In light of the Chinese, and also Japanese and US governments’ direct interference in their stock and bond markets, the following historical reminders may be in order:
On May 26, 1896, the Dow Jones Industrial Average, an index of a few companies at the time, was first published. Mr. Charles H. Dow, the driving force behind it, predicted that these companies, specialized in coal, copper, steel, flour, sugar, needles, wire nails, hay, glue and, yes, for a whimsical touch, whiskey, will shape the great industries of the future. For awhile, anyway.
Now, more than 100 years later, it is the right moment to look at the expanding stock markets around the world — and take stock. Why are people following with religious intensity the gyrations of stock market indexes around the world? Just what exactly can the institutions called “stock markets” achieve?
Correcting Mistaken Pricing
Economists and academics of finance have argued that stock markets perform two primary functions: help the investment of savings, and help raise capital for growing companies that, hopefully, would create future assets. They may be right — though the exchanges were certainly not consciously designed for finding solutions to these problems. The new 17th century Dutch Republic saw the first stock market being set up in Amsterdam, where people of all nationalities at the time traded — in sophisticated derivatives in particular. So let us use the occasion of Chinese stock market gyrations and see under what conditions do the buying, selling and holding of stocks achieve the roles assigned to them.
Mr. Warren Buffet once said that: “As far as I am concerned, the stock market doesn’t exist. It is there only as a reference to see if anybody is offering to do anything foolish.” This observation captures the essence of “stock markets,” even though at first sight it may not be clear how Mr. Buffet’s view leads to actions that redirect capital toward those who are expected to be more likely in creating future assets. At a closer look, the link becomes clear.
Management of companies make mistakes — without advertising them, of course. The mistakes must be discovered: people must find out that a company is indeed making a mistake, even though the management in question, analysts and the media may be praising the company’s strategies to the skies.
To make such discoveries, one must do serious detective work. This includes reading annual reports — with the footnotes, since accounting cosmetics covers much that would be revealing of company’s true performance; comparing one company’s management and internal organization with others’; having a broader vision where society is heading; evaluating what demands are of a more permanent nature and which ones are of a more temporary one; do the companies have — what I like to call — “a good measure of enduring uniqueness,” and do they sit on too much “lazy capital” and so forth. Just as there are few entrepreneurs with vision who do not adhere to herd instincts, there are only few good financial detectives who can do a better job than numerous others in evaluating companies not by their market value, but by other measures.
Mr. Buffet’s and other good financial detectives’ intervention and redirection of savings is, indeed, one of the ways in which stock and bond prices are adjusted, correcting the herds’ mispricing. In other instances financial entrepreneurs detect a void in financial markets and come up with innovative instruments and institutions to complete them: Michael Milken’s “high yield bonds” allowing companies to rely on bond markets rather than banks to raise capital has been an example of such an innovation.
The implications of these observations is simple: since the few good detectives do not have time to look at the valuation of all companies, discovering mispricing takes time, and it takes time too to grasp the implications of new financial instruments. Recall, for many years analysts, politicians, the media referred to the “high yield” market as a “Ponzi scheme” — even though by that time some of the rapidly defining companies of the 1970s and 1980s — in telecom, cable, medical services, casinos etc. — were all known to have been financed initially with high yield bonds. While investors gradually understand what is going on, some stocks would be traded at “foolish” prices, either very low or very high. During such times the “primary functions” that academics attribute to stock markets are not fulfilled.
However, such periods are of limited duration — we’ll discuss below what are some variables upon which such durations depend. Eventually investors uncover the mispricing, find financial solutions to correct it, and, by buying and selling, they adjust the market values of the companies in question, achieving stock markets’ “primary” roles.
Mr. Buffet is thus quite right. An increase in a particular stock price does not necessarily imply that the company in question will create more wealth, just like a drop does not necessarily imply that the particular company will create less wealth. However, when there are many independent sources of information, many players with independent sources of capital, and they are free to act, the buying and selling of stocks, and the introduction of financial innovations will correct the mispricing faster. As a result, savings get better allocated, and capital flows less toward managements who have made repeatedly mistaken decisions, which have destroyed wealth, and flow more toward the better managements, who create wealth.
When Stock Exchanges Create Wealth and When they Do Not
What about market value as a whole, rather than that of particular companies? Why do sometime stock markets crash, and at other times they boom?
The answer is that stock exchanges also reflect expectations about government and central bank policies: laws, regulations and currency policies affect companies’ fortunes, as do obviously their access to capital controlled by governments, whose sources are taxes and government borrowing. When expectations are that mistaken government policies will be corrected more quickly, the stock market will go up. When the market goes down, the drop implies that investors expect governments’ marches of folly would last longer. A closer look at these relationship brings us back to the opportunities that Mr. Charles Dow and Edward Jones discovered a century ago – but which many governments around the world – the Chinese one in particular – choose to disregard.
When either there are few sources of independent sources of information; information is being controlled and players’ hands are tied, then stock exchanges will not fulfill their roles, and will become decapitalized. It is easy to see why: Investors expect frequent and significant mispricing because of the unreliable information. Indeed, in the second half of the 19th century the US stock markets have seen spectacular booms and busts — for these same reasons. Channels of information were few; the few who had access to information did not always have the incentive to tell the truth, and they also had the incentives to collude. Not surprisingly, people without privileged access to information withdrew from the markets.
However, the United States has been an open society, and people had incentives to find solutions to these problems. By so doing they ended up with democratized access to capital. It is not accidental that following the booms and busts a century ago, Charles Dow, Edward Jones and Charles Bergstresser were among the first to come up with the idea of publishing a financial newsletter in 1880; that the U.S. stock exchange proposed in 1895 the radical innovation of publishing annual reports; that 100 years ago information started to be carried through New York’s streets from offices to banks – though by couriers running through streets rather than flowing through satellites, cable and optical fibers or Wi-Fi. And it is not accidental that the two cities with the most developed, deepest stock exchanges – NY and London – also saw the twin emergence of a critical mass of people specializing in the information industry: newspapers, radio, broadcasting, Bloomberg, financial and political analysts. It’s this competitive information industry that allows stock exchanges to fulfill their roles and prevent lasting mistakes in the allocation of capital.
Societies which, for political reasons, put impediments in the ways of this information industry — as China has been doing, when Xinhua, the state-run central news agency, set restrictions on Dow Jones’ business in the country, for example — will see the same wild fluctuations on their stock exchanges as New York’s exchange saw a century ago. Centralization of powers and functioning stock markets are incompatible.
If restrictions on the information industry stay in place, the consequence will be similar to what happened in the US more than a century ago: slow capitalization of the Chinese stock exchange. Worse: the slow capitalization will be accompanied by accusations of “greed” and “speculation” — rather than politics and government bureaucracies taking the blame. Financial markets — rather than the government’s own regulations — will be blamed for the booms and busts, for the exchange’s failure, and for the fact that Chinese companies would be falling behind. If the entrepreneurial information brokers — the Dows and the Joneses of today’s China — are prevented from fighting the central government’s control of information, the days of China’s stock exchange as a reliable institution for signaling the reallocation of capital, and matching it with pools of talent accountability — and of Hong Kong’s too — are numbered.
Whether the present stock market upheavals in China will lead to allowing the Chinese information industry greater freedoms, bring about less reliance on the state bureaucracy being the main “matchmaker” of capital and talent in the country, and this lesser centralization (and with it weakening of the Communist Party’s grip on power) — time will tell.
Reuven Brenner holds the Repap Chair at McGill University’s Desautels Faculty of Management. The article draws on his book, Force of Finance.
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