The Market is Always Wrong

on Thursday, January 27, 2011

When you buy a tomato, you are estimating its value to you personally; its use value. You can't realistically re-sell the tomato, and you are willing to buy only if its value is close to the asking price. Now imagine buying a piece of farm equipment. It would have no use value because you are not a farmer. If you wanted to get value from the machine the only way to do it would be to sell it, receiving what Adam Smith called its "exchange value." But because you know nothing about farm machines, and don't live in a farming community, it might be better for you to buy stock in a farm machine company if for some reason you wanted to invest in farming machines.
This is better for you only because of your ignorance about the value of the machines, and because you are not part of a real farming machine marketplace (A supermarket is a real tomato marketplace.) If you were a farmer you would know from experience how much money each machine would generate each year. You would be able to judge the value in the same way you judge the value of a tomato.

The lack of an effective resale market for tomatoes indicates that the value and price are closely related -- most people won't buy tomatoes unless the price is close to their personal estimation of value -- they can't resell it, and so they make sure they are paying a reasonable price before committing to buy. On the other hand, buyers of public securities are not confident about value (because it is not required) and do not or cannot formulate a personal estimation of use value (most people are not farmers). They demand an immediate ability to resell because of their ignorance.

A buyer of public companies demands high liquidity because he is not sure what the company is worth, in the same way that you would be uncertain about the value of a tractor if you were not a farmer, and did not have access to a liquid market. He is a weak owner; he hasn't made a very strong commitment to the purchase. A supermarket shopper makes a very strong, nearly permanent decision and does not demand liquidity because he is relatively confident about the value of the product.

What we should effectively conclude is that the more liquid a market becomes, the further prices will fluctuate from their true value. Securities trade at exchange value, which is a poor substitute for use value. Highly liquid markets are the product of ignorant shoppers -- the more ignorant of value buyers become, the more liquidity they demand. The efficient market hypothesis has it backwards. Liquid markets create more uncertainty regarding value because most of the participants know or care very little about the value of the products they are buying.