It's too easy to blame the shifty-eyed speculators

PUBLISHED : Tuesday, 07 August, 2012, 12:00am
UPDATED : Wednesday, 15 August, 2012, 11:07pm


The Kay report is concerned about short-termism because, in Britain, hedge funds, high frequency traders and proprietary traders account for 72 per cent of market turnover, but roughly one third of shareholding ownership. It is their short-term behaviour that drives prices and there is concern that it creates bubbles far beyond fundamental value.

Andrew Sheng,
Former SFC chairman,
Insight page, August 4

Numbers first. If it is true that short-term traders account for 72 per cent of turnover and 33.3 per cent of ownership then I have to rate Britain a nation of very long-term shareholders. I would have thought the difference between the two figures much wider.

Next, this business about what drives share prices. Andrew Sheng is a career civil servant and I don't think he has ever worked on a dealing desk. We can safely hang a question mark over his analyses of stock market behaviour.

Share prices are driven by their returns to investors. The prices set on these returns are influenced mostly by the general yield equation of the economy or currency in which the company is active and only partly by the speculative interests in the market. Speculators may push prices up and down a good way from time to time but rarely do it for long. In fact, they don't so much drive price movements as ride them, and they certainly do not determine a market's direction. But regulators like to find a bogeyman for things that do not go their way; the shifty-eyed greasy speculator is their favourite. Few have ever met one.

But where I think Mr Sheng really has it wrong is his 'concern that it creates bubbles far beyond fundamental value'. He has the wrong culprit here. Let's go back to the observation that the prices set on investment returns are influenced mostly by the general yield of the underlying economy. What this means is that if a reasonably sound investment in any economy gives you an income stream of 4 per cent a year of that investment's price, you will not easily find a similar reasonable investment in that economy with a yield either much higher or lower.

If you find something similar offering 10 per cent, then start your antennae waving. There is almost certainly something wrong with it. Variations do exist but they have mostly to do with the characteristics of the individual investment or the degree to which they are insulated from inflation. Adjust for these and you will find real pricing anomalies are rare in an efficient financial marketplace and seldom persist.

There is one exception. It is the pricing anomaly that central banks can introduce through interest rate policies. Worldwide in the past few years, central bankers have pushed down rates in order to stimulate tired economies into further growth. This anomaly has now become pronounced and persistent.

What is more, it has undermined the general yield equation for all other forms of investment. Property prices everywhere have rocketed up under the stimulus of low mortgage interest rates to the point that those who are not homeowners find themselves increasingly excluded.

Similarly, corporate earnings have been artificially stimulated and share prices artificially supported by these low-interest-rate policies. In equities, dividends have dwindled into insignificance. Returns on bonds and other fixed-income instruments have become derisory.

It means that people can no longer rely on income streams from their investments to support their living requirements, particularly in retirement. They must either steadily sell down their capital to create an artificial income stream or trade that capital actively in the hope speculative profits from trading can create a new form of income stream. This hope has generally been rewarded over recent years in property, commodities and fixed income due to the stimulus to investment prices from the central bank policies. Not surprisingly, ever more people have thus been induced to become speculators.

The danger is that when central bankers can no longer flog their exhausted economies into activity, interest rates will also slip from their control. Speculative investment values will then crash and many people seeking a reasonable income stream will find themselves without the capital to generate one.

You have worked as a central banker, Andrew. If you want to know who created a bubble far beyond fundamental value, try a mirror.