Governments in all markets have encouraged speculators to bid up assets by creating a version of reality that may not exist. If a more accurate picture emerges, those same speculators may then punish them severely

Markets all over the world are supposed to act as an indicator of their specific market’s economic outlook. They are also supposed to be an excellent guide to the value of any listed company. But, as we all know, stock markets sometimes do a very poor job of both. Sometimes they can fluctuate wildly. For example the Indian stock market has fluctuated over 19% this year alone. It recently traded at an all time high at the same time that real economic growth slowed. The Bank for International Settlements (BIS) in its quarterly review warned about excessive credit risks. It remarked that markets for corporate debt were acting “as if the typical relationship with the macro economy had taken a holiday. Spreads are low and so are default rates.”

Then there is always the possibility of an overreaction, either a bubble or a crash. A recent study by the fund-management group, GMO, used as criteria the increase in the price of an asset of more than two standard deviations above the trend as a definition of a bubble. Using this definition, it identified 60 bubbles in this decade alone. The number of bubbles has been increasing. There are more than 20% now than 20 years ago and almost triple the number of 50 years ago.

According to one well known theory markets are supposed to be efficient in that they can accurately reflect value and efficiently allocate capital. But they often act irrationally. The question is why?

An American economist, Michael Pettis, who teaches in Beijing, has what appears to be a rather intriguing answer. He looks at markets not as efficient or inefficient in and of themselves but as a mix of investment strategies. For a market to be efficient and allocate capital productively, at a reasonable cost, the market must have this mix of strategies. If it lacks one or more for a variety of reasons, or if trading becomes dominated by one strategy over the others, then it can become highly unstable and inefficient.

For simplicity, Michael Pettis divides the strategies into three types. The first is fundamental investment. It is also called value investing or stock picking. It basically involves an analysis of the economic value of a firm in order to make a determination of the likelihood of future growth. The most important part of the process is access to accurate, timely and complete information on the asset in question. If all the information is available the investor will make certain assumptions of risk and future cash flows to determine if the asset’s present and future value is trading at a discount or premium.

The second type is relative value investing, which includes arbitrage. The process involves exploiting inefficiencies to make low risk profits. The relative value investor is less concerned with fundamental value than comparative value and eventual convergence.

The third type of investor is the speculator. These investors are more interested in momentum and information that will result in short term changes in value. The change could be of very short term as in a few hours, days, weeks or even years. The changes in value may have very little relationship to the actual economic value of an asset and the change could reverse itself very quickly.

Professor Michael Pettis asserts that for markets to work properly all three investment strategies must be present, because each brings certain specific benefits to a market. Since fundamental investors’ analysis is longer term, they bring stability. They also ensure that capital is allocated to its most productive use. Speculators by trading frequently on timely information provide liquidity and trading volume that lowers transaction costs and insures rapid dissemination of information. Relative value investors force pricing consistency and improve the information value of market prices. According to Professor Michael Pettis, “Without a good balance of all three types of investment strategies, financial systems lose their flexibility, the cost of capital is likely to be distorted, and the markets become inefficient at allocating capital.”

Anyone familiar with emerging markets is well aware that they tend to be dominated by speculators. This is for one very fundamental reason: information. Both corporate and macro economic data necessary for fundamental investment decisions is often lacking for a number of reasons. In places like China information is tightly controlled. So access to it usually requires relationships. The result is massive insider trading. China is far from alone with this problem. Weak and underfunded watch dogs make enforcement particularly difficult even in more sophisticated markets like Japan. Macro economic data like inflation statistics have enormous political value. In many countries they are often suppressed or falsified to protect governments.

Information can also be distorted by government in ways that do not involve direct control. Most emerging markets are dominated by a few large state controlled companies. These companies work with alternative political incentives rather than economic ones. Since the government is running the company corporate governance is almost nonexistent. It is not just government companies, but family ones as well. Weak corporate governance guarantees that information and corporate activity will be opaque and subject to sharp and unexpected fluctuations. The economic incentives are not to find information of economic value. Instead markets rewards research directed at predicting and exploiting short term government behaviour. Obviously this leads to enormous economic incentives for corruption.

This is not only true of emerging markets but also of developed markets like the US. This is due to the enormous impact of the stimulus provided by central banks. Financial news shows in the US used to analyse economic trends. Now they spend hours speculating on the next move of the Federal Reserve. Japan is in a similar situation. Last week the market rose after a report showing GDP had fallen because it increased the prospect of more money printing.

The result of poor or distorted information is that fundamental investors are driven from the market. Relative value investors can no longer function because the markets become illiquid, fragmented with high transaction costs. The result is that the field is left to the speculators. Eventually though the economic fundamentals do reappear and become so obvious they can no longer be ignored. Markets run out of greater fools. Governments in all markets have encouraged speculators to bid up assets by creating a version of reality that may not exist. If a more accurate picture emerges, those same speculators may then punish them severely.