Linking Risk and Asset-Price Swings
WE HAVE DISCUSSED how trends in fundamentals and guardedly moderate revisions of participants’ forecasting strategies, and the contingency of such qualitative characterizations of change can account for the price swings observed in asset markets. We also sketched how swings in broad price indexes arise from movements in the relative prices of assets. In this chapter, we explain how these swings play an indispensable role in the process by which financial markets allocate capital to alternative projects and companies. However, we also show why, owing to imperfect knowledge, price swings can sometimes become excessive: prices move beyond a range of values that reflect what most value speculators would consider consistent with the longer-term prospects of projects and companies. We illustrate our arguments in the context of developments in U.S. equity markets in the 1990s and early 2000s.
If markets were entirely populated with value speculators, they would self-correct any excess in prices relatively quickly once it was generally perceived. With the presence of short-term speculators, however, the correction may be considerably delayed, resulting in substantial misallocation of capital. The possibility of a prolonged excessive price swing is further enhanced by what Soros (1987, 2009) calls “reflexive” relationships, or channels through which, for a time, an asset-price swing and fundamental trends reinforce each other.