Beauty in markets is best judged by the beholder


Once loans can be bought and sold, what matters is not their soundness but their price – with the predictable consequences of instability and price fluctuations far in excess of any reasonable assessment of underlying change in fundamental value.

Whenever performance is measured relative to a comparison group, there is pressure to conform. Do not express opinions that deviate too far from the norm. Submit your research to peer review. Wear the clothes and appreciate the music that people of your age group wear and like. If you do not, you may well be wrong – there is certainly some wisdom in crowds. Even if you are right, the crowd is where your friends are.

What is worth studying, or worth hearing, is subject to objective criteria independent of current fashion. But what is cool, or valuable, is determined only by the views of others. So markets are subject to the vagaries of fashion even more than scholarship and popular opinion, which are subject to it more than enough.

John Maynard Keynes famously likened the processes of stock exchanges to a newspaper beauty contest. The objective was not to choose the most beautiful face but to choose the one you thought others would find most beautiful.

Keynes described the two approaches to investment that followed from his metaphor. One – speculation – required careful study of the fads and fancies of the other contestants. The alternative – enterprise – believed that real beauty would always shine through. Speculation involved forecasting the psychology of the market, enterprise the prospective yield of assets over their whole life.

Perceptively, Keynes anticipated the development of a paradox. Professionalisation of markets would drive out analysts who focused on fundamental value. He laid much of the blame on Wall Street. Even outside finance, he observed, Americans were apt to be unduly interested in discovering what average opinion believes average opinion to be.

Keynes had not experienced quarterly benchmarking and never submitted his results to a performance measurement service. But he knew that had he done so, his idiosyncratic genius would soon have led to his dismissal. It is better, he said, to be conventionally wrong than unconventionally right. And so we came to live in the world of closet indexation, in which the symbiotic processes of earnings management and guidance to favoured analysts supplants analyses of the competitive advantage of companies.

What Keynes did not explain or anticipate were the ways in which these tendencies would come to affect not just equity markets but all securities markets. I used to think that insurance companies employed geeks who spent their days calculating compound probabilities. When I was sent on a summer holiday job to Scottish Widows I discovered they did (and that I did not want to be among them).

But I was not, I now realise, depriving myself of a brilliant career. Success in the insurance business is success in pricing risk, and such success requires knowledge of the market rather than skill in the mathematics. In these markets too, speculation predominates over enterprise. So insurance rates and underwriting performance display cycles, just as share prices do.

In the past two decades, securitisation and other financial innovation brought the same phenomenon to credit markets. When loans remained on the balance sheet to maturity, there was no alternative to an assessment of their fundamental value. Once loans could be bought and sold, what mattered was not their soundness but their price – with the predictable consequences of instability and price fluctuations far in excess of any reasonable assessment of underlying change in fundamental value.

Keynes perceived a further paradox. “These tendencies,” he wrote, “are a scarcely avoidable outcome of our having successfully organised ‘liquid’ investment markets.” Keynes saw that market efficiency, in a practitioner’s sense, might be a force for economic instability. That thought drove him to the conclusions that “casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of stock exchanges”. Perhaps he was right.

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