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David D. Kirkpatrick and Jamie Heller

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from: David Kirkpatrick

Unintended Consequences

Posted Monday, May 22, 2000, at 11:44 AM ET

Dear Jamie,

This assignment we have reminds me something once said by Calvin Coolidge, America's most famously pro-business president. "The American public wants a solemn ass as a president, and I think I'll go along with them."

I gather that you and I have been roped into this together because we are both in business journalism. And if that is what Slate's editors want, I think I will go along with them. It is true that these days it has become fashionable to try to throw around a little business-y lingo--I recently heard a friend refer to a cocktail party as "a branding opportunity." But I do sometimes worry that, absent compelling personalities, human drama, or egregious malfeasance, business stories tend to bore most readers. Maybe it is just that people have some residual fear of numbers. I am still constantly surprised that people don't realize how entertaining the Wall Street Journal can be.

At the risk of being dull, I'll get us started with one of the big questions of the year: Why have stock prices been bouncing up and down so wildly for the last few months? Alex Berenson, a terrific reporter for the New York Times, spelled out the problem in yesterday's paper. Since January 1, the Nasdaq composite index rose or fell more than 3 percent in one day 34 times. It rose or fell that much in one day only 35 times in the previous two years, and only 40 times in the 16 years between the creation of the Nasdaq and the end of 1997. So, 34 swings like that in four and a half months is a heck of a lot.

Volatility, as I am sure you know, is a drag in two ways. First of all, when stock prices jump around like mad they lose some of their already tenuous credibility. Can it really be that Dell is worth 5 percent more in an afternoon than it was in morning? What, did a factory burn down or something? Volatility makes it look more and more like a bunch of guys who run the market are just making all these numbers up, the way lotteries pick winning combinations. People buy stocks because they think the prices will go up and they can sell--not because they have any opinion of what they are worth--which naturally begets more volatility. You can see where that goes. Of course, people who do that are jokers--you and I aren't like that. But an even bigger problem may be that volatile prices make it harder and more expensive to buy and sell large quantities of stock. The price keeps jumping up and down just when new supply or demand hits the market. That means pension and mutual funds face higher trading costs, and people with savings in them suffer.

The familiar explanation is that an unsavory new crowd has moved in and spoiled the neighborhood: day traders. According to the conventional thinking, day traders, amateurs, and others who like to chase "momentum" are pushing the market to overshoot by jumping on anything going up and selling anything going down, in the vain hope of staying ahead of the curve. But this isn't really an entirely satisfying answer. For one thing, that kind of strategy usually loses money. Now that the market has stopped going up all the time, you would think people would get tired of the losses. Berenson's column in the Times had a novel take on all this: Maybe it all makes sense after all. Maybe the markets are still very efficient, and the constantly moving prices really do represent a changing consensus of investor sentiment about value. It's just that, in this day and age, there is so much new information spewing out all the time that the consensus changes really fast.

Maybe. That kind of theory is hard to disprove, although I suspect that people still don't think or make decisions any faster, no matter how much new information there is to process. I'm partial to another theory, one I picked up from Steve Wunsch, who founded the fledgling Arizona Stock Exchange. His idea is that the volatility is actually an unintended consequence of market reforms. As you know, before 1996, investors could trade in the Nasdaq stock market only by buying from or selling to a market maker, such as Knight-Trimark or one of the Wall Street firms. And the market-makers often got together and fixed their prices--their offers to sell and bids to buy--keeping the spreads artificially high so they could make more money. In 1996, securities regulators cracked down and broke up that game. But part of their reforms kept the market-makers from calling each other up to coordinate their prices, which has led to a lot more jumpy market-makers and a lot more volatile prices. The reforms also make it easier for day traders to trade with market makers automatically, and they started trying to make money off all those little discrepancies and jumps. As it happens, that is when the volatility really went through the roof--starting in 1997.

OK, so my theory isn't any easier to prove than the more-information theory. A lot more is screwy about the market-maker business, and may contribute to the volatility, too, but I know I am obsessed with that stuff, and if we get into that we really go off the deep end into complexity. Any thoughts? Too boring? How is TheStreet.com?

David

the breakfast table
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from: David Kirkpatrick

Unintended Consequences

Posted Monday, May 22, 2000, at 11:44 AM ET
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David D. Kirkpatrick is a contributing editor at New York magazine who writes frequently about business and finance. Jamie Heller is editor for strategic ventures at TheStreet.com, where she's worked since its 1996 founding.
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Reader Response from The Fray--to be read after the most recent entry:


I still don't understand how the stock market can be efficient in the long term and not the short run. And I'm not relying merely on Keynes' famous sentiments about the long run; my point is even simpler: when is the long run? Was Microsoft's long run value from 1990 to early 2000 or to today? Short run volatility must have consequences for people who claim long run efficiency. To my mind, and for many other reasons, believing in efficient markets is like believing in Santa Claus--there are correlations between expected results and reality, but people really ought to grow up and accept that no-one on Wall Street knows anything.

--Jeff

(To reply, click here.)

(5/22)

To Jeff: Various natural processes are long-term efficient without being short-term efficient, for example the downhill flow of water or the process of natural selection (aka evolution). Complex human processes seem to have similar behavior. Perhaps efficient is being confused with "optimal". The problem with most strategies that attempt to be optimal is that they often have truly horrendous failure cases, which wipe out all their interim or theoretical gains. Democracy has been called "the worst form of government, except for all the rest." It is hardly optimal, and in many cases very inefficient. A dictator could get the graffiti cleaned up and the trains running on time; democracy seems to have a hard time doing such things. But what about the failure case of a less-than-benign dictator or a dictator whose benign intentions diverge from many or most of the desires of the population? An example of short-term efficiency vs. long-term, in terms of human happiness.

That's not to say short-term efficiency is bad, or that we can't improve on raw systems. But it is possible for a strategy to be the best long-term one without exhibiting short-term efficiency.

--Paul Canniff

(To reply, click here.)

(5/23)