1588 THE AMERICAN ECONOMIC REVIEW JULY 2016
of Apple, we can say for sure
that odd-share certificates (if such
things still exist) should sell for the same price as even-numbered shares. I
have explored several such examples in work with Owen Lamont,[7]
and he recently told me about another one that I will describe here. One type
of security that has provided a fruitful source of tests of the law of one
price is closed-end mutual funds (a closed-end
fund (CEF) or closed-ended fund is a collective investment
model based on issuing a fixed number of shares which are not redeemable from
the fund. ... Closed-end funds are usually listed on a recognized
stock exchange and can be bought and sold on that exchange, https://www.youtube.com/watch?v=msXDmc5Yyas ). Unlike their open-ended
cousins, which accept new investments that are valued at the net asset value of
the securities held by the fund, and then redeem
(to exchange a piece of paper representing an amount of money for that amount of
money or for goods equal in cost to that amount of money) withdrawals the same way, closed-end funds are, as their
name suggests, closed to new investors. Rather, when the fund starts, a certain
amount of money is raised and invested, and then the shares in the fund trade
on organized markets such as the New York Stock Exchange. The curious fact
about closed-end funds, noted early on by Graham (1949) among others, is that
the price of the shares is not always equal to the net asset value of the underlying securities (the underlying of
a derivative is an asset, basket of assets, index, or even another derivative,
such that the cash flows of the (former) derivative depend on the value of
this underlying. https://www.investopedia.com/terms/u/underlying-asset.asp ).
Funds typically sell at discounts of 10–15 percent, but sometimes sell at
substantial premia. This is the story of one such fund. The particular fund I
want to highlight here happens to have the ticker
symbol (a ticker
symbol is an arrangement of characters—usually letters—representing
particular securities listed on an exchange or otherwise traded publicly. When
a company issues securities to the public marketplace, it selects an
available ticker symbol for its securities that investors and traders
use to transact orders) CUBA. Founded in 1994, its official name is
the Herzfeld Caribbean Basin Fund, which has 69 percent of its holdings in US
stocks with the rest in foreign stocks, chiefly Mexican. It gave itself the
ticker “CUBA” despite the fact that it owns no Cuban securities nor has it been
legal for any US company to do business in Cuba since 1960 (although that may
change at some point). The legal proviso
(a term or condition in a contract or title document),
plus the fact that there are no traded securities in Cuba, means that the fund
has no financial interest in the country with which it shares a name.
Historically, the CUBA fund traded at a 10–15 percent discount to Net Asset
Value. Figure 1 plots both the share price and net asset value for the CUBA
fund for a time period beginning in September 2014. For the first few months we
can see that the share price is trading in the normal 10–15 percent discount
range. Then something abruptly happens on December 18, 2014. Although the net asset value (Net Asset Value (NAV) is the value of a
fund's asset less the value of its liabilities per unit)
of the fund barely moves, the price of the shares jumped to a 70 percent
premium. Whereas it had previously been possible to buy $100 worth of Caribbean
assets for just $90, the next day those assets cost $170! As readers have
probably guessed, this price jump coincided with President Obama’s announcement
of his intention to relax the United States’ diplomatic relations with Cuba.
Although the value of the assets in the fund remained stable, the substantial
premium lasted for several months, finally disappearing about a year later.
This example and others like it show that prices can diverge significantly from
intrinsic value (intrinsic
value is the anticipated or calculated value of a company,
stock, currency or product determined through fundamental analysis. It includes
tangible and intangible factors. Intrinsic value is also called the
real value and may or may not be the same as the current
market value), even when intrinsic value is easily measured and
reported daily. What then should we think about broader market indices? Can
they also get out of whack (out of order;
not working)? Certainly, the run-up of technology stocks in the late
1990s looked like a bubble at the time, with stocks selling for very high
multiples of earnings (or sales for those without profits), and it was followed
by a decline in prices of more than two thirds in the NASDAQ index. We
experienced a similar pattern in the housing boom in the mid 2000s, especially
in some cities such as Las Vegas and Phoenix. Prices sharply diverged from their
long-term trend of selling for roughly 20 times rental prices,
VOL. 106 NO. 7 THALER: BEHAVIORAL ECONOMICS: PAST,
PRESENT, AND FUTURE 1589
Figure 1. Price and Net Asset
Value for CUBA Fund Note: On December 18, 2014, President Obama announced he
was going to lift several restrictions against Cuba.
Source: Bloomberg
only to fall back to the
long-term trend. Because of the various forms of leverage (the ratio of a company's loan capital (debt) to the value
of its ordinary shares (equity); gearing, https://www.investopedia.com/terms/l/leverage.asp )
involved, this rise and fall in prices helped create the global Great Recession.
The difference between the CUBA example and these much larger bubbles is that
it is impossible to prove that prices in the latter were ever wrong. There is
no clear smoking gun (clear proof that
someone has done something wrong or illegal). But it
certainly feels like asset prices can diverge significantly from fundamental
value. Perhaps we should adopt the definition of market efficiency proposed by Fischer Black (1986) in his
presidential address to the American Finance Association, which had the
intriguing one word title “Noise (economic noise, or simply noise, describes a
theory of pricing developed by Fischer
Black. Black describes noise as the opposite of
information: hype, inaccurate ideas, and inaccurate data. His theory states
that noise is everywhere in the economy and we can rarely tell the
difference between it and information).”
Black (1986, p. 553 (1938 – 30.08.1995, was an American economist, best known as one of the authors of the
famous Black–Scholes equation) says “we might
define an efficient market as one in which price is within a factor of two of
value, i.e., the price is more than half of value and less than twice value.
The factor of two is arbitrary (used about actions that
are considered to
be unfair), of course. Intuitively,
though, it seems reasonable to me, in light of sources of uncertainty about
value and the strength of the forces tending to cause price to return to value.
By this definition, I think almost all markets are efficient almost all the
time. ‘Almost all’ means at least 90 percent.” One can quibble (to argue or complain about something that
is not important) over various aspects of Black’s definition but it
seems about right to me, and had Black lived to see the tech bubble of the 90s
he might have revised his number up to three. I would like to make two points
about this. The first is that the efficient market hypothesis has been a highly
useful, indeed essential concept in the history of research on financial
markets. In fact, without the EMH (Efficient
Market Hypothesis) there would have been no benchmark with which to
compare anomalous findings. The only danger created by the concept of the EMH
is if people, especially policymakers, consider it to be true. If policymakers
think that bubbles are impossible, then they may fail to take appropriate steps
to dampen them. For example, I think it would have been appropriate to raise
mortgage-lending requirements in cities where price to rental ratios seemed
most frothy (froth refers to market conditions
preceding an actual market bubble, where asset prices become detached
from their underlying intrinsic values as demand for those assets drives
their prices to unsustainable levels). Instead, this was a
period in which lending requirements were unusually lax (not paying enough attention to rules, or not caring enough
about quality or safety).
THE AMERICAN ECONOMIC REVIEW JULY 2016
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