6.5 The behaviour of security prices

an individual investor, however, making a capital gain or avoiding a capital loss does

not require a belief or expectation that interest rates will change in the very near

future. It requires only a belief (or expectation) that other investors believe or expect

that interest rates are going to change and that they are going to buy or sell on the

strength of that expectation. Indeed, it is not necessary even to believe that other

investors believe that interest rates are going to change but only that other investors

are going to buy (or sell) for whatever reason.

This gives rise to two features of investor behaviour, one of which is certainly

observable, while we cannot be sure about the second. The rst is the sensitivity of

demand (and price) to actual events which might help to predict interest rate changes.

This often involves forming an implicit government policy reaction function. For

example, if investors know that the government is particularly concerned about the

rate of growth of credit and the build-up of inationary pressures, the announce-

ment of a big rise in bank lending causes asset prices to fall because investors make

the connection between an undesirable credit surge and the likelihood of a rise

in ofcial interest rates to try to stop it. In small open economies, changes in the

balance of trade often cause asset price changes through the same (interest rate)

mechanism.

The other feature of investor behaviour which follows from wanting to participate

in capital gains and avoid capital losses is the apparent ‘herd’ behaviour which leads

a rising asset price (for example) to go on rising even after any fundamental reason

for an increase has ended. A situation where this happens is known as a bubble.

Sometimes, as with the Big Bull Market in the US, 1928–29, the buying behaviour

affects the whole market. The 1987 crash might be an example of herd selling. It is

not possible to be absolutely sure whether investor behaviour corresponds to that

of a bubble merely by observation. It is always possible to argue that the market’s

aversion to risk is diminishing or that investors genuinely think that future growth

in productivity is going to be much higher than in the past (improvements in the

fundamentals). Or, alternatively, that they genuinely think that the fundamentals

are getting rapidly worse. The second half of the 1990s saw a steady rise in share

prices in the US in particular and in the UK to a lesser extent. Both the Federal

Reserve and the Bank of England expressed worries that share prices had risen

beyond the level which could be supported by the fundamentals. The reply from

the optimists was that economies were entering a phase of low ination, the like

of which had not been seen since before 1939. In these circumstances, rms could

expand further and more rapidly than in the past without causing ination and the

rise in interest rates that would cause share prices to fall.

It is hard to believe that fundamentals or even people’s perception of the funda-

mentals of asset values could change so much and so rapidly during some of the great

booms and crashes of asset prices. Consider as one example the collapse of share

prices by about a third in October 1987. Did the productivity of real capital assets

fall by 30 per cent in three days?

A more recent example is the dramatic rise and fall in popularity and value of

technology stocks in the course of roughly two years between early 1999 and March

2001 and in particular the group known as the ‘dot.coms’. These were rms which,

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Chapter 6 • The capital markets

at the time, had earned no prots. There was, strictly speaking, no evidence that

they were providing things which people wanted at a price which would justify their

production. Nonetheless, these rms attracted large capital ows in the hope that

they would eventually meet a genuine demand. Furthermore, as the price of the shares

increased, their cost of capital fell. A spectacular example was Lastminute.com which

was oated on the London Exchange in March 2000. Its advisers originally expected

that each share sold would raise about £2 for the rm. But such was the frenzy of

buying of dotcom shares by that stage that, in the few weeks between the issue

of the prospectus and the opening of the subscription, the advisers realised that

each share could probably be sold for over £3 and raised the price accordingly.

Within a year, the shares had lost 80 per cent of their value.

In these circumstances, it is tempting to think that investors are looking after

their own short-term self-interest by sticking with the herd. Prices are rising because

other people are prepared to pay more. So long as this is the case, we too can increase

our wealth by buying. Never mind the fundamentals for the time being. John

Maynard Keynes once famously remarked: ‘It is not sensible to pay 25 for an

investment of which you believe the prospective yield to justify a value of 30, if you

also believe that the market will value it at 20 three months hence’ (Keynes, 1936,

p. 155). Turn this around. There is no sense in avoiding something whose value you

think is probably less than £2 if you know that other buyers are going to push the

price up to £3 in the very near future. As one fund manager said looking back on

the dotcom asco: ‘You are not paid to sit on your hands while others are making

money.’ This is the dilemma that faces all fund managers. Their responsibility is

to their investing clients and if their investing clients want maximum short-term

prot, the manager must follow market sentiment whether or not he or she thinks

it soundly based. And the pressures for short-term performance are considerable.

Many newspapers run annual league tables of fund performance in which managers

are implicitly judged against an index or against other fund managers. If you are a

manager, it is no use saying to your clients when you come bottom of the league

that your decision not to buy dotcom stocks was correct ‘in theory’ or ‘will be proved

right in the long run’. In the long run, your clients will have left and you will have

been sacked.

If it istrue that investors in tradable assets are sometimes buying and selling on

the basis of what they expect the price to do in the very near future, rather than

on the rate of return offered by the asset, then Figure 6.4 gives a misleading picture.

Causalities are reversed. Investors are aiming at a target price for the asset, and

the rate of the return becomes the dependent variable. In the world we have just

described, buying and selling drives the price, as it always does, to an equilibrium

where sell orders match buy orders, but the rate of return, instead of determining

this price, is itself determined by it.

Which of the two pictures we have just described is the more accurate is an

important issue. The rational determination of prices by the required rate of return

is essential if resources are to be allocated efciently, as we described in section 2.4.

We said there that the return to investors was just enough to compensate them for

surrendering their ability to purchase real resources plus whatever degree of risk was

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