AS THE ECONOMY TURNS

STAMPEDE

Dr. William Shingleton

April 21, 2006

Last week we saw that sometimes even the world’s most advanced markets are subject to what Keynes called “animal spirits”. On Tuesday, the OPEN MARKET COMMITTEE (FOMC) released the minutes from its March meeting [SOURCE: http://www.federalreserve.gov/FOMC/MINUTES/20060328.htm], a source of NEW INFORMATION that is often sorted over with a fine toothed comb. The March 2006 record indicated that the FOMC is at least on the verge of seriously considering when to end its slow steady upward march of its target interest rate, so all of a sudden it was off to the races on Wall Street. The DOW JONES INDUSTRIAL AVERAGE jumped 194.99 in one day, with about 170 of those points coming after the release of the new information. Why did the market react in such a fashion? This week we’ll look at some ideas on how new information is processed in a market.

In an EFFICIENT MARKET we presume that all available information is used to produce the MARKET PRICE. For instance, if we are selling gasoline, and we know we can charge four dollars per gallon tomorrow when we know demand is going to rise for some reason, then we’ll be reluctant to sell it for “only” three dollars today, regardless of what it cost us. We’ll want tomorrow’s four dollars in today’s market. Similarly, as buyers, if we believe that the price tomorrow is going to be four dollars, we’ll try to buy anything we can find today at any price below four dollars. The result of the information about tomorrow’s price, the one that is going to be four dollars when we wake up, is that today’s price will be four dollars as well. One problem with all of this of course is that nobody really “knows” what tomorrow’s price will be. Instead, what we have to deal with are EXPECTATIONS, what we believe the price will be tomorrow. The expectations are based on what information we can acquire, the quality (or reliability) of that information, and the cost of that information, in terms of money, time, and effort.

Information that is completely reliable is thought to be PERFECT INFORMATION; it is never wrong. For instance, we know that the sun will set in the west tonight. This information is not only perfect, it is also FREE, we don’t have to go and do a GOOGLE search on the topic and we don’t have to pay anyone to the rights to use it. Unfortunately, since just about everyone already has the same information, it is hard to see how there could be much of an economic advantage to us for having this information. It may be perfect and it may be free; but it is also just about useless in our economic life. In addition, perfect information may be free, like the positioning of the sunset, or it may have a COST OF ACQUISITION, in terms of time, treasure, or effort. For instance, we may want to know the MANUFACTURER’S SUGGESTED RETAIL VALUE for a car before we try to go buy one. There are a number of sites where we can go online and find that information without any kind of EXPLICIT COST. However, in economics, there are other costs besides the costs for which we actually hand over money. These other costs are IMPLICIT, such as the value of our time while we are searching online for the answer to our question.

Information that is not known to be completely reliable is called, mysteriously enough, IMPERFECT INFORMATION. Like perfect information, it can be free or it can have a cost. For instance, some of us spent way too much time trying to acquire imperfect information on this year’s NCAA basketball tournament. The value of the time following the games at work had a cost, which consulting firm Challenger, Gray & Christmas estimated at $3.8 billion in lost productivity, according to a report in FORBES MAGAZINE [SOURCE: http://www.msnbc.msn.com/id/11809691/] And not only did the information have a cost greater than the total GDP of many countries, but it was all a complete waste of time because DUKE did not even make it into the final four in spite of their ordination!

So how do we deal with information? To a very large extent it can be explained by our old friends, MARGINAL BENEFIT and MARGINAL COST. Even if we believe information is both perfect and of great value, we will not acquire it unless the marginal cost of obtaining the information is less than the marginal benefit of acquiring it. When there is a market for information, even imperfect information, people decide which information to acquire and which to let go by applying those simple principles. For instance, suppose we are taking a flight in the afternoon. Unless it is an international flight, most of us have learned by now not to call the airline early in the morning to see whether or not the flight is going to take off on time. It doesn’t take long to call, so the marginal cost there is fairly low. But what if we know that we are going to be kept on hold for twenty minutes? Do we have twenty minutes to waste? The marginal cost has begun to rise. Or suppose the airline answers right away but we know that the airline NEVER admits that one of their flights is going to be late until the last minute. The information is useless because it is so unreliable so it offers little in marginal benefit, unless we like to talk with people in call centers located is distant parts of the world.

So what happened with the stock market last week? To answer the question, we’ll offer two stories. In the bad old days, when there was still a SOVIET UNION, consumers in the USSR had very little to buy. The custom was that anyone who was walking down a street and saw a line would immediately get in the line. The idea was that if there was a line then there must be something of value that people were waiting for. The line was a free source of imperfect information, indicating that it was likely that some consumer goods were available. It was only after joining the line that people would ask, “What are we in line for?” [NOTE: This custom had the unfortunate consequence of keeping people waiting in line when they could have been working at producing things, reducing the volume of goods produced, and lengthening the lines. With the transition to a more market-oriented economy, the lines are mostly gone now.]

The other story is an experiment in behavioral economics. Suppose a crowd sees a pile of red boxes and a pile of green boxes, identical except for the colors. The rule is each person can have one and while there is an unlimited supply, there are no returns. How does one decide which box to choose? It should be about 50 to 50, right? Now, suppose that two or three well-respected figures all choose red boxes. Do they know something that no one else knows? If we don’t have any other information to guide our choice, what would we choose? Most of us would choose the red, just in case we were not catching the information that these insiders seemed to be using. It is a MIN-MAX strategy. If there was no unobserved information and all of the boxes are unknown to all of the players, then we have not lost anything because we still have a 50 percent chance of choosing the right box. On the other hand, if these insiders really do know something or see something that no one else does, then following their lead will lead to be better result. The logical choice is to follow their lead.

When word got out that maybe the FOMC was going to stop raising its interest rate target, the information was imperfect, because no one was sure how it would affect the market, and information about that impact was expensive, in that it was difficult to calculate. However, some investors, perhaps remembering how PRESENT VALUES are calculated from their **ECONOMICS** classes, may have thought that their expectations of interest rates, and therefore their expectations of present values, needed to be adjusted. To put it simply, lower interest rates increase the present value of future earnings and the value of a stock is strongly influenced, maybe even determined by, the present value of the corporate earnings. When the rest of the players in the market saw some of the big players getting in line and picking the BUY boxes on their order submissions, we had the stampede to buy. And, of course, once the prices started rising rapidly, many of the players who had been watching tried to do the same thing, jump in line, check the BUY box, and make the big, quick profits. If the DAY TRADERS of the late 1990’s had still been around, the market would have jumped 500 points.

We are back to reality now. The market will rise and fall as new information comes in but the information that came in last Tuesday is no reflected in the prices as they currently exist. In an efficient market, the information is constantly digested, so you have to be at the front of the line to make the big profits. Either that, or give WARREN BUFFETT a big red box of yours to hold in front of a crowd.

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