Mises Daily Articles
The Social Function of Stock Speculators
Libertarian economists typically adopt a two-pronged approach in their advocacy of free markets. On the one hand, they stress that people have rights (whether God-given or self-evident from the exercise of reason) and therefore should be able to engage in any voluntary activities with each other, free from political interference. Unfortunately, this appeal to principle is never enough, since the type of person who votes for today's politicians doesn't care much about abstractions.
This leads to the second prong of the argument: The use of economic science to demonstrate unnoticed and often counterintuitive benefits from activities that the common man despises. For example, after pointing out that the government has no business sticking its nose into capitalist actions between consenting landlords and renters, the libertarian might use economic theory to illustrate the disastrous effects of rent control. After all, the right to property is (rightly or wrongly) easier to appreciate when populist violations of it lead to housing shortages.
It is in this spirit that I offer the present essay, an examination of the social benefits of stock speculators. Now when it comes to different ways of making a living, stock speculation certainly wouldn't make the Top Ten Most Altruistic among Oprah Winfrey viewers. Indeed, even among people who think that middlemen perform vital services in tangible commodities — such as buying oranges low in Florida, and selling them high in Alaska — there seems to be something artificial about transactions involving nothing more than electronic swapping of shares to corporations. Even among people who ought to know better, there is a presumption that stock speculation is a zero-sum game, and that if one person buys low and sells high, his gain only comes at the expense of someone else, leaving society on net exactly the same.
Speculators Correct False Prices
Speculators are out to make money, to buy low and sell high, as the cliché goes. What this truism entails, however, is that the successful speculator — who can consistently buy low and sell high — can predict certain stock prices better than others, and indeed even better than others who are risking money on those very stocks. For example, if a speculator buys at $100 on Monday and sells at $110 on Friday, he was only able to do this because other people in this very market didn't realize on Monday that the stock would appreciate so quickly. (If they did, they wouldn't have sold for $100. They would have held onto the stocks and netted the gain themselves.)1
If this were the whole story, then stock speculation might truly be a zero-sum game, where the lucky or farsighted enrich themselves at the expense of the unlucky or dimwitted. This isn't the case, however, because in the very process of profiting from their superior vision, stock speculators influence stock prices. When stock prices are undervalued, the successful speculator buys shares, an action that drives up the prices in question. In contrast, if a stock is "overvalued" — and by this term we mean nothing deeper than that the stock will fall in price more quickly than others in the market realize — then the successful speculator may "short sell" it, or engage in comparable actions (such as buying a put option) that tend to push down the share price.
In the aggregate, we have thousands or even millions of professionals who study the stock market from every conceivable angle, looking at both political events and fundamental data on individual companies. Consequently, new information is quickly incorporated into expectations and finds its expression in updated stock prices. Although some Chicago economists — as is their wont — take this notion of the "efficient (stock) market" too far, it is certainly true that individual efforts to make a buck foster a mind-boggling nexus of analysis and communication.
"Oh, what's this? North Korea just tested a nuclear device? What are the implications for the share price of IBM?" I don't know, and neither does anybody else — no one could possibly grasp all of the information relevant to this question. Even so, individuals who believe they have a better handle on this question than most others can put their money on the line by buying (or shorting) IBM stock, and waiting for events to bear out their minority view. There is no guarantee, of course, that the current crop of capitalists will make the right forecasts, but as with every other occupation here too the free market does an excellent job of pruning: people who repeatedly make erroneous bets in the stock market lose all of their money and can no longer disrupt share prices. Over time, those with the most influence on the stock market are the ones who best predicted its movements in the past.
Who Cares If Share Prices Are "Correct"?
The leftist reader might giggle at the naïveté of the above analysis. Who cares about speeding price adjustments, when the "correct" price is itself a completely arbitrary number, based on asymmetric power relations, herd mentality, and self-fulfilling prophesies?
As with the efficient market hypothesis, certain academic economists do indeed go too far when they completely rule out "irrational" behavior. However, we mustn't commit the opposite error of viewing stock prices as nothing but randomly generated numbers,2 which have no correspondence to objective economic realities.
Just to illustrate the point, let's consider an absurd example. Suppose that everyone on the Earth except you, dear reader, refused to believe that Microsoft shares would ever sell for more than $1 as of tomorrow at the opening bell. The immediate consequence of this strange alteration in expectations would be, of course, an immediate collapse in Microsoft stock. Even though its stock might currently be trading for $28.50, those owners would try to unload their shares before the market closed today. But if everyone except you, the reader, believed the price would be at most $1 by tomorrow morning, they wouldn't offer very much for the shares today. Some transactions might occur at intermediate numbers in the mad race to the bottom, but very quickly (once everyone realized everyone else thought the same thing) Microsoft stock would be trading at $1 or less.3
Now in this insane scenario, what would you, dear reader, do? In a famous chapter from the General Theory, John Maynard Keynes argued that the stock market (at least in its unregulated form) was a giant game of Musical Chairs (capitalization in the original). He implied that in our Microsoft example, you would be rendered a capitalist Cassandra; even though you would know that Microsoft really "should" be priced above $1, it wouldn't pay for you to purchase it, since everyone else's ludicrous beliefs would make their predictions come true. Keynes would argue that, ironically, you too shouldn't offer more than $1 for the stock, since you would never be able to find anyone to buy it back from you (at an even higher price) in the future.
As with most of the clever arguments in the General Theory, this one too is dead wrong. If (by hypothesis) nothing had changed with Microsoft's underlying business prospects, then you would certainly do well to purchase the stock and gain access to the flow of dividend payments issued periodically by Microsoft. Indeed, one standard definition of the "correct" stock price for a company is the present discounted value of its future dividend payments. Even if we changed the absurd story away from Microsoft, and to a company that historically has never paid dividends, it would still make sense to buy ownership in a profitable company at rock-bottom share prices. For one thing, the board of directors might change the dividend policy (in light of the crazy behavior of traders regarding its stock).
Remember: A Stock Is a Share of the Company Itself!
Although one can benefit from buying an undervalued stock because of dividend payments, this is only part of the story. The more glaring point — yet one that is typically overlooked in discussions of Wall Street — is that stock shares are partial ownership claims on the corporation itself. Thus, if our ridiculous scenario above came to pass, and Microsoft shares fell to $1 each, that means a group of investors could literally buy Microsoft itself for "only" $9.83 billion. Forget about the present value of future net revenues — speculators could almost certainly take Microsoft and sell off its assets to other companies, settle its debts, and still earn more than $10 billion. Because of this very possibility, hedge funds, investment banks, and other gigantic financial organizations would gladly snatch up Microsoft shares at $1 apiece, even if they truly believed the share price would never budge one cent above it.
Of course, this leads us to reflect that this very action on the part of professional traders would push Microsoft stock above $1. Thus we see that, even if I rig the example by giving everyone in the world erroneous expectations regarding share prices, nonetheless the stock price will move back towards its "correct" value so long as people are allowed to seek personal gain through other channels. Stock prices are no more arbitrary than tractor prices, and correct stock prices are just as important (indeed, more so) than correct tractor prices.
It is worthwhile to reflect on this last statement. What would happen if tractor prices were set randomly? There would be many (disastrous) consequences, but to name just two:
The proper amount of tractors wouldn't be produced. As Ludwig von Mises's critique of socialism illustrated, market prices in capital goods are essential for the economical allocation of society's scarce resources. If tractor prices were set below their "true" levels, then not enough resources would go into the production of tractors. These resources would flow into other goods and services that consumers considered inferior to the products made possible by additional tractors. On the other hand, if tractor prices were arbitrarily set too high (and farmers erroneously paid these prices), then resources would be wasted in the production of too many tractors, where "too many" is defined relative to consumer preferences.
Even if we ignore these long-run issues and focus on a given quantity of tractors at the moment, arbitrary prices would still lead to the improper (from the standpoint of economic efficiency) use of tractors. In particular, a price set too low would allow farmers and others to gain ownership and hence disposition of tractors who shouldn't have such control. For example, if actual John Deere tractors sold for $50, many parents would no doubt buy them as Christmas or birthday presents for their 10-year-old sons to drive around aimlessly in the back yard. It's not that there is anything intrinsically wasteful about such gifts. Rather, we know that under current economic conditions it would be a colossal mistake to divert, say, 300 tractors into the young boys' possession, because these tractors could provide much more valuable services in other lines. The free market price is the peaceful mechanism of keeping these productive machines out of Johnny's hands. Although John Sr. might pay $50 to give his son a John Deere for Christmas, he wouldn't pay $100,000 for the novelty.
What is true for tractors carries over to shares of stock. Although it's not as tangible as a tractor, nonetheless a publicly traded corporation represents a combination of scarce resources; the corporation itself can be viewed as a capital good. As with other capital goods (such as tractors), the corporation has an overall price, and the person who pays the market price is then the owner and can do whatever he wants with his property (without violating the property of others, of course). Among other problems, if Microsoft shares fell to, say, one millionth of a dollar each, this would be disastrous because Joe Schmoe might buy the entire company for a hundred bucks and play software king for fun. Now Joe Schmoe might be a poor genius who ends up leading the next revolution in software design, or (more likely) he will introduce such innovations as a mandatory game of Minesweeper (Intermediate level) every time Excel is opened. As with tractors, the way to keep Microsoft out of the hands of Joe Schmoe is to set its market price beyond his means — which in the case of Microsoft is $282 billion.
Finally, I'll close by pointing out that even the long-run supply of corporations has a "correct" amount, in the same sense as the long-run quantity of tractors. Although economists argue about the relative importance of various factors, they can agree that one of the underlying functions of a firm is to reduce transaction costs. According to Ronald Coase, the firm's boundaries include those operations that it can perform more cheaply than outsourcing to others. There is thus a true, economic benefit from the existence of firms; if the government outlawed such organizations tomorrow, and insisted that everyone be an independent entrepreneur, we would all be much, much poorer.
Once we realize the importance of firms themselves, it is easier to understand the crucial function of the market price of these firms. To make an obvious illustration: An individual or family with a small business yet great product line can currently "go public" by issuing shares of stock. This allows the organization not only to buy larger factories, hire additional secretaries, janitors, assembly line workers, and so forth, but also to bring in high-priced CEOs and other "middle management" professionals who, despite the public's distaste, do perform valuable services. But the degree to which the small enterprise can expand (by issuing stock) is dependent on the share price it achieves, and thus a correct share price is crucial to ensuring an efficient allocation of scarce factories, as well as CEOs.
Despite their horrible reputation, stock speculators perform a crucial service in the market economy. Their attempts to buy low and sell high quickly eliminate mispricings in the stock market. Although not at first obvious, accurate stock prices are crucial to an efficient use of society's resources. The average Joe — and senator! — doesn't need to worry about supply disruptions, labor disputes, or natural resource exhaustion. All of these factors, and thousands more, are watched every day by thousands of experts. These experts are not appointed by politicians, and are disciplined by the market itself: stock speculators who continually make bad forecasts soon lose their financial capital and thus any influence on the market.
- 1. For the purists, I mention the complication that investors could have far more nuanced expectations. It is possible that the person selling at $100 on Monday might not be surprised that the stock rose to $110 by Friday, and nonetheless might not regret his earlier decision. For example, suppose the stock in question is for a tobacco company, and the verdict for a class action lawsuit against it will be delivered on Friday morning. If the investor thinks there is a 1 percent chance of a guilty verdict that would bankrupt the company, and a 99 percent chance of a not guilty verdict that will totally exonerate the company, he might jump at the chance to unload his shares at $100 each. These considerations make the analysis above more complicated, but don't change the essential results. Among other modifications, we would have to be more careful in defining "successful" speculation.
- 2. Another note for the purist: Believe it or not, here I am not actually taking a swipe at modern financial theory. The textbook treatment does not say that stock prices are random, but rather that (percentage) changes in stock prices are random.
- 3. Actually, this isn't quite accurate, as we will soon show. But the exposition is simpler if we first assume the price would fall to $1, and then explore what factors would immediately push it back up.