The Misbehavior of Markets (and Corporations)

My latest Fortune article evolved out of a series of meetings put on by the CFA Centre for Financial Integrity, a part of the CFA Institute (formerly the Association for Investment Management and Research and before that the Financial Analysts Federation), and the Business Roundtable Institute for Corporate Ethics, which despite the name is not a wholly owned subsidiary of the CEO club that is the Business Roundtable. (I learned this after, in the interest of brevity, cutting down the unwieldy names of the two groups to ” CFA Institute” and “Business Roundtable” in the article.)

Anyway, the meetings were all about figuring out how to get corporate America away from its obsession with quarterly earnings—”short-termism,” the organizers called it. I’m not sure a whole lot of progress was made: The corporate executives who came complained about investors, the investors complained about corporate executives, and everybody complained about the analysts who work for the big brokerage houses (who weren’t represented.)

I was given a seat at the table in hopes that I would write up an eloquent account of the effort. But when the time came to do so, I found it pretty hard: There was so much that I could have written about that I ended up focusing only on a narrow slice of the discussion—the debate over whether corporations should give analysts guidance about what their future earnings will be.

There seemed to be something of a consensus that guidance was bad—that by giving it, CEOs and CFOs lock themselves into targets that become more important to them than the long-term health of their organization. But opinion certainly wasn’t unanimous on this front: One of the corporate investor relations guys was adamant that without some sort of guidance about the future, the analysts who followed his complex company had no hope of understanding whether it was really doing well or not.

Another possibility that I didn’t get to at all in the article, as my friend Paul Miller pointed out in an e-mail a couple of days ago, is that the best way to wean companies (and investors) of their short-term obsession might be to give out information more frequently. This might at first seem perverse, but the idea is that if companies release sales data and other performance metrics on a monthly or weekly or even daily basis, then “making the quarter” will become an irrelevance. Paul also argues that the more and better information companies provide to investors, the higher their stock prices will be be. (He even has a name for this approach, “Quality Financial Reporting,” and a book about it.)

This argument came up at the CFA/Business Roundtable meetings I attended, and again, there seemed to be some consensus that it was a path worth following. But there were, again, objections. What it comes down to is whether markets are smart enough to handle all that information. There’s lots of evidence that they are—decades of “event studies” that show prices reacting quickly (and in and the right direction) to new information. But there is also lots of evidence now that markets often overreact to information, “react” to no information at all, or are temporarily fooled by superficial earnings tweaks. (The title of this post is lifted from mathematician Benoit Mandelbrot’s newish book The (Mis)behavior of Markets, which details some other ways in which financial markets don’t follow standard pricing models.)

My own take is that it’s really dangerous to assume that you know better than the stock market, but equally dangerous to assume that the market always gets stock prices exactly right. So where does that leave us? Well, that’s what I’m trying to write a book about.

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