Do Markets Really Engage in “Useless Speculation”?
There is a view out there that stock markets, as well as other financial markets, should somehow be shielded from speculation. Speculation is all that these markets do though.
Some people believe that financial markets engage in a lot of “useless speculation.” It is curious that we would ever use the terms “useless” and “speculation” together because the word speculation already implies a use, and therefore this would involve a contradiction in terms. If we misunderstand speculation though, and provide to it a use beyond its scope, we can end up pretty confused.
A lot of people invest in the stock market for instance, meaning that they speculate on stocks, but not a lot of them properly understand even the basics of what goes on in the stock market, usually thinking that this has a lot more to do with the underlying businesses than is actually the case.
If we embellish the role of the stock market, closely linking it to the economy, and regarding it with an importance that is inflated, we certainly can see parts of it as not fitting our illusions and then hold it in disrepute to some degree.
There does seem to be something peculiar about what we could call making money from money directly that is seen as of much lesser significance than money earned from traditional enterprises such as manufacturing or any sort of enterprise that earns its money indirectly from the sale of goods and services.
All business activity involves speculation of some sort, where if you sell software for instance you invest in the company and hope to earn returns on your money over time by selling whatever it is you are selling at a profit.
The original owners of the company initially own shares in it, from either providing capital to it or as a result of their direct involvement in the company. These shares may later become placed on secondary markets, what we call the stock market, where they may be traded by all those interested in speculating on the company indirectly.
The speculation that goes on in secondary markets might be thought of as a pure form of speculation, whereas the privately held shares may not even be thought of as speculation but rather as just being in business, but both are equally speculative, although they are speculating on different things.
Privately held equity speculates on future business performance, while publicly held equity speculates on future stock prices. The benefit to companies who have their shares listed in stock markets is that this provides them with a way to raise more capital by selling pieces of their company to the public.
We Don’t Need to Justify Our Investments Because They Are Ours
Share issuers only collect funds from selling their companies once, when the shares are issued, and a good way to understand this is to imagine a company selling shares to the market with all the trades that ensue beyond this first one is investors buying and selling these shares among themselves.
What goes on after shares are sold to the market does not affect the underlying businesses in a material way, aside from their stock’s price affecting their buying or selling more stock at a later date. Other than that, a company’s stock price does not weigh upon the company’s business performance at all, although the price of their shares may be impacted by this business performance.
It is important to distinguish between a company and its stock if we’re ever to understand how the stock market affects the broader picture. If we understand stock markets as just a place where people can place bets on the future price of stocks, this will help us avoid reading too much into the stock market, as we are prone to do.
It is never useless to speculate on something, and the way to differentiate speculation is according to how sound or unsound the speculation may be. Many people harbor the belief that the goal of all activity is to contribute to GDP directly, by use of companies in business, and speculation that does not provide this is useless or even harmful.
The first thing that we need to understand though is that catering to the beliefs of others isn’t a requirement at all when we choose to speculate, and whether or not the speculation that we choose conforms to what someone may think should be the purpose of capital investment is not even relevant.
At the forefront of a free society is the prerogative to use our capital as we please, provided that we do not do so in a manner to unduly restrain others. The overall goal here is to best promote the free exchange of value, so things like collusion or price fixing are disallowed not in spite of their being a result of free exchange but because this impinges upon others exchanging value freely.
If we are ever going to restrict the flow of capital, we need to do so with justifiable reason, which doesn’t include things like lamenting about how much money people make speculating and believing that this money should be put to uses that may please them more.
It is only because people are willing to speculate in secondary markets that we have opportunities for companies to raise money by going public as they call it, because otherwise there would be no one out there to sell their shares to. Once again though, it is not about this, as secondary markets do not require any further justification than parties wishing to make free exchanges.
We Do Need to Prevent Excess Leverage, which is a Different Thing
This does not mean that regulation is not required, as financial trading involves risks and we want to make sure that we do not neglect this to the extent that we cause systemic risk. Financial institutions failing in 2008-09 is an example of what can happen when we relax our guard too much, and the speculation we allow must be within reason and with an eye to managing risk properly.
Sometimes greed can get the best of us and this is a particular risk when those who control decisions about investments are not really that invested in the outcomes. Bankers making huge bonuses that are only dependent upon the present and do not require anyone to account for the consequences of their actions properly is not something we want.
This speculation isn’t useless, as it does achieve present goals, but it can be expressed in a harmful way. The crash of 1929 occurred because people were allowed to leverage their positions 10:1 and the market became so leveraged that it could be brought down so easily, and it did.
If your position declines more than 10%, you are now broke, and your shares will be sold to the market to repay your debt. When this happens en masse, this can bring the market down like a house of cards, which it did back then.
The same thing happened with the credit market in 2008-09, but this time it was the banks and not the public that were overleveraged, which really invoked the ire of the public. Seeing these institutions bailed out with what they thought was public money, even though it actually was just money created from nothing, just being added to ledgers, added to their displeasure.
This can cause us to look upon speculation by these institutions as undesirable, which is a mistake because this is quite desirable indeed provided that it is managed properly. We do need to be careful as to not overly restrict them because doing so may involve less wealth creation overall.
The goal is to seek to maximize wealth creation provided that this is done in a sustainable manner, and whether or not some groups, the wealthy or big institutions for instance, may benefit more from the free exchanges that are permitted, cannot be seen as a relevant consideration.
We might think that people speculating on stocks and making a lot of money from it somehow diminishes the welfare of ordinary people, but this is not fundamentally different than their using the money to buy treasuries. The only real differences between them is risk and return, and we do need to manage the risk part by not allowing for excessive leverage, but we only allow for a small amount of leverage which contain the risks involved well.
We have seen this in action during the two crashes that we’ve had over the last 20 years, the one in 2000 and in 2008. In 2008-09, we saw over half of stock market capitalization removed and the market survived these losses without the wheels coming off.
Most stocks are held unleveraged anyway, and it is only traders that really use leverage, who aren’t the sort to hang around during any decline that would even come remotely close to invoking a margin call and precipitating more by driving prices further down, as we saw in 1929.
There is a lot of leverage that goes on in other markets though, with the bond market for instance. While we may allow the same leverage that brought down the stock market in 1929 with these securities, bonds just aren’t that volatile and the risk is held well within comfortable levels.
Financial regulation is very important to keep financial markets in check, but this all comes down to having enough transparency, and the goal of financial regulation boils down to just this. If banks knew of the risk of putting up 90% of the money for a stock that they did in the 1920’s, the lending market itself would have kept things a lot more manageable as the stock market would not have been pumped up so much and would not have crashed so hard.
The same holds true for the collateralized debt obligation crash in 2008, as the risk of these investments were nowhere near priced in enough and they were treated as AAA investments when they were simply a disaster waiting to happen.
The pursuit of understanding is therefore the key in managing secondary financial markets, and anytime we have the desire to tinker with them, we need to also use understanding as our foundation. If we do choose to restrain them, we need to do so with proper cause and justification and certainly not be motivated or influenced by anger or jealousy.
Talk of whatever speculation that may go on that we deem to be useless must therefore be met with proper deliberation rather than using this as a platform to lash out and try to level the playing field. What we do instead here is lower it, and we don’t just lower it for some, we may also be lowering it for ourselves.
Editor, MarketReview.com
Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.
Contact Robert: robert@marketreview.com
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