Asymmetrical Information

From the desk of Mindles H. Dreck:

Early is Wrong

Let's try a thought experiment. You are about to take a one year position in the Ten-year Treasury Note. You have access to a clairvoyant. He/she can answer one market question with perfect foresight. What question would you ask?

The answer is obvious, you ask the yield on the 9-year Note (a year has gone by) in one year's time, as that would directly determine the price of your asset. OK, now let's stipulate that the psychic can't answer this direct question (isn't that how it works anyway? the future always comes in riddles).

One's first instinct is to think fundamentals: Has GDP grown? What about consumer demand, the deficit, etc.? Perhaps one of these fundamentals will tell us enough to suggest the appropriate yield on the 10-year. But that won't help you. You don't really want to know what's happened during the year, you want to know what the market's consensus expectation for yields will be one year from now. The factors that determine the yield you can't ask for are entirely a function of the future the market attempts to discount. You ask the psychic what the market's expectations for inflation and nominal interest rates are one year from now.

In other words, it doesn't matter what happens to your asset while you own it so much as what someone thinks it is worth at the time you want to sell it.

This is a crucial distinction about markets that is repeatedly lost in the coverage of Wall Street Analysts, market bubbles and Elliot Spitzer's crusade. We tend to lose ourselves in a specific case of efficient market theory where all news is discounted, and an asset has only one true worth. That allows us the conceit of suggesting that the 'one true value' is either concealed or revealed by some overpaid smartypants analyst. But if you think about it, your not so interested in the value per se as in your ability to sell it later for more.

This is a simple and obvious experiment, but it brings into focus some difficult truths:

1) It is possible for an analyst to have a screaming buy on something he thinks is a piece of shit.

2) Said piece of shit may turn out to be a good investment, as long as the market for pieces of shit remains ebullient. How long that lasts is anyone's guess.

I distinctly remember clients criticizing us for not owning internet stocks. I remember sitting in a room discussing Amazon with about 70 other senior investment professionals at a week-long program run by AIMR in the spring of 2000. Only one of us had ever owned the stock (she ran the pension fund for a Fortune 500 company, but she owned the stock personally, not for the fund).

Portfolio managers have a saying - early is wrong. Saying we all knew the bubble would burst is a far cry from knowing when. As much as dot-coms seemed overvalued, it also seemed perfectly plausible they would be worth more in the future. As long as so many believed in their overly-rosy prognosis, that market share would turn into profits, they would be worth more later.

Don't get me wrong. Selling something you think is worthless is immoral. However, refusing to sell internet stocks into the 1996-2000 market would have been a nearly impossible choice for a bulge bracket brokerage firm. I'm glad I didn't work for one of them.

Posted by Mindles H. Dreck at June 28, 2002 9:56 PM | Technorati inbound links