the Thursday intraday low price can’t both be rational– if one was right, then the other has to be wrong. More importantly, the time to make up your mind about that question is in the quiet of some Sunday afternoon, not when the crowd around you is suddenly panicking on a particular Thursday.
Let’s take a look at one of the amusing examples of trading on Thursday. Exelon is a perfectly sound utility. The stock started and ended the day at about $42, yet at one point allegedly changed hands for a penny a share. If you are the owner of 100 shares of this stock on Wednesday May 12, the company will send you a dividend check for $55. They’ll send you another $55 (and likely eventually even more) every 3 months thereafter, as long as you own the stock. What rational person would possibly prefer to have $1 on Thursday May 6 in preference to owning 100 shares of the stock, say, for at least another week?
No sane person ever would. I wonder how many of the sell orders came not from actual humans, but instead from instructions programmed to execute automatically by computers. Anybody following such a strategy is obviously not a subscriber to my theory of fundamental value, but instead seems to be playing Keynes’ beauty contest game, having persuaded themselves, based on the historical correlations, that when the crowd starts to sell, if you can instruct your computer to sell at the “market price” faster than a human can even think, you’ll come out ahead.
Economists and financial engineers seem to approach stock markets differently. The financial engineers often see the game as figuring out whatever the historical predictability has been and trying to get ahead of it. Economists tend to ask what the equilibrium in the market would look like if everybody played the game the way the financial engineers do. The answer to that second question is, if momentum-chasing algorithms come to rule the financial world, those who try to follow them will be the biggest losers.
Another notion that’s popular with many financial gurus these days is the claim that you can eliminate certain risks to your portfolio with the right strategy of automatic trading and stop-loss sell orders. Again that claim invites an economic question– if you are getting an insurance policy, who is selling it to you? I believe the implicit answer is, you are counting on the market-maker to insure you by taking the other side of your escape transactions. But the curious thing about such an insurance policy is that the market-maker gets to decide what premium to charge you after you ask to collect on the policy. You just might find that the state of the world when you and your buddies all most desperately want to cash in on your insurance is exactly the time when the premium proves to be ruinously expensive.
Or if I haven’t persuaded you with these arguments, let me try a more modest suggestion– those of you whose computer programs sent an order to sell Exelon even if you only get a penny a share might want to consider tweaking the code just a bit.
And my advice for sane humans trying to deal with such a crazy market is this: as a first step, ignore all the other beauty-contest judges, and ask yourself whether the flow of future dividends you expect to receive by itself would be adequate compensation to you for your investment, given the risk associated with not knowing exactly what those dividends are going to be.
If it is, then allow yourself to relax as the computer programs written by the other contest judges try to devour each other.
If it’s not, then you’re in the wrong place at the wrong time.
The tendency of the stock market to extract and control the disposition of most of the value created by the real economy is distressing. But I see no way to tame the beast.
Professor Hamilton gives me hope that the beast will self-distruct. I want to believe that. But that outcome is too easy. Thursday was an aberation. In addition, the stock market officials talk about erasing extreme trades. Apparently, no one is going to loose or gain enough to spoil play. The officials are going to do all they can to make sure that their baby does not self-destruct.
Using a high-yeild mutual fund as an income source is one way to follow Prof. Hamilton’s logic.
Two points: First, the idea that stocks are any sort of hedge in an inflationary environment is a little difficult to jive with the experience during our most prominent inflationary bout from 1968-1982. If TIPs were available in 1968, they would have been a much better buy.
Second, the flow of dividends expected by holders of DJIA components like Citi, GM and GE in 2006, and their assessments of risks, were probably a little off the mark.
I think you are misinterpreting what’s happening. The market-glitch story may explain the 1,000 point intra-day fall, but not what happened over the last ten days.
Professor Hamilton,
What would happen if we limit the role of stock exchanges to just sell IPOs? If that was the case, then only long-term investors would be attracted to the market (those that trully value stocks for their fundamental value).
Investors could always buy/sell stocks on a secondary market (but not in exchanges) in the same manner I buy my used car or sell my bike in craiglist.
The only function of the markets is to channel funds to productive investments. What is the economic contribution of stock price volatility (rational or irrational)?
When, rather than keynes are we going to give attention to real sciences,when it comes to explain subprime,equities markets, and handling of the world economies that is sovereign risks and their bonds?
I found Daniel Bernoulli and the paradox of St Petersburg much more educative.It provides room for the events,causes and profit expectation in accordance to the bet size.
I bet some of the sellers who sold at absurdly low prices were small investors who placed stop-loss orders without really understanding what they were doing.
Moreover, some more sellers were probably investors who would have figured out that selling at an absurdly low price was a theoretical possibility, but noticed that nothing like that had happened yet and so did not worry about the possibility.
So we have two classes of sellers:
1. Buggy computer programs, and
2. People who placed marker sell orders confident that they would receive something close to the price of the last trade.
Do you have any evidence that most of the sellers were in category 1 and not in category 2?
RA2000,
That is the way it was done in 17th century Europe, but it is so much more fun doing it with Skynet.
Personally, I think fair value on the S&P 500 is about 800, and that is where I got out (unfortunately). But unlike Keynes, I think beauty is in the eye of the beholder.
My reasoning sort of follows Schiller’s with my forward looking view of a long term GDP growth of 2%. Schiller’s chart shows we are above PEs of most of the Great Bull Market and back then we had average 4% GDP growth. I call 1998-2000 outlier data. If you believe stocks are a discounting mechanism, then the PE should be much lower for slow growth. This would also imply slower dividend growth.
But I’m the only one that thinks that.
Limiting the stock exchanges to IPO’s is a nice idea, RA2000, perhaps. The problem I see is that people want to gamble in a game where the value of the assets are always growing (historically accurate though the future is unknown). And they want to be sure they will receive ownership for dollars sent to purchase. We are willing to take a chance on that when the dollars involved are small (as a bike or a car). But we want some certainity of exchange of value when a serious investment is being made.
I am afraid stock exchanges will continue to serve the need for certainty of ownership exchange. And stock exchanges apparently are growing rapidly outside the U.S.
There are plenty of food for thoughts in markets gyrations but figures may tell more of the truth
By Christine Harper
May 10 (Bloomberg) — Goldman Sachs Group Inc.s traders made money every single day of the first quarter, a feat the firm has never accomplished before.
GS as many other banks in Europe are stepping on the fat tail of the Gauss curve more often than probable.
A parallel look at the occ report may draw attention on capital limits as imposed to a commercial bank
http://www.occ.treas.gov/ftp/release/2010-33a.pdf
Banks and associates are the docile instrument of a purpose the cleansing of weak aspiration to become rich.
Besides playing the financial markets where are the plans (The treaty of the Union?)
http://www.bis.org/publ/work300.pdf
The S&P has been attempting to return to a price level that is justified by profits since Y2K. The central bank has been attempting to slow this process down. The dividend yield was 1% in Y2K, and is only up to 2% a decade later.
It is no longer a market based beauty contest, but a guessing game regarding the philosophy of a small committee.
Columnist Alan Abelson puts last week’s computerized-selling debacle in perspective in this week’s Barron’s: 50 to 70 % of trading is now high-frequency, and the new market structure “at every turn sacrifices protection of long-term investor interests for the profitability of serving hyper-leveraged intraday speculators.”
Never stay sane in a crazy market. Markets do not follow a random walk. Volatility clusters. If the Dow dropped 1000 points yesterday, it probably means your portfolio today is a lot riskier than you thought it was a week ago.
Markets sometimes figure things out ahead of analysts. Stock prices may not keep up with inflation, even if earnings do, because inflation reduces the the real value of depreciation deductions, leading to a higher effective tax rate on profits. This phenomenon may have been important in the performance of equities during the inflation of the 70’s.
The stock market is a complete waste of time for the average person. It hasn’t done anything in over a decade. Stick your money in some bonds, or if you’re adventurous, do a joint real estate venture in Asia (foreigners can’t solely own land in most Asian countries).
Professor Hamilton, your discussion contains a logical fallacy: a rational investor with a firm view on the value of a security would never place a market order, nor a bare stop-loss order, etc; instead, they would place limit orders with appropriate values (accepting some loss from perceived true value as a liquidity preference during an unusual event).
Retail investors are the (naieve, unfortunate) people who place market orders, and they are routinely on the losing sides of these, even in calm markets. In markets undergoing transitions and displaying extreme volatility, market orders lose big.
It’s been a long time since I’ve worked with people on the algo side of this business, but IIRC, there are incessant penny bids/asks in all electronic markets; these are used to probe and measure the liquidity in these markets. (I don’t remember the exact mechanism used, apologies.) Thus, these prices don’t reflect algo engines gone wild, but rather I believe that if you investigate these trades, you will find that the other side of these trades were bare market orders, likely from retail clients.
All this said, I sincerely hope that the push here is not to somehow make markets ‘safe’ for naieve people! (It’s not appropriate to label a naieve person an ‘investor’, as investing requires shedding any notion of naievty.) Then again, seems to me that the dominant modern theme of our American government extending its paternalistic coverage is alive and well…..
Of course, if we trully want to protect the naieve participants, we could eliminate market orders: require all participants to declare a price they are willing to transact at. Retail investors would no doubt wail and gnash their teeth, with their resulting inability to get any orders filled – which would be quite a demonstration of the care and consideration that the retail gambler, sorry, investor, actually puts into market transactions.
One way to make the market more stable would be to move from shorter and shorter trading intervals to a system that cleared the market once a day.
I think Warren Buffett said that he would be happy with markets that only let him trade every few months or years. This may not benefit Wall Street, but it could benefit Main Street.
investors have demanded as risk compensation a significantly higher average real return from stocks relative to bonds than is reflected in the current equality of dividend and TIPS yields
Professor
Does this assume that dividends grow at the rate of inflation? Since 1947 (using S+P data) dividends have grown at a real rate of 2% in the US. Nominal rate over same time period 5.6%. Non-US those rates are even higher.
Professor,
Another excellent post. Thank you.
I don’t believe that experienced investors use automatic stop-loss or trailing-loss orders. They may use downside sell price targets but manually input them.
I suspect that overall markets were behaving much more rationally than JDH suggests given what I observed. The share prices of blue-chip Canadian telcomm companies hardly budged or continued to increase during the turmoil. Resource company valuations traded down sharply but that makes sense to the extent that if European fiscal woes managed to slow global economic growth, commodity prices could be expected to decline sharply.
In passing, I would opine that many North American market pundits don’t seem to have a very good understanding of Europe.
About 70% of S&P stocks pay dividends. I always wonder how that fact changes the “discounted future income stream” valuations, because without dividends, you’re back to the beauty contest Keynes alludes to.
Flubber: A stock may not be paying dividends currently, but my presumption is that some day as the company grows and matures it will start paying nice dividends, in which case the calculations above apply perfectly well. If you are holding a stock that you are persuaded is never going to pay any dividends, I cannot explain why such a security has value to you or anybody else.
Due the structure of tax laws, where dividends are essentially double taxed, first as earnings for the corporation, then as earnings for the individual, it is often more profitable for investors to not be paid dividends at all, but for the company to instead employ those funds in a repurchase of it’s own stock. Investors thus receive capital gains income when they sell, which is taxed (for most) at a lower rate than dividend income.
As this has increasingly become the trend, especially since about 1982, payout rates have fallen. Many mature established companies today have never paid dividends, from Dell Computer to Berkshire Hathaway. Payout ratios for the S&P 500 have fallen from about 55% from 1940-1970 to 47% for the last 30 years, to only 35% for 2003-2007.
Value investors today tend to look at tangible book value, earnings, and cash flows, the things that could in theory be used either to pay dividends, to reinvest in the business, or to repurchase shares.
This makes the point using dividends a bit misleading. At the 30 year average payout rate that 1.8% dividend yield might be more like 2.4%. Still lower than the 2.8% 30 year average, but by more the same degree as your estimate based on earnings. I would still put fair value no higher than about 975 for the S&P 500 (about 13 times the 2010 earnings estimate).
Why do we think algos (computer programs) are responsible for the rapid decline and not the rapid recovery on May 6?
May 2010 was much better Oct 87 when the uncertainty lasted for days.