How Markets Actually Work and Why it Matters

I’m a lucky guy.  Most people will  never get to have the view I do at work. I’m not talking about the actual view from my office.  I mean, Keystone Avenue is mostly covered by trees, which is nice, but otherwise it’s power lines, 86^th Street and the roof of the Fidelity Investments building (oh, the irony—if only the view included an Edward Jones office also, my life would be complete).  I can't complain—at least not until the leaves are off the trees and the sky turns to deep gray for half the year beginning in November.  Actually, I’ll try not to complain then either.  

The view I’m talking about is being able to watch markets working.  There is no single “stock market,” by the way.  The shares of a company’s stock trade in their own unique market.  Instead of imagining the NYSE, AMEX, NASDAQ, etc. as markets themselves, it’s more accurate to picture them as swap meets: a bunch of little booths, some busier than others,with lots of buying and selling. 
 
If you want to buy or sell a share of stock you have to go to its market and enter your order.  Now, you might feel that you would like to buy the stock, but only if it reaches, say, $10.  If that’s the case then you’d enter a “limit order” to buy at a price of $10 or less.  Or, if you own the stock already, you could enter a limit order to sell at $11.  In those cases, you would only buy (sell) your shares when the price traded down (up) to $10 ($11).  

Instead, you might simply want to buy the stock at the best price available right when you arrive at the booth, so to speak.  In that case, you would enter a “market order”. There are actually a bunch of other variations on these two types of orders, but those are the basics.

One way to describe a stock’s market is by talking about the “bid” and the “offer”.  The bid represents the best available price to anyone who wants to enter a market order to sell a stock, while the offer represents the same for the buy side.  You might also describe a stock’s market by way of its “volume”, or the number of its shares traded in a given day.    

In theory, the bid price reflects the probability that an informed buyer will trade with an uninformed seller. The opposite holds for the offer side. In other words, the bid and offer prices convey a lot of information about the market for a stock.  If there is a wide gap between the bid and the offer and if the volume is low, you can be certain that the informed traders on each side of this trade stand to make a bunch of money from the uninformed traders (e.g., individual investors).   

Let’s look at a real world example. Apple, Inc. (AAPL) is the largest stock in the world currently, with a market value of $635 billion.  Recently, Apple’s shares traded $677.51 (bid) x $677.58 (offer).  The seven cent difference is understandable: it just says that buyers and sellers disagree slightly on the fair value of the stock.  A seven cent “spread” on a price of $677.58 is about 1/100^th of one percent—sellers and buyers are disagreeing but only in the way that newlyweds disagree when they repeat “No, Pookie, I love YOU more!” to one another ad nauseum.
 
The market for shares of ALCO Stores, Inc. (ALCS) tells a very different story of what its buyers and sellers know about that stock’s fair value.  ALCS has a market value of $25 million—a tiny sliver of AAPL’s massive value.  These shares traded recently at $6.70 (bid) x $7.35 (offer); that's a spread of roughly 9% of the price.  If you were talking to a trader you could say that the spread is wide enough to drive a truck through. 

Why the difference in spread? Information.  Everybody knows about AAPL, and many of you own at least one of their products; news from the company hits the internet and is disseminated at the speed of light; there are literally scores of professional analysts dissecting every piece of available knowledge on AAPL and turning that information into opinions, which they share with buyers and sellers.

How about ALCS?  Oh, sure, you can find headlines on yahoo finance—not many, but you can see some recent press releases.  But have you ever shopped at ALCO Stores?  There may not be any analyst anywhere with a single informed opinion about the stock.  There is just no meaningful way to compare Apple’s information flow with ALCO stores. It’s basically two different worlds of information, and the massive bid–offer spread reflects this.  

What holds for stocks applies in other markets, too.  Take gasoline, for instance.  If you had the choice of Speedway gas for $3.70 or Shell gas for $3.90, you’d always stop at Speedway.  Why? Because you know that 87 octane unleaded gasoline is a commodity.  There may be external factors (my wife thinks Shell has very clean bathrooms, and one station might be on the wrong side of the street for the direction you’re traveling), but for the price of a commodity, you have all the information you need to purchase the cheaper alternative.  

If you're still with me, hang in there.  I'm building to the point. 

When you hear someone complain about the excesses of the “free market”, they mostly believe—incorrectly—that the problem is market freedom.  But, what they’re really objecting to is the scenario in which the Widow Bradford buys a share of ALCS for $7.35 only to find that she has to turn rightaround and sell it for $6.70, thereby losing $0.65.  Opponents of free markets see this possibility as unjust and consider it a type of market failure.

The knee-jerk reaction from these folks is to regulate away the possibility of injustice.  So, returning to our stock example, they might mandate that ALCS shares trade at certain prices.  But, who would determine what those prices should be?  Further, people might not want to buy those shares at all at the set prices, and the market would simply die.  They might also want to have the government support prices, through buying or selling shares to manage the market.  But here, too, government involvement creates price distortions that cloud risk and value discovery. 
 
Here’s the big idea: if you’re worried about the possibility of injustice from inefficient markets, you basically have two choices: you could regulate the markets or you could increase information flow, thereby increasing market efficiency.  The difference is that information aids in risk and value discovery whereas regulatory intervention creates distortions.  

The next time you hear someone propose that we “rein in” free markets, just ask them why we couldn’t accomplish the same end with more information instead? 

Uncertainty about Uncertainty

First of all, let me issue a warning to the regular readers of this blog - and I mean both of you.  This one is by no means technical, but it may be dry and it involves objective data.  If you’re not interested in cracking the code as to why the economy is stuck in this rut, or if you dine regularly on the tripe that reality butchers like moveon.org sling, you'll probably want to stop reading right now.

Before I get to the main point, may I share a story? 

I use the exclamation “Pass the popcorn!” commonly on here, and in that I’m more or less publicly confessing my growing cynicism about our national political system.  But it’s not just politics that makes me cynical.  The current state of much of the field of macroeconomics has the same effect on me.  For those of you who’ve forgotten, macroeconomics is distinguished from microeconomics in that the former studies the whole country's economic climate (and especially how the federal government acts to manage the economy's growth rate), whereas the latter refers to ways in which individual firms or industries make decisions in their respective operating environments.

Now, it’s true that some part of my cynicism about macroeconomics is traceable to one of my intellectual forebears, Friedrich Hayek, who questioned whether a government of the free had any proper and effective role in macroeconomic management.  But mainly I am cynical when reading macroeconomists because they often operate as advocates for desired outcomes, not as analysts.  I used to think – oh so naively – that macroeconomics was a science: ask a potentially important question, gather data, study it seriously, and propose an answer.  I’m coming to believe that macroeconomics is only a means of accomplishing what you feel to be important.  Oh, there are honest macroeconomists out there (John Taylor and Greg Mankiw  are pretty good, and I even respect the way Larry Summers thinks), but many of them are just really smart advocates who marshal data in support of what feels right to them.

  

I first started to figure out the advocacy thing about a year ago.  I got into a discussion with a prominent Keynesian economist at a west coast university on his blog (you might know his name, he shows up on NPR once in a while). I questioned him honestly and respectfully about his view that the lack of economic growth was purely a function of demand and that, implicitly, the only effective solution was more direct government debt-financed “stimulus.”  I'd been hearing anecdotes from business owners that they were reluctant to invest given the anti-business tone emanating from Democrats in Washington.  My concern was that this tone, plus the question of whether the president would really choose to raise taxes on small business owners, would create an environment of uncertainty, and thus inhibit capital investment. 

A word of advice: don't ever mention anecdotes to academics.

After I extracted his and his sycophants’ e-arrows from my virtual tuckus, I followed the professor's link to a National Federation of Independent Business survey, which would, I was told, demonstrate that small business owners weren’t nearly as concerned about regulations & taxes as they are poor sales, which the professor took to mean demand.  I thanked him for his response, then followed his link.

Sure enough, the data in the NFIB Small Business Economic Trends survey showed that more small business owners cited “Poor Sales” as the single most important problem facing their companies than either “Taxes” or “Government Requirements and Red Tape.” 

But then I looked at the data a little more closely (we analysts have that nasty habit, especially those of us who have to put our clients’ money behind our conclusions).  It turns out that the professor had pointed me toward a September 2010 survey, which showed the following breakdown: Taxes: 23%; Government Requirements & Red Tape: 16%; and Poor Sales: 30%.  By August of 2011, that data was as fresh as a raw pork chop which had been left in the trunk of your hot car for a week.  

I then went to the July 2011 survey, which showed the following: Taxes: 20%; Government Requirements & Red Tape: 16%; and Poor Sales: 23%. 

Realizing what had happened, I hopped back on the blog and pointed out that his link took me to the September 2010 survey, and that the July 2011 survey showed a significant improvement in the percentage of business owners listing “Poor Sales” as their single most important problem.

The professor’s response?  He pulled my post.  No, I’m not joking.  It was there, then it wasn’t.  I thought I was helping his analysis but in reality, I’d compromised his advocacy and that was a threat.  He simply didn't want to be confronted with the truth.

Pass the popcorn!  (See what I mean?)

  

Fast forward to today.  The debate rages on: should the government un-encumber business, or should we borrow more money to stimulate demand?  If you find an anecdote supporting one side, you can quickly scare one up in favor of other.   My inclination, especially after a recent conversation with my friends Scott and Dustin, is to try to find hard data from original sources in order to form conclusions.  These are big questions which aren’t easily answered, but if we go back to the NFIB survey, we might glimpse part of the answer.  

Here's a link to the most recent NFIB survey.  The data below are taken from this survey and the previous five July surveys to get a sense of the trend.  There are other options as well, such as "Competition from Large Businesses" and "Quality of Labor", but each of the seven remaining categories are listed as the number one problem by fewer than 8% of respondents.

	7/12	7/11	7/10	7/09	7/08	7/07
Taxes	21%	20%	22%	19%	17%	19%
Govt. Requirements & Red Tape	21%	16%	15%	11%	8%	10%
Poor Sales	20%	23%	29%	34%	16%	11%

This suggests to me that while taxes have occupied roughly the same level of concern since before start of the recession, there have been big changes in both Government Requirements & Red Tape and Poor Sales.  Specifically, Government Red Tape is the most important problem for over twice as many business owners now as it was before the recession.  And while Poor Sales is still significantly elevated from 2007, it has declined steadily as a threat to business since the trough of the recession.

What impact do these perceptions have on business investment?  

 

I think it’s uncontroversial to say that business owners' opinions about 1) whether this is a good time to expand and 2) whether general business conditions are better or worse, in large part reflect their sense of threat from (at least) Government Requirements & Red Tape. 

This is one survey offering a few data points to consider.  We need much more honest analytical work on this topic.  And, there's no guarantee that business owners who say it's a bad time to expand won't then expand anyway - though that would be pretty weird.  But, the answer to the question of whether business uncertainty regarding the regulatory environment is impacting their investment decisions should be a little less uncertain than it is.