Of Course This Assumes That The Baboons Understand And Care About What The Market Tells Them

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If you think a company has a good business and shareholder friendly management, you might consider buying its stock. If, on the other hand, you found a company that you were pretty sure was managed by a bunch of baboons, it might make sense to short its stock, and maybe publicize your conclusions via a PowerPoint presentation and/or an ironic-adorable coffee-foam doodle. In practice, though, there are a whole lot of cases where smart investors light upon companies managed by baboons and buy them anyway.

Weird, huh? Conveniently there’s a neat paper out of NBER today (NBER version here, free version here), by Wharton professors Alex Edmans and Itay Goldstein and Columbia professor Wei Jiang, about how feedback effects can limit the efficiency of stock markets. The idea is that stock prices send a signal to managers about whether or not the company's projects, in the judgment of the market, have a positive or negative expected NPV. Buying stock because the company is doing good stuff pushes up the stock price and tells managers to keep doing what they're doing. Shorting stock because the company is putting investor money into paper bags and lighting them on fire pushes down the stock price and tells managers that maybe a change of strategy is in order. But if you short the stock because you think that the lighting-money-on-fire strategy will lead to ruin, you run the risk that managers will take that feedback seriously and put away the lighter fluid, and the stock will go back up. Or as the authors put it:

An important aspect of our theory is that it generates asymmetry between trading on positive and negative information. The feedback effect delivers an equilibrium where speculators trade on good news but do not trade on bad news. Yet, it does not give rise to the opposite equilibrium, where speculators trade on bad news only. The intuition is as follows. When speculators trade on information, they improve the efficiency of the firm’s decisions — regardless of the direction of their trade. If the speculator has positive information on a firm’s prospects, trading on it will reveal to the manager that investment is profitable. This will in turn cause the firm to invest more, thus increasing its value. If the speculator has negative information, trading on it will reveal to the manager that investment is unprofitable. This will in turn cause the firm to invest less, also increasing its value as contraction is the correct decision. When a speculator buys and takes a long position in a firm, she benefits further from increasing its value via the feedback effect. By contrast, when she sells and takes a short position, she loses from increasing the firm’s value via the feedback effect.

The rest of it is mostly mathematical formalization, some of which is pretty stylized: to believe in the feedback effect, you have to believe that a firm's managers care about whether the market likes their projects or not. The authors cite the example of Coca-Cola's contemplated acquisition of Quaker Oats in 2000: after the discussions became public, Coke's stock dropped 10%, the board rejected the merger - perhaps because of market reaction, the stock popped back up, and investors who had shorted Coke on the deal talks lost money. You could certainly question the psychology here: CEOs have certainly said "I'm not sure how the market will react to this acquisition," but I doubt too many have concluded "... and, if investors are pissed, we'll just call it off." That's not generally in the CEO-psychology toolkit. Though similar market-driven reversals do sometimes happen.

In any case, it's an interesting way to look at the world; particularly, it's worth considering the notion that publicly going long or short a company should improve its prospects by giving it feedback on what's working and what needs changing. One reaction would be to focus your short selling on frauds, where management can't make any use of your signaling because all they're doing with investor money is buying mansions in non-extradition countries anyway.

Another would be to be a long activist rather than a short seller, so you make rather than lose money when management listens to you and improves the company's efficiency. But, if the authors are right about feedback effects, that presents a similar problem. If a company is so badly run that it becomes an activist favorite, then their buys (and those of others who want to join their campaign and/or just come along for the ride) will prop up the stock and give management a false sense of security. Using this model, a long investment in a company by an activist would reduce, rather than increase, its efficiency. Of course that false signal can be overcome, which is why Dan Loeb's letters to Yahoo are so hurtful.

If the authors are right, this limit on arbitrage isn't just bad for short sellers - it's bad for the financial system's function of allocating capital:

In addition to its interesting effects on stock returns, the asymmetry of the speculator’s trading strategy can also generate important real consequences. Since negative information is not incorporated into prices, it does not influence management decisions. Thus, while positive NPV projects will be encouraged, some negative-NPV projects will not be canceled — even though there is an agent in the economy who knows with certainty that the project is negative NPV — leading to overinvestment overall.

This is a shame, but there is a solution. Congress should step in and short stocks that they think are likely to go down. And then go and make sure that it happens.

Feedback Effects and the Limits to Arbitrage [NBER, free version on SSRN]

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