If in the long run we’re all dead, in the short run we’re all disease-ridden invalids blinded by incandescent temptation, staggering around with little idea of what we’re doing.
That’s (almost) the gist of a paper published Tuesday by Andrew Haldane, Executive Director, Financial Stability, Bank of England, and his colleague Richard Davies.
Despite the efficient market hypothesis, myopia is a widely assumed market failure. Haldane and Davies quote Marshall’s famous dictum (people are like “children who pick the plums out of their pudding to eat them at once”), as well as Pigou’s “defective telescopic faculty” and Benjamin Graham’s quip about the market as voting machine in the short run and as weighing machine in the long run.
But there is not much empirical — as opposed to anecdotal — evidence for the size of myopia amongst equity investors or whether it is becoming more prevalent, write the authors. Their paper fills a hole. Here’s the top line (our emphasis):
Our evidence suggests short-termism is both statistically and economically significant in capital markets. It appears also to be rising. In the UK and US, cash-flows 5 years ahead are discounted at rates more appropriate 8 or more years hence; 10 year ahead cash-flows are valued as if 16 or more years ahead; and cash-flows more than 30 years ahead are scarcely valued at all. The long is short. Investment choice, like other life choices, is being re-tuned to a shorter wave-length. Public policy intervention might be needed to correct this capital market myopia.
The authors use a methodology based on traditional models of cost-benefit analysis and equity pricing. The presence of short-termism would mean that agents “excessively” discount future cash-flows. Investments are not made today even when the discount rate (after including the risk premium) means an investment in a firm should rationally be undertaken. That is, when the Net Present Value of an investment is greater than zero. Fewer returns today mean more than more the day after tomorrow.
Haldane and Davies use panel data from 1980 to 2009 for 624 firms on the FTSE and the S&P to estimate the extent of myopia. They use a coefficient, x, to gauge this level of short-sightedness: x = 1 when there is no myopia, x<1 when it is present. X = 0.95 would mean that one period ahead (n+1) cash flows are underestimated by five per cent.
Here’s the chart that depicts their findings:
The results are not definitive but do suggest that myopia could be becoming more prevalent — eight of the last nine years of the sample showed statistically significant myopic results. Indeed, the authors argue that:
These tests of short-termism point to two key conclusions. First, there is statistically significant evidence of short-termism in the pricing of companies’ equities. This is true across all industrial sectors. Moreover, there is evidence of short-termism having increased over the recent past. Myopia is mounting.
Second, estimates of short-termism are economically as well as statistically significant. Empirical evidence points to excess discounting of between 5% and 10% per year.
Haldane and Davies don’t speculate in detail here (though the former has elsewhere) on the reasons for this trend but, in brief, our brains are coming under increasing attack from information shrapnel:
Information is streamed in ever greater volumes and at ever rising velocities. Timelines for decision-making appear to have been compressed. Pressures to deliver immediate results seem to have intensified. Tenure patterns for some of our most important life choices (marriage, jobs, money) are in secular decline. Some have called this the era of “quarterly capitalism”.
(Other academics have argued this is part of a wider trend that helps to explain why since 1945 the US and the UK have got richer but not that much happier.)
Regardless of their origin, small excesses in discounting can have large cumulative effects. Investment and, in turn, growth is muffled.
Traditional responses to combating this market failure — as every good HM Treasury civil servant learns on day one — include more transparency, stronger governance, changes to incentives and renumeration, and, if none of that works, taxes or subsidies.
But, according to this paper, these have not gone far enough and need to be strengthened as the trend continues. There could also be a role for commitment devices. We’d add that they need to be considered across other areas of public policy, too, especially climate change, health and pensions.
It’s hard to win the future if you think that means next week.
The quantification of systemic risk and stability – Romney B Duffey (NBER)
The Challenge of Affluence: Economic Growth and Well-Beingin the United States and Britain since 1945 – Avner Offer
C-Beams Glittering Near Tannhauser Gate – Paul Kedrosky
Andrew Haldane – FT Alphaville