Playing? Within the Inventory Market? I’m Shocked.

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Fundamentals have never mattered less, yet the wild moves of a bunch of struggling stocks with dated business models could have real-world consequences. The companies can raise capital more easily by issuing new shares at elevated prices to help them survive or restructure, while executives with bonuses tied to the stock price are closer to cashing in fortunes.

The question isn’t so much whether this spectacle makes a mockery of the idea that markets provide an efficient form of capital allocation in the economy—it obviously does, at least for these stocks. The real question is whether something should be done about it, not to save investors from themselves or to prevent knock-on problems in the financial system (both worth exploring), but to improve the way the economy works.

The basic theory of markets is that they provide a way for capital to flow to the parts of the economy that can best put it to use, with the test being the ability to earn a profit. The prospect of an eventual profit should attract investors, making a stock rise. That makes it easier for the company to raise new money and for new companies in the same line of business to float, while also sending a signal to executives elsewhere that this is the right place to invest.

The theory has been turned on its head in the past couple of weeks. Reddit group WallStreetBets has delighted in buying flaky companies, because hedge funds were betting on their stocks falling. As rising prices forced hedge funds to retreat, stock-price jumps have sent the wrong signal for where capital should go.

After the crash of 1929 and the Great Depression, Congress set up the Securities and Exchange Commission to ensure fair and orderly markets. Among other things, the law creating the SEC says: “New data processing and communications techniques create the opportunity for more efficient and effective market operations.” For social media, it couldn’t be more wrong.

But calling for more market regulation because of a crowd of Reddit punters would be as cynical as Captain Renault in “Casablanca,” shocked to find that gambling is happening while cashing in his winnings. Markets have always attracted gamblers, it’s just that in recent years they’ve usually been co-head of a trading desk or a hedge fund, not a guy in a headband who goes by the name DeepF—Value.

The trick for the economy is to make sure that the gamblers, whatever their job title, aren’t the main movers of the market, at least most of the time, and that stocks have some link to underlying profits.

That link has snapped. But the break is probably temporary. After all, we’ve been here before. In 1999

Arthur Levitt,

then chairman of the SEC, bemoaned the rise of the day trader made possible by the internet. “I don’t think day traders are speculating because traditional speculation requires some market knowledge,” he said. “They are instead gambling, which doesn’t.”

The same worries motivated the late, great economist

John Maynard Keynes

in the 1930s.

“Speculators may do no harm as bubbles on a steady stream of enterprise,” he wrote. “But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a byproduct of the activities of a casino, the job is likely to be ill-done.”

He’s right. Elevated stock prices encourage capital, entrepreneurs and employees to move into the hot area, and if it is hot purely because of random speculation, it will hurt when the capital has to be written off and the workers lose their jobs.

How to prevent that? One idea popular among left-leaning economists is to put grit in the wheels of the markets, making it harder or more expensive to trade in order to discourage gambling. Economist

James Tobin

advocated a small transaction tax, something European countries have agreed to in principle but have failed to implement.

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For sure, part of the rise of the power of the private trader is because of the opposite of a Tobin tax: Robinhood and many brokerages have eliminated trading fees. Making trading cheaper leads to more trading. Putting fees back, or adding trading taxes, would probably discourage many of the new traders.

But there is no reason to think it would stop widespread speculative excess, since speculative excess was a common feature even when trading costs—in effect a tax on trading—were much higher than today.

I don’t think we need to worry too much about the rough-and-tumble world of WallStreetBets leading to massive capital misallocation, either. Over time they’ll learn not to gamble what they can’t lose, or they will lose it. Plenty of weird things that conflict with efficient markets are regarded as perfectly normal and acceptable, including stocks having price momentum or the Santa Claus effect. We can learn to live with a few more bizarro stock moves thanks to Reddit, and eventually the market will return to caring about profits.

Write to James Mackintosh at [email protected]

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