Bailouts Destroy Market Efficiency

November 12th, 2009

The hottest economic topic these days is the recession – or the recovery, if we can believe 80% of business economists who tell us that it is already underway. It vastly overshadows the importance of everything else. Will the recovery be V-shaped or U-shaped or J-shaped? Will it be fast or slow? Will it be throttled by unusually-high unemployment? The implication is that cyclical concerns are the only ones worth worrying about.

If you’re an investor, here’s something else you should worry about: the efficiency of financial markets. The following case history illustrates the basis for concern.

The Rise of Bill Miller

For 15 years, from 1991 to 2005, Bill Miller of Legg Mason Value Trust Fund was America’s top equity investor. This fund beat the S&P 500 stock index for 15 years in a row. Considering that most fund managers don’t beat the S&P in any given year, this achievement ranks alongside Joe DiMaggio’s 56-consecutive-game hitting streak in baseball. Indeed, Mr. Miller’s reputation in the financial community rivaled that of legends like Peter Lynch and Benjamin Graham.

In 2006, Mr. Miller’s streak was broken. Well, even DiMaggio went hitless eventually, didn’t he? It was in 2007 and 2008, however, that Mr. Miller went off the rails completely, losing nearly 80% of the fund’s value and many of his loyal investors. What sent America’s leading investor astray?

The Fall of Bill Miller

Two remarkable decisions stand out. First, Mr. Miller was resolute in his decision to buy Bear Stearns and he continued doing so even as the stock of the venerable Wall Street firm assumed a near-vertical downward trajectory. On Friday morning, March 14, 2008, he proudly purchased the stock for just under $30 per share. That weekend, the company collapsed. Shares were eventually purchased by J.P. Morgan Stanley Chase for around $2 per share, virtually wiping out shareholders. Mr. Miller later expressed disbelief that “the Federal Reserve would play an active role in a transaction that would let stockholders be largely wiped out.” In other words, he had assumed that the Fed would bail shareholders out. He guessed wrong.

Mr. Miller was a big buyer of Freddie Mac, the quasi-public mortgage firm that enjoyed an implicit taxpayer subsidy of its debt. Mr. Miller continued to buy in the face of a protracted decline in the firm’s share price in 2007 and 2008. He was quoted as refusing to believe that the firm would be taken over by the federal government. Yet, in 2008, that is exactly what happened. Shareholders were eviscerated. Again, Mr. Miller wrongly predicted the actions of federal regulators, this time by guessing that a federal takeover would not occur.

The Death of Financial-Market Efficiency

My point is twofold: When it came to guessing what the government was going to do, America’s leading investor suddenly became just another stumblebum, mumbling “I can’t believe they did that” on his way to the poorhouse. And he had to make the right guess in order to avoid disaster. In the old days, before the advent of “too big to fail” and “systemic risk,” fund managers and investors had a hard enough job just evaluating stocks according to the standard guidelines. Yet decades of research showed that U.S. financial markets were generally efficient – they accurately reflected publicly-available information about stocks and bonds. That is why it was so hard for investors to “beat the market” – because assets tended to be accurately valued, making it tough to find bargains and undervalued companies.

All of a sudden, the best investor in America – make that “in the world” – takes two embarrassing pratfalls in succession because he couldn’t outguess the regulators on bailouts. For the rest of our lifetimes, fund managers won’t just pick stocks; they’ll have to play regulatory guessing games, too. There is no reason in the world to believe they will succeed any better than Miller did. (It’s no good advising managers to avoid firms that might be bailed out, because nobody knows who might or might not be bailed out in the future.) Consequently, the storied efficiency of our financial markets is a thing of the past.

The average investor doesn’t break a sweat over the subject of market efficiency because it seems too remote from everyday life. Unfortunately, it isn’t. When people buy annuities, for example, they are counting on the insurance company to keep its promise to deliver lifetime income. In order to do that, the companies have to invest their policyholders’ money – not just in fixed-income securities but also in the stocks of large companies, the kind that used to be called “blue chips.” Insurance companies desperately need to rely on the tools of traditional securities analysis and the pricing mechanism of the stock market to value those companies accurately. Otherwise, that promise of lifetime income becomes shaky. The more dust that government regulators throw in the eyes of analysts, fund managers and ordinary investors, the shakier it becomes.

Unintended Consequences

Ben Bernanke claims that he didn’t want to bail out large firms – he had to because we couldn’t live with the consequences of their failure. Unfortunately, we will now live with the consequences of the bailouts – inefficient financial markets. Regulators behave as though their motto was “We’re just going to do this one thing, which will have just this one result and everything else will stay the same.” Even when their intervention succeeds, it still fails, because it never has just one result and other things never stay the same.

In the 1960s, the federal government adopted inflationary policies in the belief that it could trade off one bad thing – higher inflation – for one good thing – less unemployment. It got higher inflation and higher unemployment. But that wasn’t all. The inflation prevented financial markets from operating efficiently. The Dow Jones Index remained unchanged in real terms for an entire decade.

How much unintentional damage will bailouts end up causing to financial markets?

Category: Economic Analysis, Economic News | Tags: , ,

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