Is it possible to construct portfolios which perform better than the overall stock market? Two of the three recipients of the latest Nobel prize in economics have tried to answer that question. Roughly speaking, Eugene Fama said that all efforts are in vain, while Robert Shiller said that they are not.
These nearly contradictory views are typical of an intense but inconclusive argument stretching back four decades. Market researchers have produced a mountain of studies, but they rarely consider the macroeconomic, ethical and social meaning of equity investing. That’s a shame. If more attention were paid to these issues, everyone could calm down.
Start with the economics. For the economy as a whole, changes in individual stock prices are basically irrelevant. The companies receive no cash when existing shares trade hands, whatever the price. The trading shareholders may have gains and losses, but they cancel each other out. The net economic effect of frenetic stock markets is zero.
The share price does matter when new shares are issued, but that happens rarely. While promising young companies can use cash to expand, and troubled older ones need cash to survive, in normal times companies generate all the cash they can invest profitably from operations, so they don’t need or want to raise new capital. It’s perfectly reasonable that over the last seven years, the value of newly issued shares was only about 10 percent higher for listed U.S. companies than the value of repurchased old shares, according to data from Thomson Reuters Datastream and Factset.
The main economic influence of share price moves is indirect, and basically negative. Top managers spend too much time watching the stock market. They hope for bonuses which are often based on share prices and they fret about being taken over. Both concerns lead them to follow the advice of stock market investors, outsiders who rarely have much insight into long-term strategic issues. Although activist investors can occasionally clarify their thinking, managers would usually be well advised to ignore the market price and rely instead on their superior knowledge as insiders.