Yves here. While this post by Rajiv Sethi contains some important observations about valuation, I’d like to quibble with the notion that there is such a thing as a correct price for as vague a promise as a stock (by contrast, for derivatives, it is possible to determine a theoretical price in relationship to an actively traded underlying instrument, so even though the underlying may be misvalued, the derivative’s proper value given the current price and other parameters can be ascertained).
Sethi suggests that stocks have “cash flow anchors”. I have trouble with that notion. A bond is a very specific obligation: to pay interest in specified amounts on specified dates, and to repay principal as of a date certain. They have other restrictions to protect investors in an indenture, which might include (for riskier companies) a minimum net worth requirement, a restriction on incurring more senior debt, required minimum interest coverage ratios, a sinking fund, and so on.
By contrast, a stock is a very unsuitable instrument to be traded on an arm’s length, anonymous basis. A stock is a promise to pay dividends if the company makes enough money and the board is in the mood to do so. Yes, you have a vote, but your vote can be diluted at any time. There aren’t firm expectations of future cash flows; it’s all guess work and heuristics.
By Rajiv Sethi, Professor of Economics, Barnard College, Columbia University & External Professor, Santa Fe Institute. Cross posted from Rajiv Sethi
At 7:30pm yesterday the Drudge Report breathlessly broadcast the following:
ROMNEY NARROWS VP CHOICES; CONDI EMERGES AS FRONTRUNNER
Thu Jul 12 2012 19:30:01 ET
Late Thursday evening, Mitt Romney’s presidential campaign launched a new fundraising drive, ‘Meet The VP’ — just as Romney himself has narrowed the field of candidates to a handful, sources reveal.
And a surprise name is now near the top of the list: Former Secretary of State Condoleezza Rice!
The timing of the announcement is now set for ‘coming weeks’.
The reaction on Intrade was immediate. The price of a contract that pays $10 if Rice is selected as Romney’s running mate (and nothing otherwise) shot up from about 35 cents to $2, with about 2500 contracts changing hands within twenty minutes of the Drudge announcement. By the sleepy standards of the prediction market this constitutes very heavy volume. Nate Silver responded at 7:49 as follows:
The Condi Rice for VP contract at Intrade possibly the most obvious short since Pets.com
Good advice, as it turned out. By 9:45 pm the price had dropped to 90 cents a contract with about 5000 contracts traded in total since the initial announcement. Here’s the price and volume chart:
One of the most interesting aspects of markets such as Intrade is that they offer sets of contracts on a list of exhaustive and mutually exclusive events. For instance, the Republican VP Nominee market contains not just the contract for Rice, but also for 56 other potential candidates, as well as a residual contract that pays off if none of the named contracts do. The sum of the bids for all these contracts cannot exceed $10, otherwise someone could sell the entire set of contracts and make an arbitrage profit. In practice, no individual is going to take the trouble to spot and exploit such opportunities, but it’s a trivial matter to write a computer program that can do so as soon as they arise.
In fact, such algorithms are in widespread use on Intrade, and easy to spot. The sharp rise in the Rice contract caused the arbitrage condition to be momentarily violated and simultaneous sales of the entire set of contracts began to occur. While the price of one contract rose, the prices of the others (Portman, Pawlenty, and Ryan especially) were knocked back as existing bids started to be filled by algorithmic instruction. But as new bidders appeared for these other contracts the Rice contract itself was pushed back in price, resulting in the reversal seen in the above chart. All this in a matter of two or three hours.
Does any of this have relevance for the far more economically significant markets for equity and debt? There’s a fair amount of direct evidence that these markets are also characterized by overreaction to news, and such overreaction is consistent with the excess volatility of stock prices relative to dividend flows. But overreactions in stock and bond markets can take months or years to reverse. Benjamin Graham famously claimed that “the interval required for a substantial undervaluation to correct itself averages approximately 1½ to 2½ years,” and DeBondt and Thaler found that “loser” portfolios (composed of stocks that had previously experienced sharp capital losses) continued to outperform “winner” portfolios (composed of those with significant prior capital gains) for up to five years after construction.
One reason why overreaction to news in stock markets takes so long to correct is that there is no arbitrage constraint that forces a decline in other assets when one asset rises sharply in price. In prediction markets, such constraints cause immediate reactions in related contracts as soon as one contract makes a major move. Similar effects arise in derivatives markets more generally: options prices respond instantly to changes in the price of the underlying, futures prices move in lock step with spot prices, and exchange-traded funds trade at prices that closely track those of their component securities. Most of this activity is generated by algorithms designed to sniff out and snap up opportunities for riskless profit. But the primitive assets in our economy, stocks and bonds, are constrained only by beliefs about their future values, and can therefore wander far and wide for long periods before being dragged back by their cash flow anchors.