Priceless: The Myth of Fair Value (and How to Take Advantage of It) (37 page)

Benjamin Graham, the legendary founder of value investing, had a simple answer for the value of a $1-a-year black box: $8.50. Graham was actually speaking of stocks. A share of stock produces a stream of future earnings. Divide the share price by earnings per share, and you have the price-to-earnings (P/E) ratio. It tells how much buyers are paying for a dollar of future income. Since the black box produces an income of $1 a year, the price you pay for it, in dollars, would equal its P/E ratio. In Graham’s analysis, the stock of a company with no earnings growth should sell at a price-to-earnings ratio of 8.5.

Graham caricatured the price psychology of investors in “Mr. Market.” He’s a well-meaning doofus who shows up at your door every weekday offering to buy or sell stock. Every day, Mr. Market’s price is different. Though Mr. Market is persistent, you don’t have to worry about offending him. Whether you accept his offer or not, Mr. Market is sure to be back tomorrow with a new price.

According to Graham, Mr. Market really doesn’t know what stocks are worth. The smart investor can profit from this. One day Mr. Market will offer to buy your stock for more than it’s worth.
You should sell!
Another day, Mr. Market will offer stock for less than it’s worth.
You should buy!

It worked for Graham and for a few of his disciples, like Warren Buffett. Following Graham’s advice is easier said than done. During bull markets, less kindly known as bubbles, Mr. Market shows up every day quoting sky-high prices that only seem to go up. Most investors find it impossible to ignore the siren song. How could Mr. Market be so very wrong, day after day?

As early as 1982, Stanford economist Kenneth Arrow identified Tversky and Kahneman’s work as a plausible explanation for stock market bubbles. Lawrence Summers took up this theme in a 1986 paper, “Does the
Stock Market Rationally Reflect Fundamental Values?” Summers (now head of the National Economic Council for the Obama administration) was the first to make an extended case for what might now be called the coherent arbitrariness of stock prices. From day to day the market reacts promptly to the latest economic news. The resulting “random walk” of prices has been cited as proof that the market knows true values. Because stock prices
already
reflect everything known about a company’s future earnings, only the unpredictable stream of financial news, good and bad, can change prices.

Summers astutely pointed out that this “proof” doesn’t hold water. The random walk is a
prediction
of the efficient market model, just as missing your train is a prediction of the Friday-the-13th-is-unlucky theory. You can’t prove anything from that, as there could be other causes producing the same effect. Summers sketched one, a model in which stock prices have a strong arbitrary component yet adjust coherently to the day’s financial news.

Summers’s idea is a scary one. It proposes that stock prices could be a collective hallucination. Once investors stop believing, it all comes tumbling down. “Who would know what the value of the Dow Jones Industrial Average should be?” asked Yale’s Robert Shiller in 1998. “Is it really ‘worth’ 6,000 today? Or 5,000 or 7,000? Or 2,000 or 10,000? There is no agreed-upon economic theory that would answer these questions.”

The chart on the previous page shows the history of the price-to-earnings ratio of the stocks in the S&P Index. The S&P is a broad index computed from 500 companies presently accounting for about three-quarters of American’s total investment in domestic stocks. Like the price for a black box, the P/E ratio represents a capacity to defer gratification. You might think that this capacity would be a constant of human nature or else a slowly changing variable of American consumer culture. The chart tells a different story. The jittery line is the P/E ratio (using average earnings of the previous ten years, a measure Shiller uses). For reference, the thick gray line shows the historical average P/E ratio of about 16. In the past century, the S&P’s P/E ratio has varied from less than 5 (in 1920) to over 44 (in 1999).

Some of that variation is reasonable. The market is trying to predict
future
earnings. When the outlook for earnings growth is good, the P/E ratio should be higher, and when the outlook is grim, it should be lower. Interest rates and tax rates should affect the ratio, too. But observers from Graham to Shiller have argued that much of the ratio’s variability is due to investor mood swings. Were the P/E and sales volume figures scanner data, a price consultant would conclude that the “consumers” of corporate earnings have remarkably inelastic demand. This was roughly Graham’s assessment. He believed that most investors made emotional decisions to plunge into or out of the market and didn’t care much about the price.

There has been much experimental work on the psychology of market prices. Colin Camerer has used Caltech’s Laboratory for Experimental Economics and Political Science to create super-simplified stock markets. The lab is the creation of Charles Plott, one of the economists who replicated preference reversal. It consists of a grid of cubicles, each with a computer. Every keystroke or mouse action is recorded and archived by software. At the end of an experiment, the researcher can play back everything that happened like a TiVo’d movie.

In one of Camerer’s experiments, participants were given two shares of a virtual security and some real money. They were allowed to buy and sell the shares among themselves over a 75-minute period. All they had to do was type in buy or sell orders. The software matched buyers to sellers
and executed deals. The students understood that they would be walking away with any money they retained or earned in the course of the experiment.

Since the security was imaginary, the participants could not look up its price. They had to assign their own bid and ask prices. Camerer made this as easy as possible. Each share paid a dividend of 24 cents like clockwork, every five minutes throughout the experiment. Therefore, anyone holding Camerer’s stock throughout the experiment would collect exactly 15 dividends of 24 cents each, for a grand total of $3.60. By the standards of a strict value investor, the stock was worth $3.60 at the outset and shed 24 cents each time it threw off a dividend. A chart of the stock’s value over time would look like a descending staircase.

Once the experiment began, the stock started trading at about $3. Ten minutes later, it had risen to around $3.50. It hovered around $3.50 for practically the whole experiment. Reality took hold only in the last ten minutes. With the end drawing near, prices crashed.

Camerer debriefed his subjects. “They’d say, sure I knew the prices were way too high, but I saw other people buying and selling at high prices. I figured I could buy, collect a dividend or two, and then sell at the same price to some other idiot. And, of course, some of them were right. As long as they got out before the crash, they earned a lot of money at the expense of the poor folks who were left holding the bag.”

This is known as the “greater fool” theory. People bought tech stocks in the late 1990s, and real estate in the 2000s, not necessarily because they thought the prices were sensible but because they believed they could sell them at a profit to an even greater fool.

What about value investors (those rare souls who are nobody’s fool)? In Camerer’s experiment, they were left on the sidelines. Value investors would have sold their two shares early, after the “true” value dipped below $3.50. Thereafter they had no more stock to sell and no intention of buying at the prices sellers were demanding and getting. Value investors thus had no effect on the market price.

After many repetitions of this experiment, Camerer has learned how to turn bubbles on and off. The best way to create a bubble is through inflation. Camerer has run experiments in which he keeps pumping money into the virtual economy, much as the government does by printing money. With more money chasing the same number of stock shares,
the prices rise. Camerer has found that he can then bring back the same set of subjects and run the experiment again, this time
without
inflation. “If they’ve lived through an inflationary experience,” Camerer explained, “then we’ve planted a belief in their minds the prices will rise, like seeding clouds to make rain.” The result is that “prices do rise, because of this self-fulfilling prophecy based on their common experience.”

Shared experience is also key to turning bubbles off. Run the experiment, then bring back the same group for a repeat. This time, investors remember the previous experiment’s crash and are more cautious. They don’t bid up the prices so high, and they start heading for the exits soon. The crash is milder and earlier. Try the experiment a third time, and there’s no crash at all. The prices hardly deviate from the value investor line.

The misfortune of the real market is that memories are short and too much time elapses between bubbles. The investing public as a whole never has the opportunity to make decisions, see their consequences, and change their behavior accordingly. There is no Groundhog Day, and thus investors are condemned to repeat Black Monday.

In June 2007, the British artist Damien Hirst unveiled the world’s most expensive work of art. Titled
For the Love of God
, it was a platinum skull encrusted with 8,601 ethically sourced diamonds. The asking price was £50 million—about $100 million, or more than the gross domestic product of Kiribati. “The skull is extraordinary,” said pop artist Peter Blake, adding the jaw-dropping observation that “the price seems right.”

Hirst had built a career on creative pricing. When collector Charles Saatchi commissioned the original Hirst shark in formaldehyde,
The Physical Impossibility of Death in the Mind of Someone Living
(1991), the artist set the price at an intentionally outrageous £50,000. That sum was intended as a publicity gimmick, to boost the career of an unknown artist. It worked.
The Sun
’s headline was 50,000 for fish without chips. In 2004 Saatchi sold the shark to hedge fund manager Steve Cohen for $8 million. The price doubtless would have been higher had the shark been in better shape. Something in the formaldehyde mix was wrong, and the shark had partly decayed. (Hirst replaced it with a brand-new shark for Cohen.) By 2007, other Hirst works of taxidermied livestock and pharmaceutical cabinets were regularly selling for high seven figures. The price of the 2007 skull was exactly a thousand times that of the 1991 shark. Hirst said the skull’s diamonds alone set him back $24 million. “We wanted to put them everywhere,” he explained. “They go underneath, inside the nose. Anywhere you can put diamonds, we’ve put diamonds.”

“Is it beautiful?” asked
The New York Times
’s Alan Riding. “Compared
with what?” Critics have had a love-hate relationship with Hirst, and the skull brought out the haters. “As a trope for human folly and cupidity, a glittering death’s head is as tired as it gets,” complained
Time
magazine’s Richard Lacayo. London critic Nick Cohen snarked, “The price tag is the art.”

Hirst’s supporters argued that that was the point. The work was a commentary on the insanity of the art market. It was not accidental that Hirst chose to use diamonds, a mineral whose price has been kept artificially high by a cartel. Meanwhile, Hirst detractors predicted that the skull was not long for this world. The diamonds would hold their value better than Hirst’s reputation. Whoever ended up owning the thing would one day rip it apart to sell the diamonds.

The skull’s short history already tells a tale of that elusive phantom, price. A few days after the work went on view at London’s White Cube gallery, Hirst announced that it was “almost sold . . . someone is very interested.” The British press named onetime pop idol George Michael as a possible buyer. Then things got quiet. It appeared that the gallery was having a hard time closing the deal. At the end of August, it was announced that the skull had sold to an investment group for the full price of £50 million. A gallery spokeswoman refused to identify the buyers or give further details, except to say that the buyers planned to resell the artwork at a later date.

Resell it at a
higher price
? In any case, it was odd that those financial whizzes had paid full price. Galleries customarily offer a discount to big collectors. Someone buying the world’s most expensive artwork would appear to qualify.

The identity of the buyers leaked out. They were none other than Damien Hirst, Jay Jopling (owner of White Cube gallery), and Frank Dunphy—Hirst’s accountant. It wasn’t hard to understand what happened. The skull’s price was an anchor, a canny way of boosting the value of other Hirst pieces. Whether the $100 million skull ever sold was not so important as preserving the credibility of the price. As a publicity gimmick, the skull succeeded too well. Its failure to sell became news. So Hirst and company cooked up a financial arrangement that allowed them to announce that the skull had sold at full price.