The Feedback Effect: How the Financial Markets Affect Decisions in the 'Real Economy': Knowledge@Wharton ( http://knowledge.wharton.upenn.edu/article.cfm?

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The Feedback Effect: How the Financial Markets Affect Decisions in the 'Real Economy'
Published : October 24, 2012 in Knowledge@Wharton

Companies sell stock to raise money, so it is obvious why they should care about getting the highest prices possible. But why should they care about what happens afterwards? Once a stock begins trading in the secondary market, its changing price has no direct effect on the company that issued it. The stock price could fall to zero on Day Two, but the issuer would still have the money raised the day before. Clearly, it's not that simple. The company's executives typically own shares themselves and want to see the price rise. And they could lose their jobs if the shareholders lose money.

But there is much more to it than that, according to a new study by two Wharton faculty members and one former one. Their paper, "The Real Effects of Financial Markets," explores the subtle relationships between the share price, the company's health, and decisions made by its executives and other players, such as lenders, investors, customers, directors, employees and regulators. The study, a survey of research on the topic, finds that the financial markets, where stocks, bonds and other securities are traded, serve a critical "informational role" that affects decisions in the "real economy" composed of companies. The authors, Wharton finance professors Itay Goldstein and Alex Edmans of Wharton, and Philip Bond, a former Wharton faculty member now at the Carlson School of Management at the University of Minnesota, address the question: Is the stock market just a sideshow or does it affect real economic activity? "We believe that financial markets are not a sideshow," Goldstein said in an interview. "Rather, they play a very important role in the economy." Market analysts have long viewed the rise and fall of a company's share price as a gauge of the market's expectations about the firm's future cash flows. But the price can also reflect approval or disapproval of management decisions, and it can therefore affect what decisions are made, Goldstein and his colleagues conclude. A manager who understands this feedback role can use market reactions for guidance on a key move like a merger. "You want the market to give you some information on whether the market thinks it's a good idea," Goldstein said. The share price, for example, may rise or fall after the firm reveals it may open a plant in another country. If the price falls, the company's management may conclude that investors have spotted hazards the managers missed, and they may abandon the plan. Watching the share price becomes a way to benefit from the broader knowledge, views and analysis provided by thousands of investors. Understanding the feedback process that links the market and the firm also sheds light on phenomena that are otherwise difficult to explain, Goldstein said. One of those is the "bear raid," where short sellers bet that a firm's share price will fall. The feedback effect can make this a self-fulfilling prophesy: The short sales increase the supply of shares, depressing the price, discouraging lenders from providing capital to the firm, weakening the firm and driving the price down even further. Thus, the short sellers profit from selling shares even if the firm was fundamentally healthy to begin with. (Short sellers sell borrowed shares in hopes of repaying the loan with shares bought for less, thus profiting when the price falls.) Even though a firm's managers can be expected to know more about their operations and business prospects than outsiders, they never have complete knowledge -- some outsiders will know things the
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prospects than outsiders, they never have complete knowledge -- some outsiders will know things the managers do not. The market, the authors write, "aggregates the information of many speculators who collectively may be more informed" than the managers are. Other players also benefit from the feedback effect because they don't have the inside view that managers do, Goldstein and his colleagues write. "Credit-rating agencies are known to be influenced by stock prices, and their decisions have a large effect on the availability of credit to the firm. Regulators, who take actions that affect firm cash flows (most prominently, in the case of banks), follow market prices very closely.... Similarly, employees and customers may base their decisions on whether to work for the firm or buy its products on information they glean from the market." Managers whose compensation is related to the stock price through bonuses, stock options or other ties will base decisions on their potential to affect the share price. Tying compensation to share price is a way to discourage "agency problems," where a manager puts his own interests ahead of shareholders'. "Shareholders choose to solve agency problems with the firm's manager by tying his compensation to the stock price, because they believe that the stock price contains information about firm value," the authors write. "If prices were uninformative, shareholders would not tie managerial compensation to stock prices, and so managers would not care about them." Irrational Traders In the traditional view of market efficiency, it is assumed that investors digest all information available about a company and, through the push and pull of supply and demand, arrive at a price that reflects the firm's true value. But research has shown that various forces can interfere with this process, and Goldstein and his colleagues point to a number of examples, such as the "survival of irrational traders." "Under the traditional view, irrational traders, who trade based on considerations unrelated to the firms' fundamentals, will lose money and hence disappear from the market over time," they write. Therefore, "markets will be populated only by rational traders, and so prices will be efficient, correctly reflecting firms' fundamentals." But the feedback process can allow irrational traders to survive, because their views can actually affect the firm's cash flows and create a self-fulfilling prophesy. A flood of positive views among traders, even if they are irrational, can raise the share price by enhancing demand, make the firm look healthier and encourage management decisions that otherwise might not be made. Irrational traders may therefore make money rather than lose it, and survive to trade another day. "This again demonstrates that traditional definitions of market efficiency may lack relevance when feedback from prices to decisions is important," the authors write. Another example: the run on the financial markets. A run occurs when investors sell a stock solely because other investors are selling. A run can push a share price below the level called for by fundamentals such as earnings. This would not happen in a perfectly efficient market because investors would base their buy and sell decisions on the firm's fundamentals. Once the price fell below the appropriate level, other investors would spot a bargain and buy, and that demand would cause the price to stabilize or rise, preventing a run. However, the feedback effect can give the run momentum by discouraging lenders from providing the firm with capital, weakening the company and spurring more selling. Understanding the feedback process can also help firms fine-tune their capital-raising strategies, the authors write. A firm that wants to maximize feedback from the markets to guide decisions, for example, might choose to raise money by issuing stock rather than bonds. Bond prices are less sensitive to feedback because investors' chief concern is the firm's ability to make the interest and principal payments promised. As long as the firm is healthy enough to do that, factors like its earnings, the regulatory environment and business choices do not matter much to bondholders. But all those factors can influence stock prices, so stocks offer better feedback. A considerable volume of research explores the theory of feedback, Goldstein said, and some examples are clear. "This kind of feedback loop serves to amplify shocks, and everyone saw that in the financial crisis," he said.
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The Feedback Effect: How the Financial Markets Affect Decisions in the 'Real Economy': Knowledge@Wharton ( http://knowledge.wharton.upenn.edu/article.cfm?articleid=3100)

But there's much research still to be done, he added. Few financial models fully account for the effects of feedback. And although the theory of feedback effects seems solid, it is difficult to measure real-world results because so many factors cloud the data. A stock's price can dip, for example, simply because a mutual fund has sold a large block of shares to meet investor redemptions, a price change that has nothing to do with information flowing through the market. If information were flowing at the same time, it would be very hard to know how much each factor had influenced the share price. Future research should also look at how information from stock prices can be used more effectively by regulators, lenders, customers and others concerned with a firm's health, Goldstein said. The study of feedback, he concluded, is only beginning. "I would say it's been neglected for awhile, and it's growing now."
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