 Is your base in a garage full of old house paint that you know you'll never use? I know mine is. Avocado green, hot pink, antique white, that is a nice shade of white though. You know it's easy to recycle your leftover paint, stain and varnish all over California. Most paint care drop off locations are paint and hardware stores that take back leftover paint. Keep what you need and recycle the rest. Find a drop off site near you at paintcare.org. In defense of financial markets, lecture four. Last time we talked about the stock market. We talked about its primary role in raising capital for corporations and we talked about all the other roles, providing a secondary market for securities, incorporating information into prices, providing liquidity, all of those support the primary role. That is you could not raise capital if all these other things didn't exist as well. Now I promised you today that we talk about what does stock prices mean and how do we get to them? How do we get stock prices? If you wanted to take a specific company and you wanted to figure out what its stock price should be, what are the things that you would consider? What would you focus on? Yeah? Well, the general principle for any financial asset would be to estimate first the expected future cash flow. So in the case of stock it would be the expected future earnings of the stock of the company and then the other critical piece of information would be the uncertainty in those expected future earnings. So the two fundamental things that we need to calculate, one is what is the fumes this cash flow is going to be in the future? What are the profits of this company going to be in the future? So I'm going to put the equation on board. This is the sum sign, that's how they teach it in Israel, and then we're going to do the cash flows and we're going to take from i equals one to some time in the future. So we're looking at the net cash flows, the profits from this venture. Now we know for example that let's say the profits are $10 a year from now, or alternatively $10, 10 years from now, are those two the same? Can we add $10 from a year from now with $10 from two years and $10 from two years and say oh they're $30? No, why not? Different times. Different times, okay? Money that we receive at different times is worth, its value to us today is different. $10 today is worth more to us than $10 a year from now. Why is that? And let's just for simplicity's sake, let's assume inflation is zero, so there's no inflation. So the purchasing power of $10 today is exactly the same as the purchasing power of $10 a year from now. Why is it still more valuable for us to have $10 today? Well, you could invest the $10 today and let's say if you could earn 10% interest it'd be worth $11 at the end of the year. So one is I could take this $10 today and put it in some productive activity and generate more than $10. What else could I do with the $10 today? Yeah, I could consume it and I would benefit from that consumption now. So I can eat the ice cream now instead of waiting a year to eat the ice cream. So we call this the time value of money. In order for me to forgo having the money for investment or consumption today, I require a return on my money. That's where interest rates come from. If I loan you money, I am giving up the opportunity to invest it or to consume it today and therefore I require that you give me an interest payment on the loan. So we're going to define an interest rate R and the first parameter is going to be the time value of money. And that is equivalent to what we call the real rate of return in an economy. That is the rate of return minus the inflation rate on a security that has very, very low risk. For example, in today's world, a one-year treasury bill. Now we have to add to this something if we want to calculate the time value of money for this risky stock and what is that? That is the risk that we're taking on. Take for example an investment of $10 in something extremely safe, a company that's been around forever that had Coca-Cola. Coca-Cola is not going to go bust any day now. It might make 10%, 5%, 15% but it's not going to go bust versus $10 in a biotech company which is risky. The biotech company, where would I demand a greater return in order to provide them with the money? Biotech. And we call that a risk premium. So the return that we expect to get in our stock is determined by one, a real rate of return, the time value of money and second by a risk premium. The riskier the investment, the more return we expect to get. Now we use this rate of return, this little r, to discount these future cash flows to the present to bring them into the value of this investment in the present, so a P0 which will be the price of the stock today. So cash flows I'll divide by one plus R to the, what do they use? I. Now if you want to know the technicalities of the equation I'll stay after class and we can talk about it. But all this is doing is it's taking those future cash flows that this company is expecting to generate, the future profits and it's discounting it to today's dollars taking into account the riskiness of the company. Now these are all expectations. We don't actually know what the cash flows will be. We don't really know that much, I mean how to measure risk. Risk is a tricky thing to measure. So with regard to the risk premium and with regard to the cash flows they can be legitimate disagreement between us and therefore we could legitimately come up with different prices for the same security. That's what explains the fact that there's buying and selling of stocks. Because if we all agreed on the price, if a stock had an intrinsic value that we all we had to do was somehow look at it and glean that price out of it and we all agreed that that was the true intrinsic value of the stock there would be no trading. If we both think the stock is worth 50 and I happen to own it why would I give it up for 50? I'd only give it up for more. Not the same amount. Everything occurs when I would buy if I think that the stock is worth more than the price I'm paying for it and you would sell if you think it's worth less than the price you're getting for it. That by the way occurs in every trade. When you go buy a car, you pay $20,000 for the automobile that's because you value the automobile more than $20,000 and the car dealer values $20,000 more than the automobile. You're both placing a value on the car that is different and that's what enables you to exchange, to trade. The same thing happens in stocks. Expected cash flows were also uncertain and people can disagree on. Yes, I said both this, the expected cash flows and the risk premium are both open to disagreement in a legitimate way. So this is how prices are set. So when we talked about before on the information content of prices we were talking about the information content in P0. Now in order to further elaborate this I'd like to talk now about the economic role of speculators. What does it's speculators do? And we'll see that they have important role in setting this P0, the price that we can see in the Wall Street Journal when we open it up to the page with the stocks. Now before I get to the positive, to the positive economic role, let's look at how they are viewed by economists and by our culture. I'd like to read you a quote from the General Theory of Employment, Interest and Money by John Manett Keynes written in 1936. When the capital development of a country becomes a byproduct of the activities of a casino the job is likely to be ill done. The measure of success attained by Wall Street cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism. So John Manett Keynes sees the stock market as what? A casino. So that means this P0, the price of the stock, is determined by what? By gamblers, by speculation that is not connected to anything real. This is completely by whim, by chance. Spinning of a roulette wheel, oops, came out fifty dollars. Spin it again, it comes out forty-five. Now it is no accident, I think, given this and given his other economic theories that John Manett Keynes was a lousy investor. He managed stocks for other people and he was not good at it. Counter to what my earlier class people said that they had heard that he was a good investor. Well that's false. He was a lousy investor. He did not believe in diversification. He would buy individual stocks and do analysis on individual stocks and he lost a lot of money. Something incredible has arrived at Disney California Adventure Park. Vailing, I want action. We're going big. Elegance. And we're going fast. Speed. The Coaster is here and now open at Pixar Pier at Disney California Adventure Park. Bring your super family and your friends and come celebrate Friendship and Beyond at Pixar Fest before it ends September 3rd, only at Disneyland Resort. Attractions and entertainment subject to change without notice. Hi, it's Jamie. Progressive number one, number two employee. Leave a message at the... Hey Jamie, it's me, Jamie. This is your daily pep talk. I know it's been rough going ever since people found out about your acapella group, Mad Harmony, but you will bounce back. I mean, you're the guy always helping people find coverage options with the name your price tool. It should be you giving me the pep talk. Now get out there, hit that high note and take Mad Harmony all the way to Nationals this year. Sorry, it's pitchy. Progressive Casualty Insurance Company and Affiliates price and coverage match limited by state law. How do you analyze a casino? How do you analyze a casino? Yeah, you take a... Oh, how do you analyze a casino? He supposed to analyze specific companies. I have no idea how he even had the pretence to invest in particular stocks when he believed the casino... the stock market is like a casino. One more contradiction. Now in today's world, speculators, the people who trade on a regular basis, trade for short-term profits, they're called paper profiteers. They add no value. They create no products. They don't really supply capital to the firm. You remember we talked about last time the fact that only those people who buy the stock originally when the company issues it supply capital to the firm. They don't supply capital to the firm. They're just gamblers in this casino. Not only that, but the viewers that speculators in general are irrational, which is consistent with the casino view. That is that they act on whim, they trade on whim, they are responsible for such things as speculative bubbles, hood instincts, market psychology. So speculators tend to hood, they tend to be influenced by psychological issues, not with the fundamental economics underlying the specific companies in the stocks. No, this is not mine. This is what people like Keynes are saying. They blame speculators for being behind what they view as the short-termism of corporations. That is, the idea goes like this. A company lays off lots of people, thus cutting its operating expenses. Speculators view this as a positive event, they go in and buy the stock, which is what they tend to manage is to begin with, to do this in order to raise the stock. So they are responsible for the behavior of the managers. It is their fault. Of course they are also responsible for crashes and when the speculative bubble bursts, it is the speculators fault. So what is it? So this is what our culture perceives speculators, what some of our economists believe speculators do. What is it really that they do? Just a quote again from Midas Mulligan from Atlas Shrugged. This is on page 300 in the soft cover. When an economist referred to him once as an audacious gambler, Mulligan said, the reason why you'll never get rich is because you think that what I do is gambling. End quote. Now that's the answer to Keynes. If he thinks it's a casino, here's reality to show you that if that's what you think, you're not going to make any money. So what is it the speculators do? Speculators try and identify mispriced financial assets. They're continuously looking for mispriced financial assets. When they find them, they go in and purchase them or sell them depending on in which way they are. Mispriced, thus making a profit. So they're looking for profit opportunities. They're looking of ways to make money by buying and selling financial assets. Now the two types of speculation here. One, which I understand better, which therefore I will talk more about, is what I would call fundamental speculation, where they are looking at the fundamentals of the company and trying to find companies that these fundamentals are not reflected in the stock price. The other, which I'll say a few words about now, but which I don't know that much about so I can't elaborate too much, are speculators that look for patterns in the trading of financial securities. So regular movements and then take advantage, find ways to take advantage of those movements, by doing so, by taking advantage of those movements. And if enough money is behind them to take advantage of those movements, those movements disappear. If you look for certain patterns, let's say a simple example. Let's say everybody gets paid on a Wednesday. Therefore everybody goes into the market on Wednesday to buy their stocks. So stocks go up on Wednesday because suddenly there's this inflow of demand. So what these kind of speculators would observe, Wednesday stock market goes up and then maybe it goes down on the Thursday when people realize that these assets are misplaced. What do these speculators do? They would buy Tuesday at the close of the market and sell Wednesday before the market closes. Now if they do this enough, what will happen? If enough people figure this out, then the market will already go up a little bit on Tuesday, won't go up as much on Wednesday, and then the whole transition will be smoothed out. Is this what automatic program to trade amounts to? Yes, what they look for there is a mispricing of something called an index future. So in Chicago you trade, there's an instrument called an index future that takes the S&P 500 index, and you can trade on your expectations what that be in the future. They take the price of that versus the price of the S&P 500 stocks that are actually trading in the market. And if they are mispricing in those relationships, then they will come in and adjust them. I don't think those program trading is actually necessarily looking for patterns. Some computer models will look for this. People who trade in futures market, a lot of people who trade in futures markets, speculators look for patterns in futures trading. Sometimes the fact that one speculator will come in in order to correct a pattern creates a different pattern. Now I admit I do not know much about this and this whole area is very intriguing to me and the fact that it exists somewhat surprises me and is fascinating. I don't think, a lot of people would claim it's a result of the irrationality of the market that these patterns exist. I don't think that's the cause. I think there's some legitimate reasons. For example, being paid on Wednesday and everybody buying stock on Wednesday would be a legitimate reason for a pattern to exist until the speculators step in and erase it. I don't think it reduces the efficiency of the market because there are speculators who come in and take advantage of it and eliminate it. It's a speculator that do away with it. But I know people who make money doing this and you can't argue with that. I think that speculators do a lot of things including the fundamental analysis, as you say, and also the technical analysis and even some of the things that Keynes accuses them of but it's not as arbitrary as he suggests. They're very diligent about what they do. They're very precise and orderly in the way they take all these factors and put them together and it's a real business. And it's anything but arbitrary. I agree. But let me just say something about technical analysis. I think that 99% of what we hear about in terms of technical analysis is complete nonsense. You know, they talk about the ceilings and if a stock crosses that then it's okay. If it drops, it's not. Most of that, almost all of that is complete nonsense. They are no such regular patterns in this in securities over long periods of time as these people tend to imply. I mean, they look at months and years. We're talking about little tiny things that you have to be an incredibly fast and efficient and low-cost trader to take advantage of that don't really exist, speaking to some of these people, are very rarely exist in the stock market because if you take the transaction costs involved in buying and selling, your profits are gone. So these kind of things don't really exist to a large extent in stock markets. They're more a phenomenon in the futures market. At least nothing, they don't exist in the short term so you can take advantage of them. A lot of them are issues of arbitraging, of taking advantage of mispricing between markets or across countries. You know, the bonds in South Africa and the bonds in the US, given the currency rates, given everything else might be mispriced and by selling and buying the one, by selling one and buying the other, you might be able to make a profit and if you do that enough, also eliminate the mispricing. And that's why I think the people who make money at it make money at it. But the stuff you hear in, I don't know, what is it, CNN or some of the financial news network, these guys come out with these charts and stuff, that is a lot of nonsense. It's always apps complete witchcraft, yeah. It's completely mystical, they have no reason, they have no reasoned argument on why any of this works and it doesn't. They can't make money consistently. Okay, so let's go to the fundamental speculation. What is it that these people do? What they are trying to do, what speculators are trying to do is they are trying to get the best estimate possible on the cash flows in the future and on the riskiness of the phone. So what they are doing is they are looking for information, they are trying to analyze whatever information is available to them, they are trying to seek out new information in order to get these numbers as accurate as possible to what is really in reality, what is really going to happen. So they are trying to predict the future the best that they can, better than anybody else out there. So they have large research staffs, they have people that go to interview the CEOs, the boards of directors, they look at the competition, they look at individual companies very, very carefully. And then based on their analysis, they would either buy or sell depending on the price. So if they discover, oh, this company is not as good as the price and the market would suggest, they would sell that stock. Or if they believe that they based on information and new knowledge that they have, the firm is worth more than the price implies they will buy the stock. By doing this, what they are doing is embedding the information that they have gathered, embedding the knowledge that they now possess into the price of the stock. So for example, let's say the stock is trading at $45, they believe it should be 50, that is based on their calculations, it should be 50. What are they going to do? Well, they're going to buy at 45, right? They buy enough, what's going to happen to the stock? People are going to observe that there's buying going on, and if they know who they're buying, so they say, oh, these are people that in the past, after they bought the stock has gone up, the stock will start going up until it reaches 50 and then they'll start buying, okay? Now, if the market agrees with them, the stock price will stabilize, that if other participants in the markets agree that the real price should be 50, it'll stop there. If market participants think, no, that's too high based on our knowledge and our information, the price should actually be 48, then it'll be driven down to 48, or when it goes up, it'll stop at 48, won't go up any higher. The point is that the new information and knowledge that you have gets embedded into the price together with the information and knowledge that everybody else in the market has, that the other speculators and long-term investors have. So speculators and long-term investors out there searching information. Now, I would say that the information that speculators have is often of higher quality and better than the long-term investors, why? But why do they work hard about it? Because they need a short-term. They need a short-term, yeah? They're also expecting a larger profit. Because they are in it to make a profit now. They wanna make money on this specific transaction. That's just somebody like Juan Buffett, who is a lot, does everybody know who Juan Buffett is? The richest or second richest man in the world depending on the day measured, okay? Right now he's the second, but if the market goes up and Microsoft go down, he'll be the richest, which happens sometimes. He's worth somewhere between $15 and $20 billion. All his money was made in the stock market. He started with absolutely nothing. All of the money was being made in the stock market. He buys long-term. He buys a company that he likes, where he likes the management, where he likes the product, where he sees long-term future prospects, and he holds it, okay? So that the new information that the trading of Juan Buffett provides is very small. He bought it once and he just holds it on. Because he's expecting his rewards many years into the future. It doesn't have to happen today. Whereas the speculator needs to make profit on every trade that he makes. And he won't hold the stock for years and years and years. He might hold it for a week, a month, a day. See, he's continuously researching. He doesn't research once and buy, hold for 10 years. He is continuously involved in the researching of the company on a day-to-day basis in order to glean as much information as he can. That's the combination of both those types of investors that gives us a price and gives us the best kind of information. Yeah. A comment. A speculator, somebody also had to do what is called a margin analysis. You know, were there, you know, any problems they make is based on volume, not on the change. It depends on the size of the thing. The problem the speculator faces is that if they come in with large volumes, then let's say I want to sell the stock. And suddenly I see somebody come in and want to put $10 million to buy the stock. I say, wait a second. This guy must know something that I don't know. I'm gonna jack the price up. So they have to be very careful in how they come into the market and how they buy. If they come in at huge volumes, the price is gonna go up before they trade. And if you actually, if you see, if you look at stock price return on a given firm, let's say this is the company and it's kind of not very volatile, it's fairly flat. And then a new news announcement comes up. A new product has come about. What you'll see is the price shoot up almost immediately. No trade has to occur that moves it up gradually. Because if I'm the seller, I've learned this information as well as you have. I immediately demand a higher price for it. So information gets incorporated and in this case, very, very quickly into the price in one spike. Yeah. The validity and pricing stocks based on other companies in the same industry doesn't seem like one should analyze a company based on its own assets, its book value, et cetera. However, there is a tendency and it's valid because people make money all the time and price stock based on other stocks in the industry. One reason to look at the other stocks in the industry is to get a good handle on these cash flows. The cash flows for your specific company are related to the cash flows for the industry. For your competitors and maybe even for industries that are related that today might not be competitors to you but might be in the future. Phone companies might be interested in the cash flows of internet providers because they are gonna compete with one another one day or they might be going into that business one day. So when you look at the cash flows and when you look at the riskiness, you can't just look narrowly at the company. You have to look at the company within the context of the industry that it's in, within the context of the complete market. So I think it is relevant to compare your company to other companies, to compare it to the industry returns in the past, to compare it to the cash flow expectations, to compare it to the competitive relationship between them. So by trading, speculators provide information about the company. The stock now has, contains information about the company, the movement if it's going up, if it's going down, is meaningful, is informative. The fact that there are different views on this makes this number a kind of an average, the average expectation of people who are trading in the stock. Now prices are very sensitive to information and they reflect that information very quickly, again for the profit motive. If there's just been an announcement, if you find out about it before somebody else does, because that might be construed as insider trading these days, but if you can find out about it first and you can trade before it reaches the sellers, then you can, if you can get it right, right there, then you are gonna benefit the most from it. So there's a large premium on good, fast research that provides you with accurate information before anybody else can get. So by the fact that you are out there researching, finding the information, information gets revealed and information gets traded on. Now as we saw before, the information embedded in prices is very important economically. The fact that this is not a random number is important to the allocation of capital in our economy. So they play a very significant role by providing this information. It is speculators more than any other type of investors that make prices of stocks meaningful. Speculators continually take on risks because they might be wrong. Let's say they think it's worth 50 and they start buying at 45 and then it turns out then a news announcement comes that an earthquake has come and destroyed the factory and they don't have insurance and the price tumbles to 20. The speculators have lost. Or they just made a mistake. Turns out that the research is flawed and it's only worth $40. Again, they're gonna lose money. So the speculators take on a lot of risk. Again, it's counter to some of the perception in the media that these guys are just raking it in left and right. There's no challenge. There's no risk. They don't have to work hard. Again, if you saw in Wall Street, the movie, they talk about how finance is not. Getting information is not an issue of working hard. There it's an issue of breaking into other people's offices and stealing it instead of doing research and finding it, which is how this is really done. It's the very, very rare exception, the criminal activity. True objective criminal activity is involved. They continuously evaluate new information buy and sell based on it and by doing so are taking on some substantial risks. In addition to their role as, since providers of information, they also make the markets more liquid by their willingness to continuously trade. Some people who sell stocks don't sell stocks because they think that they are mispriced but because they need the money. Need the money to buy a house. You sell your stock portfolio and you put the money in a house. Speculators are almost always there at the right price to buy your stock from you. Or if you just inherited a lot of money and you want to make an investment in the market, you don't necessarily research each firm like a speculator does. You might buy a diversified portfolio. So you buy a little bit of a lot of companies. They are there to sell it to you. And of course they make money off of that. And they are condemned for making money off of that. Okay. They are also the ones that are responsible for taking care of whatever irrationality really does exist in the market. That is if there are people in the markets and there are people like this who do trade on whim, who trade on the configuration of the stars that day on some bizarre technical analysis. Something that makes absolutely no sense is not connected to reality. Then speculators would be glad to trade with those people. Because those people are the least knowledgeable. It's where they can take advantage the most of their knowledge. You know, there's a book about the delusions of the market. Something like that is in the title. Or find me somebody delusionary. I'd be glad to trade with them. I can really make profits. Now by trading with those people, you're eliminating, you eliminate their influence in the market. It is the speculators that determine this. Not the delusions. Because for every delusion, there's always somebody who can make money off of that. Let's say somebody decides this stock is actually worth 100. Just stop buying it up to go to 100. Well, what will the rational investors are gonna do? The stock goes up to 100. What are they gonna do? They're gonna short the stock. You know what shorting a stock is? You borrow the stock and sell it at 100. So you borrow it from somebody who owns it and you sell it at 100. That's shorting the stock. You don't actually own the stock, but you can still sell it. By doing that, what kind of pressures are you putting on the stock? Downward. So the price goes down to 50, and then you buy it at 50 and you hand it back to the person you borrowed it from. That's basically the mechanism of short selling. What? Sure it could backfire. And that's, again, speculators take on risk. Just like it could backfire that when you buy it at 45, hoping it'll go to 50, it actually goes to 35 at backfires. You could short sell it at 100 and it goes to 120. But assuming the 100 was determined by irrational people, it's not gonna stay there for very long. Because the rational investors, the money-seeking, profit-seeking speculators, they're gonna come in at 100 and short sell the stock. Or let's say the environmentalists decide that this company is a polluter. With no, you know, they can't sue or something like that. So there's no external elements. They just decide, therefore, all the environmentalists in California sell the stock. Basically most of the population of California. They sell the stock, driving the price down. So it's worth 50, it's actually gone down now to 25 because of all this selling. What are the rational profit-seeking speculators gonna do? They're gonna buy it at 25 and make a killing as it reaches 50, okay? There's enough money in the hands of rational profit-seeking people in the markets today to make this work. So that whatever irrationality is in there gets wiped out very quickly. Because of that, for example, I don't believe that right now we have a specular bubble and overpriced market and everybody has to run for cover. I think prices today in the market reflect the true value of the market today. That doesn't mean it's gonna go up for now. It might even go down. It depends on what happens. It depends on what the new information that has revealed what our expectations about the future, whether they change or not. Part of that might be determined in the next election. And a lot of other things, other than certainties are gonna get settled in the next few months. So the price today reflects, I believe, the true value of the market today. Now, short-term, there might be exceptions. You know, where the people who are less rational can dominate, but that is only in the short-term. And in an individual stock, it doesn't take long for those things to get adjusted. Yeah. Explain crashes in the stock market, like everything falls. 1987. October 19th, the stock market crashed, went down by 25%. It had already gone down a little bit the week before. What do you mean by, I guess the question, what do you mean by explain crashes? How do they come about? Okay, let's say that over the weekend, October 19th was a Monday. Let's say over the weekend, the president had come out with an announcement that he intends to increase income taxes by 50%. I'm making this up, right? By 50%. And especially on capital gains. So they're gonna increase capital gains, which is the tax that is taxed on your gain when you sell the stock on whatever profit you've made, by 50%. The market says, okay, taxes are going up by 50%. That's gonna decrease my cash flows. What does government policy do to risk? Gonna increase the risk. Therefore, so this goes up, this number I'm dividing becomes bigger. This number goes down. What's gonna happen to my price, to the value of all the stocks? Gonna go down. You have a crash. And it all happens at once, because all these speculators, all these long-term investment, all these other people on stock realize this, they do this calculator and say, oh, it's not 50. It actually should be 25 the value of the stock. We'll all sell at the opening bell in New York Stock Exchange in the morning. Something incredible has arrived at Disney California Adventure Park. Darling, I want action. We're going big. Elegance. And we're going fast. Speed. Credit Coaster is here and now open at Pixar Pier at Disney California Adventure Park. Bring your super family and your friends and come celebrate French Offend Beyond at Pixar Fest before it ends September 3rd, only at Disneyland Resort. Attractions and entertainment, subject to change without notice. Morning. So you're saying in a free market, there won't be any crashes? I'm saying in a free market unless there is some kind of either technology shock or natural disaster, there would never be any major crashes now. Just like there would never be any depressions or big, big recessions. I believe that they would be a business cycle. I do believe that there would be a business cycle in a free market, but it would be nothing like the type of business cycle we see today. The business cycle would be driven by technological shocks. Where new technology came in and made a whole bunch of other industries useless. But there wasn't yet enough capital to build a new industry to compensate. For those, he might go through a mild recession, but nowhere near depression or the kind of recessions that we have. So in the same sense, I think that they might be downward times in stocks, but you would never see a 25% drop in the stock market in one day if there was no government intervention in the economy. And there were a lot of things, by the way that happened before October 19th, that made it very rational to start selling. Now, people did overreact. That is, people did oversell. It shouldn't have gone down by 25%. It should have maybe gone by by 15%. And the fact is that the next day, on the Tuesday, the market went up by a lot. It went, I think, down by 500 points and then went up by 100 points the next day. So the markets, even when they overreact, that is, when they make a mistake, the correction is very quick. Again, because people out, they don't make money. And they are, this is how they make their living. It's not a sideshow, you know, the saving for their pension. They are in there to make them money. And if they do well, they might make a million dollars a year. And if they do poorly, they might make $50,000 a year. Now, that's good motivation to do a good job at it. Okay, so that's the role of speculators. Now let's look at a different complaint against the markets, which is very related to this. So this one should be easy to debunk. And that is that the markets are short-term. All they care about is short-term profits. It goes back to this idea, you know, what the company does is we lay off all our R&D staff. We just fire them. Why? Because now we don't have the expense of R&D. We don't have to pay these people what happens to our short-term profits? They go up, what happens to long-term profits? There you go, way down. Does the market respond positively or negatively to this? Well, let me read you some quotes from one of the principles in Culpers. Culpers is the California public pension fund. The largest pension fund in the country, therefore the largest institutional investor in the country, the largest single investor. And I quote, the real culprits of corporate greed, the boards of directors that have allowed the hollowing out of America's corporations to obtain short-term increases in stock price. Culpers is not pushing to bump up short-term stock prices. We are company's long-term patient capital and are troubled when companies sell out to short-term Wall Street traders. Well, I quote, Culpers opposes layoffs to lift stock prices in the near term. This is wrong and will not work to create wealth over the long run. You could shrink your way to profitability in the short term, but it isn't the road to greatness in the long term. So the idea is that we can, that the CEOs and the board of directors can fool Wall Street by cutting things that are valuable for the long run, for the benefits in the short term and the stock will go up. If we look at how a stock price is determined, what plays a role? The present profits right now or profits in the future? These are future profits. So the way the market prices stocks is with a look into the future, not into the past and not to the present even. The present and the past are important only in what? In that they tell us something about the future. They say we can tell something about the reliability of management, about the success of the product, about the profitability of the company from the past and we can project that into the future. But they are meaningless beyond that. So the whole nature of the stock market is to look long term. So for example, let's take this company that just fired all its R&D staff and has promised never to put a dime in R&D again. And according to this theory, the market would go up. And let's assume it did. Let's say there were some irrational investors out there and they bought the story and they don't use this equation. They use just the cash flows next year and that's it. They don't look further than that. So the price of the stock goes up. What would the rational investors and speculators do? They would sell the stock like pancakes. I mean, this is dangerous stuff. This company is committing suicide. So yes, we might get something in the near run, but in the long run they're dead. They're not investing anything in the long run. Yeah. That would depend of course on the kind of company if it was Microsoft or Intel you'd say that's absurd. I'm assuming here that R&D is a positive investment. Yes, you're right. There are companies where you want to fire the R&D staff because they're not doing anything because there's nothing left to do. Algae and Obisco's R&D staff for example. And if you saw a barbarians at the gate or read barbarians at the gate, the smokeless cigarette that they invented tasted like a four letter wood. It was awful. And they lost billions and billions of dollars on that investment. So I'm assuming R&D is a positive, not as something that you don't really need, that you're not an industry that needs it. So what, so the key here to remember is that stock prices are derived from future cash flows. And if stock prices do not reflect this, then there's a profit opportunity. There's money to be made by either selling or buying. And when there's profit to be made, somebody's gonna come around and make that profit and by doing that, it eliminates the mispricing. Now, an example of this on a very perceptual level and this whole argument is absurd, is look at companies like Netscape or look at biotech companies that go onto the market with no earnings, no profits, all they have is long-term future growth potential. Like Netscape had a product, but it had no income. It lost money when it went onto the market. It's only now starting to generate some profits. But for Netscape, for the price of Netscape to be justified, they are gonna have to make enormous profits in the future. And not next year, but we'll talk about way in the future, because nobody expects them by next year to be making profits like Microsoft. But the stock price would imply that one day they will. What does this tell you about the investors who are buying Netscape? Are they short-term or long-term? These are very, very long-term investors. Or biotech investors, people who buy biotech stocks who often don't have a drug on the market, who are just in R&D. This is capital to increase the R&D. Are these short-term investors or long-term investments? These are long-term investors. If anything, the same people that complain about short-termism claim these people are irrational because Netscape will never make that much profits. So, I mean, they attack you on both sides. On the one hand, they say all the traders are short-term. On the other hand, they say, oh, you're looking too far into the future. Netscape will never make this much money. You can't win with them. They always come out with an argument. So, on the very perceptual level, one way to debunk this idea is to look at stocks of very, very risky, high-tech new companies that have no revenues, and hey, they do pretty well. The reason is that there's enough investors out there that are long-term, rational investors that have expectations regarding the long-term. Welcome to the Total Wireless Store, where total confidence awaits. Our daughter's off to summer camp, and we're worried our network coverage won't reach her. Don't worry, you got this with Total Wireless. Our phones run on the nation's best 4G LTE network. It'll be like she never left. The nation's best network? I feel better already. Now you can focus on how you're spending your summer. Discover the Total Wireless stores and get Total Confidence, the latest phones, the best network, all at great prices. Now open in Los Angeles. Refer to the latest terms and conditions of service at TotalWireless.com. Now, yeah, that's fine. Where does the company's fixed assets come into the pricing of the stock for their company test? They don't really. The fixed, where do the fixed assets of the company come into pricing the stock? They don't directly, they do indirectly. And they come into it because it is the fixed assets plus the labor that is employed to generate the profits. So when you're looking at a company, how do you get these cash flows? Well, you look at the fixed assets, you look at the ability of the employees, and you say these assets with these employees and this management with this expectation regarding the future, this is what they'll generate. But you don't actually use that number in coming up with a price. Yeah. Maybe it'd be helpful to distinguish accounting value of a company, which is based on assets and liabilities and financial value. Accounting value in a sense is looking backwards at historic costs whereas finance value is looking forward at anticipated revenues. Okay, finance always looks forward, accounting is history. Accounting is describing what happened in the past. Finance looks forward into, it speculates as to what will happen in the future. That's a good point. I make quite a bit of fun of accountants in my class. Because of this, because in finance, one of the things I teach my students is when you do financial analysis, you don't look at accounting numbers. Because not only are they historical numbers, but they are also what? Open to manipulation. Accounting can be manipulated in various ways. If you've taken an accounting class, you can take five-fold accounting and life-fold accounting and this is taxable and this is depreciable and that is not. And in finance, we don't really care. Money, how much cash flow has come in, how much cash flow has gone out. We don't care if you're depreciating over 10 years or if you're depreciating over two years in finance. Unless it affects the cash flow. So it's one of the things you have to kind of root out of the students because they've always come with an accounting background into the finance class. Now there is one sense in which the critics who claim the markets are short-term are correct. And markets today are more short-term than they were 100 years ago. Markets today are a lot more short-term than they were in the 19th century. And why is that? Look at this equation, because it's all in here. It's all in this risk premium. The further into the future you go. The less significant that cash flow is today, right? Because you're discounting it over more periods of time. Now if this number is small, if the risk premium is small, that doesn't have a big effect, right? So $100 10 years from now is quite a bit of money if all I'm doing is discounting, let's say 2%. But if I'm discounting it 50%, $100 and 10 years is meaningless to me. It's a fraction of the $100. Now how do I determine this? Well, you can split this risk premium up and you can, let's assume that this is risk premium that does not include the risk of inflation. So you could add inflation to this. Not only just inflation, but the risk that inflation will be very high in the future. On a gold standard, there is no inflation. So this number is always zero. There is no uncertainty about purchasing power of the dollar in the future. Therefore I don't have to take that into account in my analysis. Today I do. Not only do I have to take into account the inflation rate today, but I have to take into account the possibility that it'll be greater in the future, the risk, the variability in inflation rates. So that's one. In addition, business today. Business today is a lot riskier than it was 100 years ago. Not in the sense of what the market has created. It is a lot riskier because of what? Because of regulations, because of taxes, because of monetary policy, because of the deficit, because of government intervention. So for example, yes, code decisions. For example, you were thinking investment in a biotech company. It has a very promising line of research. They project they will have the drug ready in a year. Drug, it's gonna be a revolutionary drug. It's gonna cure all forms of cancer. So you expect this is a multi-billion dollar company. But one additional consideration now do you have to take into account that you wouldn't have had to do in the 19th century. If they approve it at all. Maybe it'll have side effects. Maybe you get a rash. An unseemly rash or maybe one out of a hundred people who take the drug dies. You know, side effect, they die. And maybe the FDA will decide that curing 99 people is not worth the death of one person even if you announce it on the label that that is a risk. So you don't even know if the FDA will approve it. Never mind how long it'll take because these things can take years and years and years. So the risk of those billions actually becoming real has increased substantially. Therefore your interest, your risk premium in our equation is larger. Therefore this bottom part is greater. Therefore P zero is smaller. The price of the stock is smaller. So by increasing our risk premium, the more distant cash flows now are discounted by a larger number, we pay less attention to them. Of course it influences the cash flows themselves. We are less certain about the cash flows. We're less certain about how big they are gonna be. Maybe the environmentalists will decide that the steel industry is an evil industry and drive them all out of existence 20 years from now. So we might say, listen, in the environment we live in today, I cannot predict more than five years into the future. And I'm not gonna pay any attention to the cash flows after five years. That'll make me more short-term. In the 19th century people sold, companies issued hundred year bonds just to give you a perspective on the kind of long-term planning people were doing back then. Hundred year bonds, today it would be meaningless just because of inflation. Hundred year bond would be worth nothing a hundred years from now. Even at a 3% inflation, which we think is a great deal, 3%, low, low inflation. Well, the standard should be zero. So if there is short-term thinking, if there is short-termism in the market, it is a direct consequence of government intervention. Now let me give you an example of a government cure for short-termism. Because this is a proposal. This is a proposal in the House of Representatives that if the Democrats win, we'll get a vote on. If the Democrats win the House. It's a proposal by Senator Jeff Bingman from a Democrat from New Mexico. And I'll quote from his little proposal. We have concluded, along with many experts, that our current financial markets exert enormous pressure on American business to produce short-term profits, which inevitably makes it harder for businesses to make the long-term investment in the employees that a true alliance with America's working families requires. Now you make sense of that sentence. We believe that this counterproductive phenomenon must be confronted head-on. At a minimum, we need to create a speed bump against short-termism, end quote. What's the speed bump? What would you do in order to stop short-termism? You? Yeah, you tax it. You say, if you trade in a stock, if you buy and sell a stock, according to this proposal, within a span of less than two years, then you will be taxed. Now think of how this would affect a stock market. And this would be, talk about a crash if this thing passes. It would mean that speculators could no longer work. They time horizon is not two years. They would need two years to drive this up. They could never get out of the stock in two years. So even though they think the stock is 50 worth 50 today, they don't know what it's gonna be based on their research a week from now or a year from now. They would just go out of existence. Why do any research? So you'd see investment bank is stopping and speculators of all types, stopping to do research in stocks. And then you'd get what Keynes said we had. Then you'd get a casino. Then you'd get a stock market and it didn't mean really anything. Is your check engine light on? Don't ignore it. Stop by O'Reilly Auto Parts today and let our professional parts people scan your vehicle for free. We'll retrieve the codes, discuss possible solutions and even help you find a professional technician if needed. Visit O'Reilly Auto Parts today for our free check engine light help. O'Reilly Auto Parts. Better parts, better prices every day. Oh, oh, oh, oh, O'Reilly Auto Parts. I just definitely think that they did the thing that's lowering their existence of that precipitating crash. Well, that is the one reason I think that this kind of law will not pass, fortunately. Is the fact that they realize that it's going to, that the stock market will crash. At least, I mean we live in somewhat sane period as hard as it is to believe sometimes. But markets, by crashing and doing things like that, do exert influence on Congress. I'll give you an example, going back to the October 19th, I don't remember if I've told you this or not, but going back to October 19th crash, 25%. That morning, the morning of October 19th, the, both the House Banking Committee and the Senate Banking Committee were putting in the final changes to a bill. You know what the bill was? No? It was a bill to prohibit takeovers. Would it be made takeovers impossible in the United States? It would have been a federal law that makes them impossible. As the ink was drying, the market collapsed 25% and that bill was torn into shreds and put in the waste basket. Now, that didn't really help that much because all that happened is the states passed similar bills and we'll talk about this if we get to that section that we're structuring. But the market said, this is what we think of your bill, you know, basically. Now, I believe there's a strong relationship between the passage of that law or the introduction of that law in the House of the Senate and the administration's willingness, expressed willingness to sign a bill like that. The Treasury, this is still Reagan. The Reagan administration as well was willing to sign off on a bill like that. That was one of the reasons, there were others, but that was definitely one of the reasons why the stock market crashed in October 19th. And the crash stopped the bill, so there is an impact, yeah. I understand they were a little less direct than that. They actually attacked the financing of takeovers by attacking junk bonds and they said that corporations would not be allowed to deduct junk bond interest as a business exchange. That was one of the provisions, they had other provisions. The whole bill was in a general and anti-takeover bill that put in all kinds of provisions like that. That was just one of many to restrict the takeover market. What they landed up actually doing is finding other ways, and again, I hope we'll get to this, but finding other ways to destroy the financing. They actually succeeded in destroying the junk bond market. And we'll see that at least for a while. And they destroyed takeovers. Takeovers are very rare occurrence today, especially when you compare it to the 80s. So they succeeded in doing that. They just didn't succeed with that law because they realized it's impact. Part of the bear market of the 1980s, the bull market of the 1980s, the rise in stocks in the 1980s is directly attributed to the restructuring going on, to the takeovers and LBOs going on. And investors feared that if this was coming to an end, then all these stocks were worth less money. And when we talk about the restructurings, we'll see why they were so important, okay. Any other questions about short-termism or about speculators? Okay. The stock market as objective. Why is the stock market objective? Do you know the idea in capitalism, not known ideal, and in opa, in Dr. Peacock's opa, about socially objective value? Anybody know what socially objective value is? I forgot the definition for my end. She said that a price, a market price, a price set in a free market is socially objective. It is the sum of the individual judgments of all men involved in a trade. At a given time, the sum of what they valued each in the context of his own life. Read that again. The sum of the individual judgments of all men involved in a trade at a given time. The sum of what they valued each in the context of his own life. In other words, a market price reflects the rational judgments of market participants, speculators and others. This price, this P0, this price of the stock is an objective price in that it reflects these rational considerations, these rational judgments. And in a market, as I've tried to explain, in a market, that's what prices reflect. Because the irrational, the idiots, if you will, the people who trade on whim, get wiped out. And the price lands up reflecting only the judgments of the rational. So prices are, prices in any free market, prices of all goods are objective. They are not subjective as, for example, the Austrian economists would have us believe. Austrian economists would say, no, I feel like buying, you feel like selling. So the price happens to be this, there's no objective reason why it should be this. Well, the objective reason is, that based on my best rational, on my rational judgment, this is the price, on yours and we trade, and that is the price. That makes it objective, the fact that the participants are rational, the fact that the judgments are being made, based on the facts of reality. And that's why Inran calls it socially objective. Because it is a consequences of social interaction, of a trade. You know, the intrinsicist would say that a price is in it, it's in the table, somehow. This is the price because it has to be the price. Because it's something about the table that makes it the price. The subjectivists will say, the price of this table is generated by my whim and your whim, by our feelings towards the table at any given time. As objective as we would say, the price of the table is gonna be determined by our best judgment regarding the use of the table, the ability to make another table to reproduce it, the cost of the labor and the materials of the table. So the price of the table will be determined by objective facts. And it will become a price by the activities of us trading. For example, if I set this table at 100 bucks and nobody buys it, that's meaningless. It only becomes a meaningful price when there's a trade. And that trade might not occur at 100, it might occur at 50. Prices in the market are set by, not by somebody coming in and saying, the price of IBM is $50. No, the price of IBM gets determined by the trade. So prices in the stock market are objective, are socially objective. And the only way to defend free markets, the only way to defend from an economic standpoint, a stock market is to show that they are efficient, that it is objective, that these prices mean something, that they are not driven by women and it is not a casino. And in that sense, stock markets are efficient. Now how many of you know of the efficient markets doctrine? There is a, let's see if I can do this quickly. There is the idea in academia among finances that markets are efficient means that there's no way to make money in the market because the markets reflect all the information, everything that we said, all the information is already in the price. Therefore, if you buy, you're just buying something that all the information is there already. And since, according to economists, we are all the same, endowed with the same talent and the same information, there's no way for me to know more about the stock than you. There's no way for me to discover information before you discover information. And since we all discover the information at the same time, we're all going to buy at the same time and the price will adjust instantaneously and nobody will make a profit. That is called the efficient market hypothesis. It is, it's not directly related, but it is the same type of assumptions of being made, yes. Yes, there's a joke about a Chicago professor is walking down the street with a student and the student says, look, there's a $100 bill in the pavement. And the Chicago professor says, without looking, he says, no, there isn't. And the student says, how come? And the professor says, well, if there was a $100 bill down there, somebody would have picked it up. No. And the idea is, if this stock is underpriced, somebody would have discovered it already and it would have been, this would have happened. You know, that the price would have adjusted. Of course, he forgets that somebody actually has to pick it up or somebody actually has to adjust. So people believe that these things are instantaneous. Okay, yeah. In fact, in California, the California Public Utilities Commission has created an exchange that it's superimposing on the market, forcing people to use, based on that set of suppositions. Now, I believe that the markets are efficient. So I do believe in stock market efficiency, but I would interpret stock market efficiency differently. I would say that somebody who's ignorant, who doesn't spend lots and lots of time working for it, cannot make money on the stock market. The only way to make money on the stock market is to work hard, be smarter than other people, get better research than other people, and find the $45 before they hit 50. That is very, very difficult. And for example, 75%, on any given year, 75% of all mutual funds underperform a market index. And if you take the 25% that do perform better than the index, they are not the same 25% every year. So even if you outperform the index once, it doesn't mean you'll outperform it again. There are very, very few people who can actually make money in the market regularly over long periods of time. And that is because this is an extremely competitive market with very smart people in it. And to make money, you have to be smarter than they are. And they're only a very few that are smarter than everybody else, that are better at doing this job. It's just like any profession. Some people are better. And I always tell the professors who believe this, I tell them, well, that means that the really good finance professors, oh, let me backtrack. They say, I say, what about one Buffett? How can you explain somebody like one Buffett who's made all his money in the stock market? They say that's chance. You flip a coin, you put monkeys in a room, they flip a coin, one of them is gonna flip heads 100 times in a row. Just a matter of how many monkeys. So I say, well, that explains why some finance professors are better than others. You're just lucky you got those publications. You're just lucky that good things happen to you, right? And of course, then they start backtracking. Because we have to end. I have a few years ago, Buffett wrote an article on that very point, and he said, but what if the people who long-term are very successful share underlying investment philosophy? I like Benjamin Graham, fundamental analysis. And he argued that that was in fact the case, that those who were most successful in the long-term did share that perspective. Some variation of it, yes. And by their argument, at some point, there would have to eventually be an utter idiot to become a billionaire, which I haven't noticed now. Exactly, but anyway, so the idea behind this is you can't just randomly go into the market and expect to make money. You have to be better than other participants, and you have to have more knowledge or information. You have to have a competitive advantage. And tomorrow we will start talking about restructurings. This course continues with lecture five. Best baby shower ever. Let's open presents. Okay, it's a brochure from Westcom Credit Union. You're welcome. 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