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Less dramatically, the Standard & Poor’s 500 lost 10.1% in 2000, “its worst [performance] since 1977.” The Dow Jones Industrial Average, a selection of 30 of America’s largest corporations, concluded the last business day of 2000 with a loss of 81 at 10,787. At that closing level it recorded its first year-on-year decline (6%) since 1990 and its “worst performance” since 1981. In contrast, on 29 December the Toronto Stock Exchange 300 composite index rose 58 (0.7%) to 8934, and the blue-chip Standard & Poor’s/TSE 60 index gained 5 (0.9%) to 529. According to the National Post, “for the year the 300’s 6.2% rise meant it outperformed most other world indexes, but the gain was lacklustre compared with its 30% rise in 1999. The 60 was up 6.6%.”
What to make of all this? Simply that market participants in Anglo-American countries obsess about ‘the market’ and its short-term ‘performance.’ They define the market in terms of a price index, i.e., a weighted average of the current prices of the assets (shares, bonds, etc.) comprising the index. They also think about their own portfolios as an index and equate the performance of that portfolio with the weighted average of changes in the prices of its assets. Accordingly, for virtually all market participants the greater an index’s increase from one point in time to another the more favourable the evaluation of its performance; conversely, the smaller the rise or the greater the decrease the more negative the interpretation. Further, if Index A (say, Jack’s portfolio) increases relative to Index B (Jill’s portfolio or some market index), then A has ‘outperformed’ B. In the U.S. during 2000, according to The Wall Street Journal (12 January 2001) the average mutual fund (Americans’ term for a unit trust) experienced its “worst performance since 1990” and unit holders are presently receiving reports about the damage wrought by swooning market prices. It will be the first time that many have had to cope with anything less than double-digit returns – to say nothing of losses. Using the conventional definition of ‘performance’ and figures from Lipper Inc., the average American unit trust lost 4.5% last year. Some formerly highflying technology trusts experienced declines of 30% or more.
What Prices and Price Indices Tell Us
A free market price for a single good or service, such as a stock or bond, transmits one critically important piece of information. It is the ratio at which the “most eager” buyer(s) and “most eager” seller(s) are willing voluntarily to exchange some specified good, service or commodity. A buyer is “most eager” in the sense that (s)he is willing to exchange it for the greatest amount, relative to other buyers, of some other commodity such as money. A seller is “most eager” in the sense that (s)he is prepared to accept a lower price than is any other seller. It follows that a drop in stock prices need not imply the destruction of wealth. It necessarily reveals only that a change in market participants’ subjective preferences for one commodity vis-à-vis another has occurred. (See the article by Robert Murphy and Gene Callahan for an elaboration).
Given the obsession with market prices, short-term price changes and the equation of these changes with ‘performance,’ at first glance a share or bond market index appears to have important uses. Depending upon the index in question, it summarises into a single figure dozens, hundreds and sometimes thousands of prices and changes. It thereby provides a benchmark from which market participants and commentators can state whether “the market is too high” (or too low). It also serves as a basis from which ‘strategists’ can make predictions about prices at some point (i.e., the next month, quarter, year) in the future. In Australia these prophesies tend to be most prevalent towards the end of the calendar year and the financial year on 30 June. Around the world these predictions are surprisingly inaccurate: William Sherden, in his outstanding book The Fortune Sellers (a must-read for all value investors), reviews research about the accuracy of various experts’ (including brokers’ demographers’ and management consultants’) forecasts. He finds that their accuracy is universally poor.
Humans’ inability to guess consistently accurately the level of a price or price index during the next month or quarter (to say nothing of the next year) suggests that the obsession with short-term price changes is pointless. Short-term volatility, whether of individual assets or bundles of assets, is an essentially random and hence unpredictable phenomenon. Beginning with this premise, this circular reasons towards a sharply contrarian conclusion: the definition of an asset’s (or a bundle of assets’) ‘performance’ in terms of the direction and magnitude of short-term changes in its price reveals much that is trivial and obscures much that is relevant. Its companion, dated 15 January, discusses alternate means used by value investors to gauge the results of their investment decisions.
What Prices and Price Indexes Do Not Tell Us
Prices in unfettered markets transmit signals among producers and consumers which cannot be transmitted by other means: a higher (lower) price tells us that, for whatever reason, consumers are prepared to exchange more (less) money for the good, service or asset. Producers compare this objective price with its subjective opportunity cost (i.e., their perception of the most profitable alternate use to which they can put their leisure, labour and capital). If producers are prepared to forego this alternative, then they may have an incentive to commence, maintain or increase production; conversely, if costs are greater than prices, then producers may have an incentive either to reduce or to cease production.
On the other side of the transaction, consumers also compare price and opportunity cost (i.e., the best alternate use of what they must forego in order to make the transaction). If the former is greater than their perception of the latter, then they may have an incentive to reduce or cease consumption of the good; conversely, if they are prepared to forego this best alternative, then consumers have an incentive either to commence, maintain or increase consumption. Market prices thus provide an objective means whereby buyers and sellers can make calculations about their subjective wants.
As such, a price is specific to a given buyer(s) and seller(s), to the preferences of each, to the information to hand at a particular point in time and to a particular good or service. The buyers and sellers in a market constantly change. So too do their preferences, the information at their disposal, their evaluation of this information – and hence both the goods and services exchanged and the prices at which they change hands. Accordingly, a price does not necessarily tell us anything – and, indeed, may tell us nothing – about the exact value of the goods and services exchanged. Price and value, in other words, are distinct things; and in any given exchange the one need not equal and may differ considerably from the other. Indeed, no incentive to trade exists unless the perceived value of what one receives exceeds the perceived value of what one pays. As the saying goes, “price is what you pay; value is what you get.”
Observing Price and Discovering Value
None of this, however, presupposes that market participants are omniscient. Quite the contrary: the market’s function as a mechanism by which value is discovered assumes that miscalculations and changes-of-mind are commonplace. A buyer, for example, may without any intention to deceive on the seller’s part decide or realise retrospectively that he received less value than he paid. Many buyers of tech stocks learnt in 2000 that they had made such miscalculations. Conversely, the buyer makes a more fortunate error when (without any obvious ignorance on the seller’s part) he discovers after the transaction that he has received far more value than he paid. In this respect both the buyers and sellers of Berkshire Hathaway since the 1960s ‘miscalculated.’
Let us assume that the economics and operations of the business which underlies a given stock change little from day to day. If so, then the stock’s short-term price volatility tells us nothing about these economics and operations. Admittedly, some price changes stem directly from the appearance of genuinely new information about the business, its operations and financial results. Equally clearly, however, most fluctuations bear little or no direct relation to these things. Every day buyers and sellers enter and exit the market for the company’s stock. So too do the preferences of these buyers and sellers, and their evaluations of the information at their disposal. It is these superficial “stock market” influences, as opposed to fundamental changes in the operations of the business which underlies the asset, which are reflected in the short-term fluctuations of the asset’s price. If so, then the absurdity of defining the ‘performance’ of a financial asset or bundle of assets in terms of short-term price changes becomes readily apparent.
...continued in Part II
 
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