Investors Behaving Badly

story_images_sheep-herdIt’s funny that, when markets go awry – when the expected step by step rise is asset values is thwarted – there’s hell to pay. Not by asset managers of course – since they were just doing what everyone else was doing. Nor by investors, who, by the same token, were just following advice.

There’s a riff on this in The Guardian. It’s a faint echo of the Saturday Night Live dot-com spoof.

Of course, this is not new. And investors are not always their own best friend. Since Standard and Poor’s made its controversial decision to mark down the quality of U.S. Sovereign debt, investors have reacted with panic. Instead of looking for good-quality dividend-paying stocks, they have flocked into Treasuries. That’s a bit like trying to catch a falling knife once it firmly stuck in the floorboards. As a result, U.S. stocks have shed $1 trillion.

As Bloomberg reported:

“One of the most perverse things I’ve seen in 25 years of doing this is that S&P downgrades the United States government, and investors’ reaction is to run towards the securities that they downgrade, selling businesses without asking at what price,” Kevin Rendino, a money manager at BlackRock Inc., which oversees $3.65 trillion in New York, said in an Aug. 23 telephone interview. “Equity prices have swung well too far.”

But even Pimco’s Bill Gross, manager of the world’s largest bond firm was caught short. He expected investors to dump Treasuries, rather than pushing their yield down.

In the U.S., strangely enough, matrimonial discord between rich and poor has led to lower, not higher, Treasury yields as approaching recessionary winds force the Fed and private investors to favor bonds. There are limits, however. Ten-year Treasuries at 2.25% are discounting a heap of trouble (none of it strangely enough due to its own credit standing), and neither investor nor borrower may emerge from this brouhaha unscathed. We prefer the “cleaner” dirty shirt countries of Canada, Australia, Mexico and Brazil, where higher yields and more pristine balance sheets prevail.

Investors are behaving badly. Still, they need scapegoats

The curious response of some European authorities to stock market volatility – volatility fuelled in part by the notion that not only sovereign Europe, but European consumers are broke, and hence perhaps not a good risk – is to ban short-sales on financial stocks. We saw how well that worked last time:

British financial stocks dropped 41 percent in the four months after regulators imposed a ban on short selling following the collapse of Lehman Brothers Holdings Inc. in September 2008. The benchmark FTSE 100 index fell 15 percent in the period. When the Securities and Exchange Commission prohibited short-sales for three weeks in September 2008 a Bloomberg Index tracking the 880 U.S. stocks affected fell 26 percent, outpacing the Standard & Poor’s 500 Index’s 22 percent decline.

Why not go whole hog and ban credit-default swaps? The truth always hurts, so let’s delay the pain. We  durst not let short-sellers get their views out. After all, they may profit when everyone else is selling.

But what is the source of volatility? Negative views, or negative views too hastily expressed? There the Europeans are proposing to tax financial transactions – with a Tobin tax. Tobin won a Nobel Prize, partly for his work on the fundamental value of financial assets in relation to their real accounting value. The Tobin tax was designed to slow down the volume of round-trip currency transactions once the U.S. went off the gold standard.

Now the European Union has proposed a Tobin Tax, which has banking firms in a lather. Would it be the disaster the City of London thinks.

Raman Uppal, Professor of Finance, at France’s EDHEC Business School, offers a more nuanced view:

Almost each time volatility in equity, debt, or currency markets increases, there are cries to introduce a tax of financial transactions, first proposed in Tobin (1974). This tax is motivated by the view that the excess volatility in financial markets is the result of trading by  “speculators”; thus, even a small tax on financial transactions would “throw some sand in the wheels” of financial markets, and hence, by slowing down the trading activity of speculators would reduce volatility.

The theory is ambiguous: and reduced volatility may come at the cost of reduced liquidity.

The findings of theoretical models are mixed about the effectiveness of the Tobin tax to reduce volatility and improve welfare. The Tobin tax will obviously lead to a reduction in the trading of securities on which the tax is imposed. But, a reduction in the trading of financial securities also means that it is now more difficult to smooth consumption over time and across states of nature. The Tobin tax reduces speculative activity in financial markets; but, this tax also drives away investors who provide liquidity, stabilise prices, and help in the price discovery process. (One hears the resonance of the short-selling argument here: ban short-selling and there’s no taker on the other side of the offer, until, perhaps, it gaps down enough for a value investor). But the theory, while nice, isn’t terribly helpful. Nor are the empirical studies. Except for this nugget: “the imposition of a transaction tax leads to a reduction in the demand for that financial security, and thus, a drop in its price.”

Which might be just the thing for overly exuberant markets. Ironically, stamp duty is already charged on UK stock transactions, which has dampened neither the highs nor the lows of FTSE stocks.