In our May Comments, we quoted from The Price of Peace by Zachary Carter (May 2020), which chronicles the work, life, times, and impact of John Maynard Keynes. This month we return to a subject we have discussed before, namely the extraordinarily important distinction between investors on the one hand, and traders/speculators on the other. We start with some observations from Keynes, written many years ago, and then reference a few recent newspaper articles that have finally picked up on the impact of the extreme volume of trading/speculating in the current stock market.
As Carter details in his book, Keynes’ The General Theory explains how “financial markets and stock exchanges had enabled disparate individuals to pool their resources and knowledge to support enterprises that had been inconceivable only a century or so before. Classical theorists believed the more liquid the market the better. More money and more investors enabled the market to settle on the right price of various companies and securities. But that was not the way it worked in practice, as Keynes had observed over the course of his nearly two decades as a speculator. People didn’t actually bet on the value of different enterprises, they bet on the judgment of other speculators.” What follows is his now famous description of financial markets resembling a beauty contest, where the judges are asked not to pick the prettiest contestant, but rather the contestant who is chosen prettiest by the greatest number of judges.
The section continues as follows: “This meant that there was no reason to believe the market ever [emphasis in original] actually gauged the value of various investments… Speculators and investors have to make their judgments under conditions of uncertainty [our emphasis; see also last month’s May 2020 Comments on “Uncertainty”] about the future… Who knows the yield from an enterprise ten years hence… At best, capital markets could only magnify the hunches and disputations [that is, subjects about which people cannot agree] of the participants. But the market prices of stocks, bonds, and other assets created the illusory sense of mathematical certainty about prospective investments.”
The impact of speculation on the current markets has been discussed recently in the financial media. Jason Zweig, writing as The Intelligent Investor in the Wall Street Journal (WSJ, 6/13/20), observed as follows: “Wall Street also resembles a casino, even more than it normally does… partly driven by people who are flocking to the stock market for the thrill of taking big risks, whether they pay off or not. Such gambling can be fun, but you should never confuse it with investing [our emphasis]… People, mainly young men, with the lack of professional sports to bet on because of the virus, have turned to trading stocks. For them, the magnitude of moves matters as much as the direction; a big loss can be as much fun as a big gain…Yet, however crazy the stock market may seem, it isn’t really a casino. Play most games in most casinos long enough and you are sure to lose. The stock market, on the other hand, tends to reward those the best who hold on the longest [our emphasis]. Speculating has some entertainment value, and you might learn something useful, and there’s even a remote chance you will make money, but always know you are speculating.”
In the same WSJ edition appeared an article titled, “Investors Bet on Volatility, Making Markets Even Wilder,” written by Gunjan Banerji (WSJ, 6/12/20). Before quoting from that article, we emphasize that this headline misses the key distinction we are making in our material, which is that “investors” do not bet on the financial markets, and “bettors” are not using those markets as investments. For us, investments are intended to remain in place for lengthy time periods, with asset allocations to help achieve client goals while accounting for risk and rebalancing the allocations under certain circumstances. Gambling and speculating, on the other hand, are activities where the gain or loss is known in a short time frame, sometimes the same day.
Returning to the WSJ article, Banerji writes that “[m]arkets were once dominated by bulls who thought stocks would go up and bears who thought they would go down. These days another animal is on the rise, one who doesn’t care what stocks do, as long as they do something. These investors are focused on volatility, the amount of movement in prices over time. In recent years, volatility has gone from a specialty of derivatives traders to a vehicle for trading in its own right. Investors big and small are wagering hundreds of billions of dollars on volatility, including by betting directly on the moves of measures like the S&P 500, shares of individual companies, and oil prices…Volatility trading, and volatility itself, is likely to stay elevated as investors seek to either protect themselves from it, or increasingly, to make money from it.” The article continues at length, discussing the various ways this trading is accomplished.
The New York Times presented its view of this subject (NYT, 6/15/20, page A1) in an article with the headline, “Arenas Empty, Sports Fans Bet On Wall Street,” by financial writer Matt Philips. “Some Wall Street analysts see people who used to bet on sports as playing a big role in the market’s recent surge, which has largely erased losses for the year… Millions of small time investors have opened trading accounts in recent months, a flood of new buyers unlike anything the markets had seen in years [our note: again, the author is referencing investors while discussing their trading activities]. On most days, the overwhelming majority of stock investors do nothing, while the buyers and sellers establish the prices. So even a small influx of hyperactive speculators can have a significant effect [our emphasis]. Gamblers were a small but important segment of these new arrivals, along with video game aficionados… The short-term swings make betting on stocks no different from betting on a game… The bettors stress they play the market as entertainment. Many have 401(k) plans filled with plain vanilla index funds that are the bedrock of retirement planning.”
And finally, the well-known economist Paul Krugman wrote an Opinion Piece (NYT, 6/15/20, page A31) entitled, “Market Madness in the Pandemic”. Krugman notes that “First came the huge declines as the threat from the virus became clear. The decline reflected justified concerns about future profits, but also a developing financial crisis… Next came the Federal Reserve to do whatever it took to lubricate markets and keep money flowing freely, the result of which was a stock rebound that made up half the losses from the initial plunge. Up to that point, the behavior of stock prices generally made sense. But then came another surge in stock prices that eliminated most of the previous losses… Most of the evidence suggests that a major role in this latter surge was played by small investors, looking for an alternative source of excitement.” [Note that even Krugman appears to refer to the new traders as investors; going forward, a focus on more precise terminology among the financial press might help reinforce the difference between speculation and investing.] Krugman quotes Keynes: “even staid investors who usually stabilize the market tend to abdicate judgment in ‘abnormal times’.”
All this speculation is important because it creates unnecessary volatility. This in turn makes the media strive for daily explanations, and prods long-term investors to consider portfolio changes they would otherwise not make. During June, the S&P 500 changed by a modest 56 points in 22 trading days (from 3,044 to 3,100), but within June there were 14 up days totaling 478 points, and 8 down days totaling 422 points. The relatively new trading activity described above may well be a factor in this volatility. We continue to advocate maintaining asset allocations developed for the long term, unless rebalancing is in order based on the change in market prices, which means selling the better performing asset class and buying the weaker performer.