Adam Smith writes, ‘The natural price is the central price, to which the prices of all commodities are continually gravitating. Different accidents may sometimes keep them suspended a good deal above it, and sometimes force them down even somewhat below it.’ Any commodity will find its natural price based on supply and demand.
Smith is obviously an avid admirer of letting the market decide and certainly if everyone plays fair, it’s a good system but people don’t always play fair.
DEFINING IDEA…
Trying to squash a rumour is like trying to unring a bell.
~ SHANA ALEXANDER, JOURNALIST
‘Different accidents’ are not always accidents. In late March 2008 rumours began to circulate that one of the UK’s biggest banks - Halifax Bank of Scotland (HBOS)—was experiencing liquidity problems. Those rumours wiped more than £3 billion (or 20%) off the bank’s market value in just one morning of trading as worried investors pulled out. This is known as ‘trash and cash’ and considering there’s an actual term for this type of market manipulation, this would indicate that it’s not an accident at all! Basically, traders can make a great deal of money by ‘shorting stock’ or betting that a share price will fall. It doesn’t take a genius to work out that starting a rumour greatly assists that process. In an unprecedented move, the Financial Services Authority (FSA) issued a sharp warning about market abuse. However, in their subsequent Inquiry, they were rather unsurprisingly unable to uncover enough hard evidence that the rumour had been deliberately set in motion.
‘Different accidents’ can also take the form of what Nassim Nicholas Taleb terms, ‘Black Swans’—totally random, unpredictable and extremely rare events. Taleb is a former quantitative analyst and derivatives trader who made $40 million from shorting the market on Black Monday in 1987. Today, he is the Dean’s Professor in the Sciences of Uncertainty at the University of Massachusetts and is described as one of the world’s most sought-after thinkers. He believes that most city traders are like children picking pennies off the road in front of a steamroller: in other words, the majority of those inside the industry have no idea what they are doing or the potential damage they can cause. As the title of his first book suggests, Taleb believes we are Fooled by Randomness (2007) and that the arrival of completely unpredictable ‘different accidents’ such as the events of 9/11 can cause catastrophic consequences that we have no way of predicting.
Smith reminds us that, ‘whatever may be the obstacles which hinder [price] from settling in this centre of repose and continuance, they are constantly tending towards it’. This can be evidenced by the immediate aftermath of 9/11, when the Dow Jones Industrial Average declined by 14% and yet, in just over two months, recovered to pre-9/11 trading!
HERE’S AN IDEA FOR YOU…
If you want to invest in the stock market, but don’t have the time or inclination to work out which rumours are true and which ones are deliberate manipulations, consider investing in the Index, i.e. FTSE, Dow Jones or NASDAQ instead of investing in particular stocks of a company of your choice. Have a financial advisor explain how this works and why it is potentially safer than buying individual stock.