The Inherent Flaw in All Markets...

I think most of us agree that markets are pretty good at determining prices. Historically, markets have proven to be better, in the aggregate, than any other system certainly including "central planning" of fascist (often communist) governments. But just as the recent (2008/2009) collapse of the stock & real estate markets have demonstrated, markets can be vastly inefficient at any given time. The effects of such inefficiency are so damaging that it's worthwhile to fully understand the obvious, inherent flaw in all markets: Just because one person is willing to pay a certain price for a given item doesn't mean every copy of that item is worth that same price to all people. However, for the sake of "simplicity" generally accept accounting principles ignore that truth and assume all identical items are worth what "the market" says they are worth. Consequently, the stock market compounds this flawed thinking. Generally it isn't a big problem... except when it its (like now). Let's switch gears so I can show you my "The Price of Some Stuff List": Currently... A painting by Degas sells for $37,000,000.00 A "Park Avenue" apartment in NYC sells for $3,750,000.00 A mint condition Babe Ruth rookie card sells for $517,000.00 A new Lexus RX 400 Hybrid sells for $41,403.00 A Raymond Weil watch sells for $3,762.00 A survival kit (2 people for 7 days) sells for $449.94 A fire extinguisher sells for $41.31 An emergency battery charger for your iPhone sells for $7.99 And a bottle of water sells for under a buck. Surely you can imagine scenarios where you would make any of those purchases. - e.g. My birthday is indeed February 14th and I could really use that Degas ;-) At the high end: You would buy an item if you had the means and you knew you could turn around and sell that same thing for a profit to another buyer. At the low end: You would buy especially if emergency circumstances dictated. But it is my contention that as an item exists further from necessity and closer to luxury the less exact its "universal value" can be. (I plan to later define "universal value"). Here's a useful and "not entirely absurd" analogy: Let's say I start a "widgets" business (which could be anything: tech devices, toys, works of art, clothes, houses etc.) and I make 10 that are ready to buy. - The first widget I sell to my parents for $100. - The second I sell to a well-to-do friend and as a favor to me he pays $1,000 for it. - That friend displays it to his wealthy friend who likes it so much that he offers $10,000 for the third widget. - After publicizing that third sale, I offer the fourth widget at a private auction which sells for $100,000 and gets even more press. - My well-to-do friend and his wealthy friend are elated at their bargain purchases of escalating-value widgets and talk-up their massive ROI to their mega-wealthy friends. - Those mega-wealthy friends decide to buy 5 of the 6 remaining widgets for $1,000,000 each so that they can then sell tiny percentages of the 5 widgets as investments for people who can't afford to invest a million dollars in one chunk. So here's the big question: IS MY LAST WIDGET REALLY WORTH $1,000,000? Wall Street folks might say it's worth more than one million dollars. But is it really? What if the widgets were actually shares in a start-up company. This example of escalation might seem extreme but it isn't at all when you compare it to virtually every successful "IPO". Recognize that the widgets valuation/market cap went up 10,000x. Heck, Google went up much more than that from its first investor's valuation to current market cap. Notice that the price of something can rise entirely independently of its fundamental value or objective utility (q.v. Enron, Madoff, Tulips et al.). See the "Greater Fool Theory". Therefore, when a stock price rises much more than the rest of the market most novice-investors take that to mean the price will continue to give a better ROI than the rest of the market. But, ceteris paribus, just the opposite is true. If a stock price rises in response to fundamentals (winning a lawsuit, clearing regulatory hurdles, greater earnings due to increased sales etc.) then it could mean the company has great management or a unique advantage over its competitors which may indeed lead to a better ROI than the market. But the reality is if a stock price jumps before you buy then that means you missed the best chance at an extraordinarily good ROI. That's why financial advisors keep giving the caveat "past performance is no guarantee of future results". It's foolish to try to "chase winners" by buying the stocks that jump right after they jumped. Now review the "Price of Some Stuff List" (above). Surely, you can imagine rare but legitimately possible situations where you would be willing to pay many times more than those prices for those "low end" items (plane crash survivor etc.). All of this may seem intuitively obvious to many of you. But it is my contention that this basic understanding is not yet sufficiently shaping our public policy. The ramifications / logical conclusions / recommendations seem just as obvious: 1) A country should ensure that necessities (food, water, energy etc.) are created in vast overabundance. Being beholden to any other countries for a necessity enables them to potentially exploit you when markets are inefficient. You don't want to have to trade your "Park Avenue apartment" for a bottle of water because, on a rare occasion, you happen to be literally dying of thirst. 2) Problems that can create such inefficient markets (war, disease, crime) should be the top priority of the wealthy (countries & individuals) because they have the most to lose when "bubbles burst". Alleviating poverty, educating & vaccinating the population, have a profitable ROI. To paraphrase Jon Stewart - social programs are "revolution insurance". 3) In order to protect "on the way down" you must restrain "on the way up". I acknowledge that balance or tradeoff is very tricky. By enabling U.S. banks to leverage at 26x (compared to 18x in Canada) Americans clearly had an advantage during the bull market. Stock prices had added upward pressure from more demand (due to more supply of effective dollars being used for bidding-up prices) and this echoed in the housing market boom as well. But the collapse of American banks (compared to Canadian Banks) seems to be evidence (if not proof) that policy should be prudent and stable over aggressive and unstable. Sacrificing some "upside", through regulations and enforcement, seems preferable to prevent collapses. This is especially so because such aggressive "upside" is often independent of actual increases in productivity & utility (as evidenced in part by the widgets example above). 4) As I've mentioned before, the focus of all industry must be to "grow the pie" through innovation and efficiency. Because profit without it is invalid, unsustainable, and unjust. Ok, this is long enough. Feel free to contact me with questions, comments, criticisms and/or praise. Good karma to you. Regards, Dan P.S. I still think Burton Malkiel's "A Random Walk Down Wall Street" is worth reading and full of useful information.