Speculation, Human Action and Financial Markets


Speculation, Human Action and Financial Markets

By Duncan Whitmore

Within the past two weeks, retail investors congregating on the social media site Reddit bid up the stock of ailing company GameStop at the expense of large Wall Street hedge funds, all of whom had significant financial stakes reliant upon the price of the stock falling rather than rising. Several of these hedge funds were thrown into serious financial difficulty as a result of the price rocketing from around $20 a share to a high of nearly $400 in the space of only a few weeks. At the time of writing, the day traders have apparently turned their attention to the manipulated silver market, which is also starting to see significant gains. Fed up with a rigged casino market in which all of the spoils go to large Wall Street banks and financial firms, the amateurs appeared to have beaten the latter at their own game – at least, that is, in terms of having forced them to reveal the corrupt nature of the system if not in monetary profit.

This latest round in the battle of the populists vs the elitists is part of the ongoing collapse and rejection of inflationary state corporatism (the Western form of socialism that was birthed by World War One) and political globalism. Every blow that is dealt to this odious, oligarchic system – such as by Brexit and Trump – is one to be welcomed. However, whereas outright socialism (such as that practised in the former Soviet Union) entails direct state ownership over the means of production, the corporatist system operates through capitalistic facades such as nominally private businesses, free trade and exchange, stock markets, and so on. As a result, the socialised elements of our economic system have, for too long, been able to get away with offloading the blame for the problems they cause onto “capitalism” or “too much freedom” instead of the root cause which is state privilege and state interference with genuine private property rights. Indeed, that was exactly what happened after the housing market crash in 2008, with the whole fiasco being blamed on “greedy”, private bankers instead of the state induced, inflationary financial system. The long run result of our failure to identify the state as the true source of the problems has been that state failure has been rewarded with state growth.

Unfortunately, therefore, it is not enough for libertarians to simply cheer on the demise of the current, rotten system. In addition, we have to ensure that the proper enemy is identified and outed as state force and fraud, not the capitalistic institutions through which they operate. We must keep an eye not only on the current crop of elites, but also the circling vultures of popular, hard left politicians such as Bernie Sanders, Elizabeth Warren and Alexandria Ocasio-Cortez, who will be poised to blame everything indiscriminately on “capitalism” before advocating for total economic socialism as the answer.1 It would be a complete disaster if we were to allow one form of tyranny to be succeeded by another. Indeed, even the so-called “Great Reset” – which, far from being any kind of “revolution” or “renewal”, is actually a repackaging and rebranding of the present system in a far more potent form – is being sold as a reset of capitalism, the latter of which has supposedly failed us.

One of the most vilified activities associated with the capitalist economy is that of speculation. Even in a world where managers of large multinational firms and wealthy shareholders are denigrated as evil, greedy and exploitative, the full brunt of the most concentrated ire is directed towards the class of persons branded as speculators. Indeed they are a convenient scapegoat for a whole host of (often contradictory) symptoms of an ill economy or financial system – rising prices, falling prices, volatility of prices, inflating bubbles, bursting bubbles, price gouging, supply shortages ad infinitum. Even respected investors and their mentors – Warren Buffett and Benjamin Graham respectively, for instance – are keen to point out how their methods differ from speculation, reserving the word to describe arbitrary, capricious, and undisciplined trading.

More than any other aspect of the free market, then, it would appear that speculation is in need of the most detailed clarification and defence. What follows, therefore, is an explanation of the benefits of speculation that would be realised if it was being done on the genuine free market. What we will see is that speculation is endemic not only to all exchange, trade, business, production, etc. but also to the very nature of human action itself. Further, following an explanation of the different ways in which it is possible to speculate, it will be demonstrated that no principled distinction can be made between anyone who tries to “buy low and sell high”, and that perceived differences that are used as grounds for criticism are instead based on the relative difficulty in visualising the true economic effects of some speculative activities. However, we will conclude with some remarks concerning how speculation comes to take the blame for distortions to the economic system caused by state interference.

Valuation and Human Action

Humans act because they wish to direct the scarce resources at their disposal to uses that are valued more highly than possible alternative uses. If this was not true humans would not act. All human activity, whether it is brushing one’s teeth, purchasing a bag of shopping, selling a house or trading billions of dollars worth of securities on the financial markets are all carried out because the acting individuals perceive that the value of the outcome is higher than the value of the alternative. I brush my teeth because this act, I believe, will produce clean teeth that I value more highly than doing something else while retaining dirty teeth. I buy groceries because I value them more highly than the money I am using to pay for them (and more highly than other things that I could have bought). I buy a house or securities on the financial markets for the same reason.

However, all valuations are made ex-ante – that is, we must estimate the increase in value that an action will produce before we act. We do not have the luxury of acting out all of the different things we could do with our resources before then going back in time and picking the one that actually yields the most valuable outcome. Rather we have to anticipate that the resources chosen and the method of our action will actually bring about the end that is sought, and that this end will indeed have the value that we believe it will have. In short, we speculate on the outcome of our actions and, all of our actions are, therefore, speculative.

Different actions have differing degrees of speculation, particularly when we have experience of the outcome. Most people will be fairly confident as to the results of brushing their teeth, both in terms of the physical product and the value it has. It is unlikely that, after the act of brushing our teeth, we will end up in a condition we did not expect, nor are we likely to regret what we have done and wish we had done something else. Further we are not likely to have undervalued the outcome ex-ante and end up wishing that we had devoted even more resources to produce more of the outcome.

Other actions, however, are less certain. When, for instance, a person buys a new brand of sausages from the supermarket he doesn’t necessarily know whether the enjoyment of the taste and the satiation of hunger will outweigh the money spent on them. In order to mitigate this uncertainty he may at first be reluctant to devote too much money to these sausages, perhaps displaying a willingness to purchase them only when their price is reduced. Once he has eaten them, he may feel that he made a satisfactory purchase, and that he is glad that he bought them for the amount of money he gave up; alternatively the meal may be so ghastly that he regrets the experiment and, if he could go back in time, would keep the money and not buy them. However, another possibility is they might be so enjoyable that he regrets not having spent more money on more sausages, and that the other uses to which he devoted another part of his money ended up being wasted as a result.

The point, though, is that all valuation of our actions is made ex-ante and that they are, therefore, speculative. Even with a commonly repeated act such as brushing one’s teeth there is no absolute certainty. What if the time you devoted to brushing your teeth caused you to miss something important on the television and that, if you had your time again, you could go back and leave the brushing until after the show had finished? Speculation is, therefore, not only an essential and undeniable aspect of human action, one that we are immutably bound to using, but the very generator of human action itself – it is the impulse of our belief that we are moving on to something better with each act that causes us to act. It is no exaggeration to say, therefore, that speculation is at the heart of the nature of human existence. Everyone is a speculator.

Market Participants and Exchange

Having established, therefore, that speculation is the anticipation of the increase in value that will be produced by an action, let us narrow our focus to the forum where speculation is typically used to describe these activities of valuation – the marketplace. But is it the case that only city traders staring at price charts on six computer screens all day are “speculators”, or is the scope of the definition much wider?

The “free market” – something which its critics would like you to think is an uncontrollable beast completely divorced from “ordinary” people – is nothing more than an abstraction for individual people voluntarily buying and selling on their own terms. But why do they buy and sell, or to use a more precise phrase, why do they exchange?

Here we come to a second important law of human action – that in order for two individuals to exchange goods, each must value the good that he receives more highly than the good he gives up. If A owns a watch, B owns a fountain pen and they agree with each other to exchange these two goods then it must be because A values the fountain pen more highly than he values the watch while B values the watch more highly than he values the fountain pen. If this was not true why would the exchange happen? If A viewed the fountain pen as being equal in value to the watch then why bother to exchange the watch for the pen? What would he be gaining from the exchange?

It follows, therefore, that if market participants are attempting to gain value through trade, and the value can only be anticipated in the way that was outlined earlier, then aren’t all market participants speculating? Aren’t we all expecting that what we gain from an exchange will be of greater value than that which we gave up? Do we not also live with the uncertainty of our expectation either materialising on the one hand or failing to materialise on the other? If so, everyone in the marketplace is a speculator, and every market transaction is a speculation on the outcome of an exchange being more valuable than the prior state of affairs.

Let us concentrate, however, on the market participants who buy and sell, i.e. those for whom the relationship of exchange does not end with their purchases as in the case of a consumer. Consumers, after all, are expecting psychic gain. When a consumer purchases a steak he is expecting the enjoyment gained from eating it to be greater than the money he spends on it. With other market participants, however, the goods they exchange are not for their final enjoyment; rather, they buy goods with the desire to sell them onto a third party in due course.

Here we have the starkest and simplest way of determining a gain in value from an exchange – that the price at which you bought a good is lower than the price at which you sell it. Market participants other than final consumers aim at this end (except in cases of charity or special favour). And once again the participants can only expect that the good will sell at a price higher than the price at which it was bought. All market participants are, therefore, speculators, and the object of their speculation is the variation in price of an economic good. It does not matter who you are – a corner shop, a restaurant, a bank, a large multinational firm, a derivatives trader. All of these speculate that the price at which they purchase the factors of production will be lower than the price at which they sell the final article to their customers. Price movement, therefore, is king to the speculator.

Prices

The market price for a good is a function of the supply of an economic good and its demand. If the market price is at a level where the quantity of the good that is willingly demanded equals the quantity that is willingly supplied then the price is said to be at the equilibrium price, or the “clearing” price. Equilibrium is established because all willing market participants – buyers and sellers – are satisfied at this price. All of the willing buyers go home with however many units of the good they wished to buy, and all the willing sellers go home having sold however many units of the good they wished to get rid of.

It follows, therefore, that if there is a change in supply or demand then one set of people must become unsatisfied. If, at the current price, demand increases but supply remains constant there are now, suddenly, not enough willing sellers to supply the goods to all of the willing buyers. The result is that the price must rise to a point at which the willingly supplied stock can be rationed to the sudden influx of new, willing buyers at the old price. Conversely if supply increases but demand remains equal then price must fall to a level at which the increased supply can find new, willing buyers who were not prepared to pay the previous, higher price.

Disequilibrium in the relationship between supply and demand therefore causes prices to change. It is this ongoing and varying disequilibrium that causes the price movements in goods that we commonly associate with speculators – in stocks, bonds, currencies, commodities, property etc. But the currents of supply and demand are common to all prices, even those that appear to change little from day to day.

As we have already established, a speculator in the marketplace is a person who “speculates” on the prices of goods – he believes that the price which he pays for a good today will be lower than the price that he is able to sell it for in the future. But, as we just explained, this can happen only if there is disequilibrium in the relationship between supply and demand. What follows, therefore, is an important, applied economic law that is seldom realised by even the market participants themselves: that anyone who buys goods in the marketplace with the desire to sell them at a higher price necessarily intends to buy at a point when/where demand is relatively low compared to supply, before selling them at a point when/where demand is relatively high compared to supply, pocketing the difference in prices as profit. All market participants are therefore speculators on the disequilibrium between supply and demand. There are no exceptions to this law – every investor, entrepreneur, manager, businessman, capitalist, shopkeeper, distributor, agent, anyone you can think of who wants to “buy low” and “sell high” must look for where and when demand and supply are in disequilibrium. It follows that identifying the points between which the disequilibrium is greatest will yield the most handsome profit margins.

Methods of Speculating

We are now getting closer to the area where the most common grumbles about the act of speculation lie – that the speculator just buys something, sits on his rear end, waits for the price to rise and then sells it. “But what on earth has he done?!” cries the typical lament. “What value has he contributed? How has he improved the situation at all and why should I pay this person a ludicrously high profit?!” Such vitriol is usually reserved for certain types of market occupation – investors, bankers, middle men, and agents for example. But we must remember that all market participants are speculators, and so there is more than one way of anticipating where and how the supply and demand for a good will change. Further, as will be demonstrated, all speculators, in whichever occupation they are working, must, if they are successful, add value.

What, then, are the methods of speculating? What is the focus of the individual speculator when he is buying low and selling high? There are three, possible objectives at which the speculator may aim:

  • To transform the good into another good;
  • To change the location of the good;
  • To change the time when an economic good will be made available.

Little needs to be said about the first except that it always involves a material transformation of a combination of goods into the final good and is synonymous with what we usually call “production”; the second is effected by transporting the good from one location to another and is what we would typically call “distribution”; the third consists of buying the good, withholding it from circulation and selling it at a later date.

In practice, of course, it is something of a fiction to treat these aspects entirely separately; for a start, all methods of speculation must take place through time. Further we could argue that a change of time or a change of location is also a change of form – that, for example, oranges in Florida are a different economic good from oranges in London, or that Christmas trees at the height of summer are a different good from Christmas trees in December. However from the point of view of the physical actions and preoccupations of the speculator, they are separable and analytically different methods of speculating. How then do these methods of speculation take advantage of changes in supply and demand?

Transformation

If a speculator transforms an economic good then he takes pre-existing goods and turns them into another good, a finished product for sale. It is easy to envisage this for the reason that every manufacturer fits into this category, whether he is a sole trader or a large factory. A carpenter takes wood, tools, varnish and his labour and produces a table or a chair. A printer takes plain paper, ink, staples and labour, and produces a book. A car plant or plane manufacturer takes hundreds of factors of production in order to turn out their products. Such transformation can take place with previously produced goods or with land (in the economic sense). The carpenter’s wood, for example, has already been transformed, at the sawmill, from a tree into a plank, whereas a farmer has to take land, seeds, water, fertiliser and labour to turn them into crops. Further, the transformation is not limited to tangible goods but also to services. A taxi driver will take a vehicle, fuel, a payment meter and his labour, producing with them a journey for a customer. Nothing physical that the customer can hold in his hand results, but the factors have been combined to yield a valuable service.

How is it, then, that a transformation produces the all important increase in value, indicated by aiming for selling the produced good at a price higher than the price of the individual factors? It can only be by buying factors that are lower in demand relative to supply and transforming them into a good that is in higher demand relative to supply. The several economic effects of this service are important.

First, it discovers an economic inefficiency that is ripe for correction. Factors that are used to produce a good that is highly valued are, in and of themselves, relatively undervalued. The larger the profit margin the greater the extent of this disequilibrium.

Second, such a discrepancy means that the factors, because of their relative cheapness, are being conserved with less zeal and, moreover, are being wasted in production processes that turn out less valuable items. When the speculator begins to buy these factors he creates for them an additional demand. This additional demand drives up their prices, rendering them too costly for other, less valuable ends, diverting them instead to the more valuable output. Hence resources are no longer wasted.

Finally this discovery of the discrepancy and its subsequent correction, yielding a large profit margin, will encourage competitors to enter the field. Thus, the demand for the factors will increase even more, driving their price up further while, at the same time, additional production will mean that the supply of the finished product will decrease, hence lowering its price in turn. Profit margins therefore diminish as the increasing cost of the factors approaches the decreasing selling price of the final good. Investment will continue to increase and the industry to expand until profit margins no longer justify it and funds are attracted to other projects whose discrepancies and imbalances have now become relatively more pressing.

Therefore, speculation – the discovery of imbalances between demand and supply – prevents the waste of resources by identifying wide profit margins and closing them. As a result the scarce factors of production are directed to their most highly valued ends. This is the essence of economic efficiency – getting the greatest value that we can from scarce resources.2 However, there is no guarantee that the speculator’s buying prices will be higher than his selling prices. Just as the consumer does not know in advance whether the new brand of sausages he bought from the grocery store will end up being worth the money spent, neither also does the speculator know whether the price of the good he sells will be higher than that of the goods that he combined to produce it. There are several possible outcomes:

  • It may be that the speculator’s customers are satisfied with the product and will purchase it at a modest premium, in which case he identified a discrepancy in the market, but it was relatively minor. The speculator has provided a service but the factors of production clearly have very competitive, alternative ends into which they could be drawn, otherwise their price would have been lower and the profit margin higher. The speculator has therefore done an important service, but not one of tremendous magnitude;
  • Alternatively the customers may be absolutely delighted with the new product and rush to buy it as quickly as possible. Demand is so high that the speculator can barely keep up with orders, and the only way to ration the existing stock is to raise the price. The increase in price will, therefore, increase profit margins. Hence the speculator here has identified a very wide and serious imbalance in the economy, a pressing and urgent desire of his customers for a product whose factors were drastically under-utilised.
  • Finally – the undesired outcome – the speculator finds that he cannot sell his finished product for more than the cost of the factors of production, and so he makes a loss. He has, erroneously, diverted factors that were in high demand relative to supply and transformed them into something lower in demand relative to supply. Hence the factors have been wasted as the high demand for these factors indicates that there were more pressing needs to which they could be diverted.

If the third outcome materialises, the waste is cut short quickly because no market participant wishes to (or even can) sustain losses. Even if the speculator persists with the loss making enterprise, there will a come a time when he runs out of money. He therefore loses the ability to continue to divert resources to wasteful ends, and his proven lack of talent for speculation eliminates him from that role in the economy. The successful speculators, however, are able to use their profits in order to command more resources than they were before. Their successful identification of where to divert the scarce factors of production means that they are trusted with being able to do so again with more money. But if they make a single error in anticipating the desires of the consumers they will begin to make losses. They must therefore be successful in identifying the most pressing needs for valuable economic resources continuously, day after day.

Location

Having explained the economic effects of speculation with reference to speculators who transform economic goods, the remaining categories can be elaborated relatively swiftly. However, when it comes to transformation of some goods into another, it is relatively straightforward to visualise the productivity of the speculator; indeed the word “speculator” is seldom associated with what are perceived as routine businesses and, moreover, we believe these businesses to be meritorious. However, with speculators who change either the location or the time of a good, the understanding of precisely what is going on becomes more obscure, resulting in the perception that these types of speculator are either adding no value or, worse, are actively destructive and exploitative. These beliefs will be demonstrated to be false.

With the speculator who changes the location of an economic good, we are confronted with the case of the dreaded middleman – the agent, the dealer, the distributor and the marketer. These people buy an economic good from the manufacturer, and do nothing except move it elsewhere before selling it for a higher price, so the argument goes. If, however, they are not adding value then it raises the question of why people are willing to pay the despised mark-up, the difference between the retail price paid by customers and the wholesale price paid by speculators. Are the latter simply able to rip people off or is there a genuine reason why they are able to sell their goods for higher than the price at which they bought them?

Let us take the example of the distributor. Why is he able to purchase goods for a lower price in one location before selling them for a higher price in another location? Going back to our analysis of prices it can only be because the goods at the original location are in lower demand relative to supply whereas the goods at the final location are in higher demand relative to supply. In other words the speculator has identified an imbalance in the market – goods at one location are plentiful and valued poorly relative to another location, and so the speculator steps in to correct this imbalance.

This is straightforward to perceive with goods that can be manufactured or produced only at certain locations in the world, either because of climate or because of the ease of access to raw materials. Let us assume, for instance, that oranges can be grown only in Spain. In Spain, there would be a very heavy supply of the oranges as the crop ripens – baskets and baskets of them stacked up in the groves. Oranges may be so abundant that they exchange for pennies, and people devote them to meeting all sorts of ends – eating, juicing, garnishing, animal feed, etc. However, at other places in the world – let’s say, London – oranges are not produced at all and so are in very short supply. Consequently they trade for a very high price, and as soon as someone gets his hands on an orange he will conserve it and take extra care to make sure he devotes it to his most highly valued use (probably eating as an occasional treat).

The actions of the speculator who steps in here differ in no way at all from the actions of the speculator who transforms goods. If he buys oranges in Spain, his buying action will drive up prices there and so curb the relatively wasteful uses to which oranges are presently being directed. After shipping them to the UK, his selling action will drive prices down in London, allowing more people to enjoy the fruit and to devote it to a wider number of uses than they could before. The height of the speculator’s profit is determined by (and will demonstrate the height of) the economic imbalance between the two locations, encouraging competitors to enter the field who will continue the buying in Spain and the selling in London, thus reducing profits. This will continue until the return no longer justifies the costs of transportation.3

Therefore, just as where the transforming speculator brought about a unity in price between the factors of production and the final product, the speculator in location brings about a uniform price for goods across all places (plus or minus transportation costs). Thus, economic resources are not just turned into their most highly valued form but also they are transported to their most highly valued location.

Economically the speculator in location is no different from the speculator in form. The only difference is that the focus of his operation and his expertise is in movement and distribution rather than in transformation. However, it is still the case that he takes factors – oranges in Spain, wooden crates, trucks, fuel and labour – and transforms them into oranges in London, and the latter is really a different good from the original. Hence, he has produced a good in a different form except that this is not evident from the physical quality of the final good. It is this difficulty in perception that leads people to question the added value of this type of speculative activity.

Another advantage of the speculator is that he eases the burden of the previous producer. For example, by buying the oranges from the farmer in Spain, the speculator relieves the latter of having to find a market for his product. The farmer receives a definite price now rather than having to, himself, arrange for transportation, marketing and whatever else in order to sell his product elsewhere on the planet. He can therefore concentrate his time and resources on farming the oranges. Similarly, the car manufacturer sells to a dealer so the latter takes on the burden of having to market and sell them to consumers. In fact, the same is true also of those who change the form of goods. The carpenter relieves the lumberjack from having to fashion the wood into tables and chairs; the miner does not need to learn how to turn gold into jewellery because the goldsmith will do that instead (and the jeweller will then buy from goldsmith). Hence, the more speculators there are attempting to analyse differences between buying and selling prices in different markets then the greater becomes the extent of the division of labour – each market participant only needs to concentrate on a very small section of the entire economy, and may be completely unaware of where his factors came from and where his final product will end up. Such specialisation leads to enormously greater productivity and, indeed, is the very raison d’être of the extent to which humans have, at least in some parts of the world, achieved a standard of living far in excess of that when they first walked the Earth.

Time

Finally, let us turn our attention towards the speculator who changes the time of an economic good. Here lies the (apparently) most lazy and undeserving of all speculators – the person who buys something, holds onto it for a period of time, then sells it a higher price while having added nothing of any value whatsoever. Surely this person is ripe for condemnation?

Such a point of view again overlooks an analysis of supply and demand.4 If the speculator buys a good at a time when its price is low it must be because the demand for the good is low relative to its supply. However, the speculator is anticipating that demand will rise at a point in the future which, in turn, will cause the price to rise, allowing him to sell at a profit. If the speculator is correct, therefore, then it means that the good in question will become, in the eyes of the consumers, more valuable than it was before. What he has anticipated is that a relatively worthless good today will become more sought after tomorrow. The speculator’s buying action therefore serves to remove the good from circulation at a point when demand is low. This removal prevents it from being wasted by a diversion to a less urgent use today when it will be needed for a more urgent use tomorrow. Once prices have risen as a result of the anticipated increase in demand, the speculator releases the good for sale on the market again, but now only those who value the good most highly will be willing to pay the increased price.

The economic function of the speculator in time is, therefore, to conserve resources in times of plenty and release them in times of scarcity. It is almost exactly like the squirrel who, during the summer and the autumn when nuts and fruits are in abundance, abstains from consumption of a part of them and stores them away. Come the winter when these goods are scarce he has plenty to consume that he would not have had but for his hoarding.

Indeed, seasonally available products are amongst those that are ripest for speculation in time. The general effect of this speculative activity on the market is a reversion of prices to the average. If we assume, for the sake of simplicity, a constant demand for wheat during the year, at harvest time there is plenty of wheat to satisfy this demand, and so prices will be very low. Wheat will be so cheap that people will gobble it up and devote it to minor and un-pressing needs on account of its abundance. However, in the spring and early summer, wheat will be very scarce and will therefore command a high price. There will not be enough to go around and what little there is will be devoted only to the most urgent needs.

To counter this, the speculator, in the abundance of autumn when prices are low, will introduce additional buying pressure which will drive prices up towards the average, annual price. Conversely, during the springtime scarcity when prices are high, he will release his hoarded stock which will push prices back down to the average. The overall result is a stable price for wheat throughout the entire year, in spite of the seasonal variations in supply. This is why consumers are able to pay the same price throughout the year for products such as bread that are produced with seasonal factors of production.

Similarly to other forms of speculation the height of the difference between the buying and the selling prices determines the scale of the economic imbalance, most noticeably after poor harvests. In these years speculative action, reaping handsome profits because the price rises so high, serves to conserve what little of the crop there is for those who need it most urgently.

Of course those speculators who behave contrary to what supply and demand are doing – those who sell when prices are low and hence drive down the price even further when the good is in hot supply, or those who buy when prices are high thus choking off even the most willing buyers from being able to purchase the good – will quickly lose funds and go bust, ending their short reign of destructive buying and selling. For no speculator, in the long run, can change the ultimate direction of prices; every speculator who buys at some point has to sell. His buying pressure that raises prices today will become selling pressure that lowers them again tomorrow. The overall price and its movement can only be determined by original supply of a good by its producers, and the final demand by its consumers. The volatility of prices and bubble formations that are allegedly caused by speculative activity will be dealt with below.

A further benefit of speculation in time is the correction of momentary price discrepancies. Let’s say that a seller offers a good for sale at a price below the market clearing price, a level where demand outstrips supply. The speculator purchases the good but then offers it for resale at the higher, clearing price, pocketing the difference as profit. By purchasing at the lower price the speculator ensures that sub-marginal buyers are not able to get their hands on the good and divert it to wasteful uses; by selling it at the higher price he releases the good to the marginal and supra-marginal buyers who will divert it to more urgent uses.

Conversely, a buyer may offer to buy a good for higher than the clearing price where supply exceeds demand. Here, the speculator will sell the good at the higher price before buying it back at the clearing price. This means that sub-marginal sellers are not able to sell their goods ahead of the marginal and supra-marginal sellers, ensuring that the former cannot crowd the market with wasteful surpluses.

It should be clear that the speculator’s profits in cases of momentary price discrepancies are funded entirely by the erroneous sellers who sell too low or the erroneous buyers who buy too high. They must bear the penalty for trading at a price level where supply and demand are not in equilibrium. Those buyers and sellers who are prepared to trade at the clearing price do not suffer at all; indeed buyers are benefited by the prevention of a shortage of stock resulting from prices below equilibrium and sellers are helped by the prevention of surplus stock resulting from prices higher than equilibrium.

Once again, if the speculator himself is on the wrong side of these trades then he is the one who is punished with losses. If he, for example, suspects that the current price is below the clearing price whereas it is, in fact, either at or above the clearing price, he will buy and then attempt to sell at an even higher price. But at this latter price there are few, if any buyers willing to purchase all of the stock offered by sellers at this level. The only way the speculator can compete with the other sellers is to lower his price until all the stock can be sold at a level that fills every willing demand to buy. Depending on how erroneous his original price was he may break even or suffer a loss. Repeated losses will deplete the speculator’s funds until he has no wherewithal to speculate further, preventing him from causing any more distorting activity on the market.

A final benefit of speculation in time is similar to that of the service that the speculator in location provides the orange farmer. When the speculator is tasked with finding a market for oranges, the orange farmer is relieved of the risk and burden of having to do so, allowing him to concentrate solely on farming. Similar concerns face those who sell goods with a length of production that is relatively long and, thus, fraught with uncertainty. Once again, crops are a good example. The farmer has to begin production and incur expenditure on factors in the spring whereas he will not reap the harvest (and thus make an income) until six to nine months later, during which any number of intervening events could occur that will affect the quantity and quality of the final good. In steps the speculator who will, say, at the start of the growing season offer a definite price to the farmer for his whole crop, regardless of how it turns out at the end of the harvest. The speculator, of course, believes that the final crop will be of a quality and quantity that will enable him to earn a profit on what he paid to the farmer. The farmer, in turn, is willing to forego this profit so that he can purchase factors of production and begin work safely with the knowledge that the costs will be covered by a fixed amount of revenue in the future. Hence the risk of future prices is transferred from the farmer to the speculator.

It should be noted also that every owner of a productive asset, which will deliver its productive services not immediately but over a long period of time, is a de facto speculator in time.

Let’s say, for instance, that a business purchases a copper mine for £1m, this amount representing the discounted future value of all of the copper that can be extracted from the mine. The value of this mine will now appear as an asset on the firm’s balance sheet.5 How much of the copper should the firm mine for sale this year and how much should be left in the ground for extraction in future years?

To answer this, the business must ensure that the revenue earned from extracting and selling a certain quantity of copper exceeds, in addition to other costs, the write off charge of the mine’s value that results from having reduced the amount of copper remaining in the mine. Let us say that the business estimates that one fifth of the mine’s supply of copper this year is the right amount to extract, and so it charges a write off of £200,000 (£1m/5) to its expense account.

If the revenue earned from selling the mined copper exceeds £200,000 (plus other costs) then the firm has made a profit. The premium that consumers were willing to pay shows that the copper’s extraction and sale this year was valued more highly than leaving it in the ground for a future year. The firm has, therefore, done consumers a service by making enough valuable copper available for use this year. In fact, depending on the height of the profit, an increase in production to mine even more of the available copper may be justified.

If, however, the revenue earned falls short of £200,000 (plus other costs) then the firm makes a loss. This means that the copper that the firm made available for sale this year is less valuable to today’s consumers than it would have been to consumers in future years. Thus, the firm has mined too much copper this year, creating a wasteful surplus and doing a disservice to consumers.6 Production therefore needs to be cut back to curb the oversupply.

With produced capital goods such as machines, tools and even buildings, this problem is shared by the manufacturer and the purchaser. They must ensure that the productive capacities of the capital goods used will neither over- nor under-produce consumer goods in a given time frame. If the capital goods over-produce, then the firms have wasted money on excess capacity, and so will lose out to competitors who produce/use leaner machines. If the machines under-produce then firms with bigger and more robust machines will dominate.

Financial Traders

The financial trader is the speculator in time par excellence. He will buy financial securities – stocks, bonds, currencies, options, futures contracts etc. – withdraw them from circulation and sell them again for a higher price. Everything essential that needs to be known about this type of individual has been covered in the previous discussion. Nevertheless, as the financial speculator in particular is the least understood and most vilified of all market participants some additional elaboration would be beneficial.

The consumer, as discussed above, bases his buying decisions upon whether the object of his purchase gives him greater satisfaction that the sum of money with which he parts for it. His gain is a psychic profit, one that cannot be measured or demonstrated but one that is, in his own mind, either achieved or not achieved. It follows, therefore, that his buying decision is dependent upon the quality of the good that he buys. For example, if it is food it needs to have a nutritional value and taste the benefit of which exceeds the cost that was paid for it.

This, however, is not the case with those who sell goods to the consumer. If, for instance, you are a fishmonger, your primary preoccupation (aside from garnering expertise on your industry) is not with whether fish is delicious, nutritious and will provide a great deal of benefit if consumed. Rather, you are more concerned with the fact that consumers are willing to buy it at the price you offer and, so, in order to meet this demand, you focus your concentration on where you can source the fish at the lowest possible cost. Indeed, the fishmonger himself may utterly detest the taste of fish, but so long as his customers are willing to buy it then he will continue his endeavours to sell it.

Similarly, a café owner doesn’t care whether he thinks coffee is good, bad, or ugly, nor does a carpenter care about whether he finds the tables and chairs that he produces would be nice in his living room; indeed both may utterly abhor the products that they turn out. The main focus of their operations is to recognise that consumers demand these things, and so they meet these demands by purchasing the factors of their production at the lowest possible cost. What emerges therefore is a symbiotic relationship in which the desire to earn profits on the part of the trader is harmonised with the desire of the consumer to acquire a good that will satisfy him.7

If we turn, however, to the financial markets the same relationship is present between what we might call pure financial traders on the one hand and investors on the other. The latter is concerned with whether the companies he buys will produce products that best serve the needs of consumers and, hence, make the highest profits. In other words, if he needs to decide whether to invest in either companies A, B or C he must determine which of them (if any) is utilising (or will utilise) its assets in the best possible way in order to fulfil the demand of its customers. Even though, therefore, the investor is, like all market participants, a speculator in supply and demand who ultimately derives his entrepreneurial profit from imbalances between the two, there is an inherently qualitative dimension to his operation, similar to that of the consumer himself.

The market capitalisation of a company represents the discounted value of the company’s anticipated future profits. If you were to buy a whole company what you have really bought (and what you are really paying for) is all of the company’s future profits discounted to reflect the fact that you cannot enjoy these profits today but must wait for their generation at some future date.

However, the medium of such investment activity in publicly traded entities is financial securities – stocks and bonds being the most obvious – which are merely ways of scattering the ownership of a company across many different investors, each of whom owns a portion of the company’s future profits8. Stocks are themselves traded on the stock market, and markets, as we know, are formed by the demand of buyers and the supply of sellers. There is, therefore, a supply and demand for ownership of these “pieces” of companies. This supply and demand is driven by investors and their views of whether a particular company will be the most profitable. It follows, therefore, that if a great number of investors believe that a company will be particularly illustrious and successful in making profits the demand for its securities will be very high, relative to their supply. If however, the investors believe the contrary – that the company is wasteful and has little or no prospect of earning a profit – there will be an eager rush to sell its shares, and so demand will be very low relative to supply. This is what, proximately, causes some share prices to be “high” and others “low” – the opinion of investors regarding the ability of companies to generate future profits.

Notice that the stock market operates entirely independently of the operations of the company itself; although the share price should, theoretically, follow the success of the company, it can (and does) diverge because investors change their minds over whether the company will generate future profits successfully. All this proves is that the investment operation is speculative – that it is looking forward to a possible future state, a state which may turn out very differently from that which is expected9.

The stock market is, therefore, an investors’ market where people will buy not consumer goods like meat, bread or coffee but securities in companies. But this market operates just like the consumers’ market and it is based wholly on the supply and demand for the products that are traded. If coffee is suddenly demanded very highly then in step the speculators – caring not of the reasons for the consumers’ desires – who buy, and hence bid up the prices of, the factors of coffee production to ensure that less urgent needs are choked off from their use in order to ensure that they can be devoted to this very pressing need of the consumers that has emerged. But exactly the same happens on the market for securities. In just the same way that consumer demand for coffee might rise because they believe it to be delicious and nutritious, so too at any one time investors might increase their demand for shares of Company A on the belief that A has a strong prospect of earning future profits.

In, therefore, steps our financial speculator. In just the same way as the speculator in consumer products has to speculate on the demand and supply of these products, so too does the financial speculator speculate on the demand and supply (of investors) for financial securities. In just the same way that the café cares not for the underlying qualities of coffee but only for the fact that it is in heavy demand, so too does the financial speculator care little for the qualitative prospects of the company from which the security is derived to earn future profits; he cares simply for the security’s supply and demand driven by investors. He will buy the security if he believes that, at the current price level, demand will soon outstrip supply, leading to an inevitable price rise; he will then sell the security when it reaches a price level where supply and demand are in equilibrium.  Alternatively, he will short sell the security (borrow it so as to sell it) if he believes that the supply of the security will soon be in excess of its demand before then buying it back at a lower price level (and returning the security to its original owners)10.

It follows, therefore, that the majority of investors may be totally erroneous as to their opinions of the company; they may all want to buy a complete turkey of a company in the mistaken belief that it will be handsomely profitable, or, alternatively, they may sell the golden goose. The financial speculator cares not about whether these companies really have an underlying ability (or lack thereof) to generate future profits; his focus is entirely on whether the investors believe that they do, and on the consequential supply and demand that is generated for the securities11.

What economic benefits does such a speculator achieve? They are more or less identical to those of all other types of speculator. If the speculator predicts that demand for a security will be very high then not all of the investors who wish to buy will be able to do so at the current price. The speculator’s additional buying will therefore cause a price rise to occur sooner than would otherwise have been the case. In the same way that bidding up the factors of production diverts their use from less urgent needs, so too will the financial speculator begin to choke off demand from incompetent investors – not merely dabblers, gamblers or those with insufficient funds to purchase at the higher price, but also those who are less certain or have been less scrupulous in forming their belief that the company is a worthwhile investment. The rise in price therefore reserves the supply of the security for the investors whose belief in the company’s prospects to earn returns is so strong and committed that a purchase even at this higher price would, for them, be justified by these anticipated, future returns. It is to these people whom the speculator will sell.

Conversely, when the speculator believes that supply of a security will, at the current price, be in excess of demand – i.e. that the majority of investors believe that the company will not, at this security price, earn a future profit that justifies it – he will short sell it. As not all willing sellers can sell at this high price due to the lack of demand, the speculator’s actions in driving down the price will again choke off the less competent sellers – those who are less certain or have been less scrupulous in forming their belief that the company is a turkey – and the resulting fall in price to where demand is higher means that investors whose belief in the lack of the company’s prospects to earn returns is strong can now find a demand to sell to. It is from these people whom the speculator will buy to cover his short sale and, indeed, his aim – if he is to achieve the highest profit – is to buy from the very last of these investors, when the price movement is necessarily at the lowest it will go.

In sum, therefore, the financial speculator provides the committed investor, the one most dedicated to directing resources to where they are most urgently desired by the consumers, a supply of securities when the latter wishes to buy and a demand for them when he wishes to sell. There is, therefore, no substantive difference between the relationship of a shop with a customer and that of a financial speculator with an investor. It is merely that the service of the financial speculator, by ensuring that security prices most quickly reflect the underlying supply and demand, is not to directly channel resources to where they are most urgently needed, but, rather, to facilitate the ability of the investors to do so.

It should be clear that the most lucrative investment operation is one that takes note of this speculative ability. For if one wishes to make the highest profit it pays to combine the two operations – by finding those companies a) that will best meet the needs of consumers and generate the highest profits, and b) whose securities are trading at a price where demand will be far in excess of supply and, hence, are due for a price rise. It is for this reason that the famous philosophy of value investing – buying the most profitable companies at prices below that at which the investor believes represents their discounted profit stream – is so successful. Indeed, it is analogous to a consumer being able to buy at wholesale rather than retail prices – you are buying the same utility but at a lower price, hence the differential between the price and your reward is greater. As the first chapter to one introduction to value investing is titled, “Buy Stocks like Steaks…On Sale”12.

Charting and “Gambling” 

In this penultimate section, let us lay to rest some of the other myths that are associated with the financial trader.

The speculator’s primary tool of price charts and its associated array of mathematical studies that are derivatives of price (used in methods that are collectively known as “technical analysis”) lead the casual observer to declare that all that speculators do is follow a few patterns or look at a few studies and then repeat this over and over in order to rake in huge and “unjust” profits. To assume this, however, is to make the cardinal error of treating human activity like that of unconscious matter – that when any pattern or mathematical progression repeats it signifies a buy or sell signal that, unfailingly, will produce profits.

Such nonsense detracts from the central task of the speculator, one that has been stressed over and over in the above – to find imbalances in the relationship between supply and demand. All that the chartist is doing, just like any other speculator, is finding the prices where supply and demand are in the largest disequilibrium, except that he finds these areas by interpreting price charts. There is nothing technically or mathematically certain about this process; it is, rather, an entrepreneurial skill just like any other.

Every profitable trader knows that there is not a single technical study with a fancy name (“Moving Average”, “MACD”, “Stochastics”, “Relative Strength Index”, etc.) that, taken alone, will yield consistent profitable trading activity; indeed it is the fastest way to run down a trading account. Rather, the charting speculator learns what areas of supply and demand imbalances tend to look like on a price chart, and so he confines his trading to these areas. But he knows that human action is neither uniform nor repetitive, and so he does not expect every instance of his analysis to provide the same result. Rather, he condenses his interpretative techniques to a handful of rules that he applies with a probabilistic approach to discovering where supply and demand are most in disequilibrium, risking a small percentage of his funds by stopping out of a trade in cases where he is wrong. The most skilled trader can minimise such losses to the extent that they simply become a cost of doing business; indeed with proper risk management skills which ensure his losses are small and his profitable trades are large, his interpretative methods may even allow him to make losses on more occasions than he makes profits. But regardless of his precise win/loss ratio, recognition of the fact that a trading method does not work one-hundred percent of the time (a point on which all successful traders will agree) proves that there is nothing about trading from charts that can be scientifically or quantitatively determined. The only science is in the fact that disequilibrium in supply and demand causes prices to rise or fall; interpreting where these points lie on a price chart is a rare, entrepreneurial skill.

Nor can it be said that financial traders are “gamblers”, i.e. that their returns are based on pure luck. The point of this essay has been to demonstrate that all market participants are speculators – they all, fundamentally, are doing the same thing regardless of their specific methods and preoccupations, and the economic effects of their actions are always the same. There is, therefore, no way in principle to distinguish one type of speculator from another. If a financial trader is a gambler on rising or falling prices then so is every business, every shop, every carpenter, and every plumber in the world. The fact that some businesses in each industry will consistently tend to do better than their competitors suggest that there is more than luck involved, and the same is true for financial traders.

Even if, however, financial traders or any speculators were simply gamblers then what harm would it do? Every speculator, as we have noted, must one day sell after he has bought. He is a producer neither of original supply nor final demand; rather he greases the market towards prices where the original suppliers and final demanders are in equilibrium. If he is successful in doing this he sells for a profit; if he is not then he sells for a loss. If the former then he has aided economic efficiency by moving supply and demand towards its equilibrium price, regardless of his methods. Consequently he is trusted with more funds on which to make larger and more important speculations in the future. If he loses then the situation is the opposite – he has harmed discovery of the equilibrium price, but his resources for doing so are limited. If he keeps making losses then, very quickly, the market will wipe out his means for causing ill economic effects. However if these losses occur because the speculator is gambling then the situation is no different from that of any speculator who applies faulty methods, whether they are laziness, sloppiness or simply a lack of entrepreneurial talent. There is no way to separate a gambling speculator from one that is simply bad.

State Interference with the Financial Markets

Of course, much of the ire directed at speculators results from the fact that the state, through inflationary finance and credit expansion, wildly distorts the pricing mechanism of the financial markets and, indeed, appears to turn them into a casino rather than a mechanism of allocating prices. This leads to wild, speculative bubbles that, during boom years, inflate like an aphrodisiac balloon until they eventually pop, ushering in a recession or depression following a crash in prices.

This is not the place to discuss at length the cause of the business cycle by artificial credit stimulation. But if such artificial stimulation distorts the underlying fundamentals of the economy – by making longer and more roundabout production processes appear more attractive and diverting resources unsustainably into capital projects – then this is not the direct fault of the speculator, even though the largest institutional  speculators will, of course, be in bed with the state.13 As we mentioned earlier, every speculator is always in the position of having to sell after he buys. He cannot, therefore, affect the overall or average price level of the speculative good. In buying capital goods at the start of the boom, the very ones that he knows will be sucked up by all the freshly created and loaned money that is emerging from the artificially low interest rate environment, the speculator merely moves prices quicker to where they are already heading as a result of all this newly printed money. The boom therefore happens quicker, but it is only in response to the anticipated demand that has been falsely stimulated by credit creation.

The same happens at the bust phase – by selling (or short selling) the speculator simply lays bare the fact that demand and supply, at such inflated prices, cannot continue to be in equilibrium in the absence of continued credit expansion. His action at the peak of the market and on its slide down liquidates the boom’s malinvestments quicker and, if uninterrupted, provides a painful but much speedier recovery to a sound and stable economy than otherwise would be the case. In fact, the reason why short sellers tend to attract such vitriol is that they are the ones who are turning down the music, taking away the punchbowl and, thus, inducing the inevitable hangover sooner, whereas the state would prefer to keep the party going. From the point of view of economic progress, it would actually be better if we had more pessimists and sceptics operating in the market at the height of these unsustainable bubbles instead of castigating them as bandits and bank robbers.

Speculation exists to serve the direction of supply and demand in the economy whatever causes this supply and demand to occur on the part of market participants. If the directions of supply and demand are distorted by destructive interventions then their consequences are not the fault of the speculator per se. Proper blame should be laid at the door of the easy credit policy which is the favourite of states and central banks everywhere.

Conclusion

At the opening of this essay, we noted that capitalistic institutions need to be distinguished from the abuse of those institutions by actors operating with state privilege so that the latter are identified as the true source of our problems. However, it should be noted also that much of the precise extent and form of today’s financial markets would not have been possible without state interference. “Pure” speculative activity will be much reduced in a market where there is no “easy money” being pumped in to cause widespread price fluctuations. But I suspect also that a real free market is likely to be characterised by much smaller and more local entities, wholly owned by professional entrepreneur-managers, in contrast to the publicly owned, multinational behemoths that we have today. A preference for equity financing rather than debt financing – the latter, again, made prevalent by easy money – will also reduce the size of the debt markets. As a result, it is likely that the volume of public security trading will be much reduced from what it is today, so much so that it will be unable to garner the prestige and attention that it attracts today.

Nevertheless, speculation as a whole will always be at the heart of the market process. To summarise what we learnt above:

  • All human actions are speculative and therefore everyone is a speculator;
  • All consumer choices are speculations;
  • All market participation – buying and selling – is speculative;
  • Speculative activities channel scarce resources to their most urgent needs and uses by harmonising supply and demand;
  • It is not possible to distinguish, in principle, between different speculative activities on the market; and that, further, differences between types of speculator usually centre on the fact that a lack of physical change to a good is falsely regarded as a lack of added value;
  • Common myths regarding the nature and alleged destructiveness of financial trading in particular are entirely false.

*    *     *     *     *

Notes

1Of course, such politicians may end up siding with the current system anyway, at least temporarily. But their rhetoric will not fall on deaf ears.

2We might also point out that the higher prices of the factors will also cause speculative action for them as well, with investment being drawn towards increasing the supply of these factors. Hence their factors also will increase in price, and so on and so forth right back through the chain of production until prices for all of the factors and their respective finished products approach equilibrium.

3If equilibrium is reached then oranges would still trade at a premium in London to account for transportation costs.

4For the avoidance of doubt, we are not referring here to the premium placed on present goods vs future goods as a result of the law of time preference; we are discussing real changes in the supply and demand for a good that is available now.

5In the real world, the value of the copper mine will also fluctuate depending upon expected changes in the supply of and demand for copper but, for the sake of simplicity, we will assume it remains constant at £1m.

6Of course, other speculators should have noticed this and purchased the surplus copper, storing it for sale in a future year in which it is expected to be more valuable, and, thus, ensuring that any waste of the copper is minimised.

7This does not mean to say that producers do not benefit from being able to enjoy their own product. We can imagine, for instance, that the best vineyards are probably run by the keenest wine connoisseurs. The point is that their focus is upon whether their customers enjoy the product, not upon whether they themselves do and, in some cases, a producer’s strong commitment to a particular product can actually impair this focus.

8 Shareholders and bondholders fulfil the same economic function as each other by advancing investment funds to the company. The difference is that they do so on different legal terms. Bondholders sacrifice the possibility of unlimited profit or loss and any say in the running of the company in exchange for a fixed return and priority in insolvency; vice versa for stockholders, who are considered to be the owners of the company. Modified versions of each, such as preferred stockholders, will benefit from slightly different rights and privileges.

9Earnings announcements are typical examples of where the share price diverges from the company’s ability to earn future profits. If a company reports that its earnings have been good (or better than expected) the share price normally rockets on the news, whereas if they are bad (or worse than expected) it plummets. But today’s earnings are not intrinsically connected to those of tomorrow. If today’s earnings are bad it might be that the company still has the ability to pull itself together and deliver a better result tomorrow; or it might really be a turkey and still continue to lose money. If, on the other hand, today’s results are good this might be the best that it ever gets and tomorrow will only generate lower profits or even losses; or it might just be the start of a long and prestigious career of generating truly handsome returns. All of these options are possible yet nearly always investors react as if good news today is good for tomorrow and bad news today is bad for tomorrow.

10Space precludes us from examining the much maligned practice of short selling in detail. Suffice it to say that the ethics of short selling are similar to the ethics of borrowing and lending money. Shares borrowed for short selling must come from a segregated pool that has been placed on time deposit at a brokerage by their owners. They should not be lent out by brokers on fractional reserves, which would mean that both short sellers and the stock’s owners would be able to deal with the same stock simultaneously in such a way that requires actual possession. Such a practice can exacerbate so-called “short squeezes”: similar to how the over-lending of deposited money on fractional reserves can lead to bank runs, if an excess volume of shares has been sold short then a rising stock price can lead to a panic as those outstanding short positions have to be covered by the purchase of a limited amount of stock.

In principle, so-called “naked short selling” (contracting to short sell shares before having actually borrowed them) is also lawful within the confines of libertarian ethics. There is no requirement for a good to be in the vendor’s possession at the time of contract. B could, for instance, contract to sell a car to C which will only come into B’s ownership next week, with delivery being made some time after. However – in just the same way as C cannot drive the car until delivery is made – the purchaser of the shares should not, prior to delivery, be able to deal with them in such a way that requires actual possession .

Nevertheless, while the purchaser couldn’t sell any actual shares, he could sell on his contract for the shares to a third party, with the result that the contract itself becomes the tradable instrument (similarly, C could sell to D his contract to purchase the car from B, with the result that B must now deliver the car to D). This is where we get into the realm of derivative securities, which are not trades in the actual shares but trades in certain rights or obligations over shares (and, thus, their value rises and falls in tandem with the value of the shares). Options, contracts for difference, and forward contracts are all derivative products where the equivalent of short selling the actual shares can be carried out with little legal restriction.

11These facts should indicate the falsehood of so-called “efficient market hypothesis” (EMH), the notion that the current stock price reflects all available information, and so consistent, above-average profits from the stock market should be impossible. This implication that markets are somehow “better” than the individuals of which they comprise has been ridiculed by the joke that there could never be a £20 note on the ground for the reason that it would have been picked up already.

The first problem with this theory is that, to the extent that stock prices are influenced by information, such information has to be processed by the human mind, a mind which is not only fallible but also has to deal with competing desires and choices. Thus, reactions to newly available information are likely to be scattered, heterogenous, imperfect and piecemeal rather than “efficiently” uniform, predictable and quantifiable. In the hindsight of major stock price movements, it has often been possible to see that earlier, available information was underweighted or ignored (and/or false or misleading information was overweighted). Indeed, groupthink is a not phenomenon from which market participants have been particularly successful at protecting themselves.

In any case, however, the current stock price is always an estimate of a company’s ability to earn future profits, an ability which is not known for certain and, as such, is unavailable in any “information”. It is, rather, the task of entrepreneurs to bear the risk of predicting it. A million investors, acting on all of the publicly available “information”, may dump the stock of a company that, tomorrow, will earn sky-high profits. The one investor who goes against the grain, buying up all of the cheap, unwanted stock, is the one person who will reap the “excess” reward that EMH states is impossible, or at least unlikely.

The leads onto the main problem with EMH which is that it is based upon a misunderstanding of why markets are said to be “efficient” (an adjective which, in any case, tends to be unhelpfully vague). Markets are “efficient” for two reasons: a) the price mechanism directs goods from where they are most willingly supplied to where they are most willingly demanded (and, a fortiori, from their least valued to their most highly valued ends); and b) profits and losses are internalised so there is an incentive to maximise value-producing activity (and to minimise value-destroying activity).

EMH, however, implies that “efficiency” extends to the accuracy of the underlying valuations that drive market action in the first place, rather than being limited to fulfilling those values as best as possible. Valuations are, however, a product of the human mind and, as such, may be entirely erroneous, especially when one is not valuing a good not for one’s own use but is, instead, trying to estimate its value for consumers.

To illustrate, if a hoard of investors/entrepreneurs developed a peculiar fetish for producing mud pies, markets would do exactly what they are able to in channelling resources into producing mud pies in the most efficient manner. But it doesn’t follow from this that those investors were right to place such a high value on mud pies in the first place. Once they realise how badly these products sell on account of their inedibility, the whole mud pie industry will experience a much deserved crash, with every mud pie investor suffering losses. In contrast, the businessman who has realised that consumers will want apple pies instead (and so has been busily investing in producing apple pies), will find himself rewarded with handsome profits. Every market mania, such as the Dutch tulip bubble, is of this ilk – a huge boom in something which later turns out to be worthless. Needless to say, such manias are normally induced by the value-distorting activities of states, the effects of which are merely transmitted through the markets.

In short, markets will produce what people want in the most optimal manner in accordance with current valuations, but they cannot make people value things correctly in the first place. For entrepreneurs, this can only come from developing an understanding of what customers will want in order to increase their welfare, and some entrepreneurs and investors will be consistently better – i.e. more profitable – at this than others.

12Christopher H Browne, The Little Book of Value Investing, Wiley (2006).

13In a genuine free market, the financial services industry would be no more profitable than any other type of business. But in an environment of inflationary finance, this industry benefits from a) being one of the earliest recipients of newly created money; and b) the increased profitability of speculative activities resulting from the wider price discrepancies caused by easy money. Indeed, in a genuine free market where these discrepancies would be far fewer, the relative dearth of arbitrage opportunities would also mean that there would be far fewer “pure” speculators.

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