Investing in a Rigged Market, Part IV
If we care about the health of free market economies, then we need to care about how efficiently capital is allocated in those economies. And if we care about efficient capital allocation, then we need to care about the health and efficiency of capital markets, because those markets are the principal instruments we have for the allocation of capital. And if we care about the efficiency of capital markets, then we need to care about the asset management business, because that is what makes capital markets efficient.
Eugene Fama proposed his Efficient-Market Hypothesis (EMH) back in the 1970s and in 2013 he shared the Nobel Prize for his work. EMH essentially postulates that in a well-constructed market stock pricing is efficient because all relevant information about pricing is widely known and acted on by investors almost instantly. (We won’t trouble ourselves about whether the “weak form,” the “strong form,” or the “semi-strong form” of EMH best captures the real world, since those issues are not crucial to our discussion.)
As far as most investors are concerned, the key implications of EMH are that (a) it is extremely hard to beat the market, and (b) therefore, most people should buy index funds. But for purposes of this discussion we are more interested in the implications of efficient capital markets for the world’s capitalist economies. Specifically, the more efficient capital markets are in a society the better that society’s capital will be allocated. The less efficient (or corrupt) a society’s capital markets are, the worse capital will be allocated. Societies with efficient capital markets will always eventually outperform societies with inefficient or corrupt capital markets.
And this goes for China, by the way. China, like the USSR before it, grew very rapidly using a top-down, centrally controlled economy in which capital markets are instruments of government policy and control, not instruments for the efficient allocation of capital. But as China’s growth inevitably slows (it is already growing at roughly half its former rate), and as its economy becomes more complex, China will have to free up its markets or fall ever-further behind the U.S. and other market economies.
How is it that capital markets allocate a society’s capital? Let’s look at a few extremely simplified examples.
Suppose a particular company has terrific products or services and is very well managed. A Google or an Apple, let’s say. Investors will flock to those companies, driving their stock prices up. As a result, the companies have an extremely valuable currency—their high stock price—that can be used in all sorts of competitive ways.
For example, the companies can use their equity to acquire other companies, outcompeting other potential acquirers. Since top management’s compensation is tied—often heavily so—to the performance of the stock price, the companies can outcompete for management talent. In other words, a company that succeeds in attracting investor capital can outcompete other companies even if the company itself isn’t especially profitable (e.g., Amazon).
Or consider a company that is an apparent also-ran. It operates in a slow-growing sector of the economy and its operating results have been ho-hum. As a result, its stock price languishes. But some investors (the superstars we described in last week’s post) have noticed that new management has put together a plan designed to improve its products and distribution, clean up its balance sheet, and close unprofitable operations. Almost nobody else has noticed this, and it will be awhile before they do, but in the meantime our star investors can accumulate the company’s stock at a price well below what its value is likely to be in the future.
Capital markets don’t become efficient by accident. In fact, most of the capital markets across the world are hopelessly inefficient, at least by U.S. standards. Markets become more or less efficient depending on the number and quality of the investors in them. When markets are thinly traded, for example, there can be very large spreads between bid and asked prices—or no prices at all.
When markets are corrupt, investors can find that their capital has been effectively confiscated by insiders. In places where capital markets are inefficient and/or corrupt, most capital flees to safer havens and the capital that remains is very poorly allocated, often winding up in Swiss bank accounts.
For most of the 20th century the U.S. was fortunate to have had the most efficient capital markets in the world. The first-tier result of this was that capital was exceptionally well-allocated in the U.S. economy. The second-tier result was that the U.S. economy grew much faster than the economies of other developed countries.
When central bankers rigged the capital markets so that stock and bond prices could only go up, everything naturally went up—good companies and bad companies, well-managed enterprises and badly messed-up enterprises. Capital was no longer allocated efficiently, it was allocated randomly. Thus were the economies of the developed world thrown into confusion. The U.S. economy came to resemble the economies of Western Europe and Japan, and the economies of Western Europe and Japan came to resemble Dead Men Walking.
And with their economies on life support, Western societies lost faith in the vision for the future that had been propagated by their elites, turning instead to populism. Does anyone believe that if Western societies had recovered powerfully from the Financial Crisis we would have Brexit, Trump, the National Front, Alternative for Germany, the Freedom Party of Austria, the Sweden Democrats, the Finns Party, etc., etc.? Economic decline is the fetid soil in which extremism propagates.
Next up: On Populism