Are the markets telling the truth?

The opening month of 2016 has been marked by sharp falls in asset prices, not just in financial markets but in commodities such as oil.  The conventional wisdom is that the markets form a rational assessment of future prospects for the economy, and set prices accordingly.  So if prices fall, we should be downgrading our forecasts for economic growth.

The underlying theory is that shares in any particular company only have value because of the future stream of dividends which the owner of the share will receive.  If the outlook for the economy becomes gloomier, the expectation becomes that firms will not make as much profits, and dividend payments will be reduced. So share prices fall.

It sounds plausible.  But in recent years, developments within economics have cast serious doubt on whether financial markets are rational in this way.  A key player has been Robert Shiller, professor at Yale and winner of the Nobel Prize in 2013.  The title of his first paper on the topic, published as long ago as 1981, summarises his argument: “Do stock prices move too much to be justified by subsequent changes in dividends?”

Shiller looked at data from the 1920s onwards, and showed that stock prices moved up and down to a much greater extent than did dividends.   This excess volatility, as he called it, was confirmed when evidence going back into the 19th century was examined.  If dividends are meant to determine prices, yet shares fluctuate much more, there is clearly something wrong with the theory.  Although his article was published in the top ranked American Economic Review, it was originally widely regarded as a bit weird.  Gradually, however, as events unfolded like the 20 per cent crash in share prices in a single day in 1987, his arguments became more persuasive.

Recent years have seen developments which reinforce Shiller’s point.  In February 2015, for example, Brad Jones published an IMF Working Paper on asset bubbles.  He points out that the value of globally traded financial assets increased from some $7 trillion in 1980 to around $200 trillion now.  Even more importantly, banks no longer dominate the market.  The value of assets under management of investment firms is now nearly as large as that held by the large global banks.  People have become richer, are saving more, and look for companies to manage their money.

Jones argues that the incentives facing asset managers lends itself to herding behaviour and excess volatility in the markets.  The tyranny of the quarterly report drives decisions.  A fund simply cannot risk taking a view which is too contrary to that of the consensus.  A manager may eventually be proved correct, but if in the short term loses money, investors will simply pile out of his or her fund.

Ironically, of course, large falls in markets still have the capacity to be self-fulfilling.  By destroying the value of wealth, they reduce future spending.  Still, it was another Nobel Laureate, Paul Samuelson, who famously remarked that “the stock market has forecast nine of the last five recessions.”

Paul Ormerod

As Published in CITY AM on Wednesday 27th January 2016

Image:Robert Shiller by Bengt Nyman licensed under CC by 2.0 

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Alex O’Byrne, Associate at Volterra, is an experienced economic consultant specialising in economic, health and social impact, economic strategy, project appraisal and socio-economic planning matters.

Alex has led the socio-economic and health assessments of some of the most high profile developments across the UK, including Battersea Power Station, Olympia London, London Resort, MSG Sphere and Westfield. He has significant experience inputting to EIAs and s106 discussions as well as drafting economic statements, employment and skills strategies and affordable workspace strategies.

Alex is also experienced at economic appraisal for infrastructure. He was project manager of the economic appraisal for the City Centre to Mangere Light Rail in Auckland. He also led the economic and financial appraisals of the third tranche of the Transport Access Program for Transport for New South Wales, in which Alex developed and employed innovative methodological approaches to better capture benefits for individuals with reduced mobility.

He is interested in the limitations of current appraisal methodologies and ways of improving economic and health analysis to ensure it is accessible to as many people as possible. To this end, Alex recognises the importance of transparent and simple to understand analysis and ensuring all work is supported by a robust narrative.

Alex holds a BSc (Hons) in Economics from the University of Manchester and he was a member of the first cohort of the Mayor’s Infrastructure Young Professionals Panel.


Senior Partner

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Ellie is a partner at Volterra, specialising in the economic impact of developments and proposals, and manages many of the company’s projects on economic impact, regeneration, transport and development.

With thirteen years experience at Volterra delivering high quality projects to clients across the public and private sector, Ellie has expertise in developing methods of estimating economic impact where complex issues exist with regards to deadweight, displacement and additionality.

Ellie has significant experience in estimating the economic impact across all types of property development including residential, leisure, office and mixed use schemes.

Project management of recent high profile schemes include the luxury hotel London Peninsula, Battersea Power Station and the Nova scheme at London Victoria. Ellie has also led studies across the country estimating the economic and regeneration impact of proposed transport investments, including studies on HS2 and Crossrail.

Ellie holds a degree in Mathematics and Economics from the University of Cambridge.