WEBVTT NOTE Can Austrian Economists Beat Financial Markets? A Reconsideration of Austrian Financial Economics 1 00:00:00.000 --> 00:00:10.000 A very wise man, well-known to all of us, said the incentive that impels a man to act is always some uneasiness. 2 00:00:10.000 --> 00:00:15.000 My act to prepare this presentation for you is no exception. 3 00:00:15.000 --> 00:00:27.000 My uneasiness stems from an apparent contradiction between my theoretical convictions as an Austrian economist and my practical beliefs as an investment manager. 4 00:00:27.000 --> 00:00:45.000 Specifically, in managing my clients' money, I act as if I believed in the implications of efficient market theory, that means the possibility of stock picking and market timing, although, as an Austrian economist, of course, I don't believe in efficient market theory. 5 00:00:45.000 --> 00:01:03.000 So in order to avoid, to suffer from schizophrenia, I decided to reconsider and to explore as rigorously as I can, the implications of Austrian economics for investments in financial markets. 6 00:01:03.000 --> 00:01:11.000 That's what I'm going to talk about. You can see there's a kind of group therapy. 7 00:01:11.000 --> 00:01:20.000 So, if you look at the Austrian literature, the answer is quite clear, most Austrian economists support an active investment approach known as value investing. 8 00:01:20.000 --> 00:01:26.000 So what's the claim that value investors or fundamental analysts do? 9 00:01:26.000 --> 00:01:37.000 They claim that some investors, always including themselves of course, can systematically outperform the market by identifying temporarily undervalued securities. 10 00:01:37.000 --> 00:01:47.000 I could provide you lots of quotations expressing this view. I provide only one, which has particular authority because it's from the Elgar Companion to Austrian Economics. 11 00:01:47.000 --> 00:01:55.000 So the investor-co-entrepreneur has the ability to find temporarily undervalued stocks and to get out of overvalued investments. 12 00:01:55.000 --> 00:02:04.000 Why do Austrian economists support this view? If you look at the literature, there are basically two reasons. 13 00:02:04.000 --> 00:02:10.000 First of all, they reject the efficient markets theory, which is logical. 14 00:02:10.000 --> 00:02:19.000 It is this theory which implies basically that value investing is impossible, that you can't pick stocks with superior performance. 15 00:02:19.000 --> 00:02:29.000 And the second reason for this view is that they transfer the concept of entrepreneurship that is central to Austrian economics from product to financial markets. 16 00:02:29.000 --> 00:02:30.000 in Financial Markets. 17 00:02:30.000 --> 00:02:34.000 So, obviously, if entrepreneurs with their superior foresight can generate profits, 18 00:02:34.000 --> 00:02:38.000 why shouldn't they be able to do this in financial markets as well? 19 00:02:38.000 --> 00:02:43.000 Well, my view is that these arguments are not as strong as they appear to be. 20 00:02:43.000 --> 00:02:46.000 That doesn't mean that they're wrong, but they raise some questions at least. 21 00:02:46.000 --> 00:02:50.000 So, first of all, regarding the rejection of efficient markets, 22 00:02:50.000 --> 00:02:53.000 we may agree that we don't believe in this theory, 23 00:02:53.000 --> 00:02:56.000 but that doesn't mean necessarily that the empirical phenomenon 24 00:02:56.000 --> 00:03:01.840 that this theory tries to explain is invalid as well, which is the random walk phenomenon, 25 00:03:01.840 --> 00:03:09.440 the unpredictability of stock prices. If you look at the first Pharma paper in 1965, it 26 00:03:09.440 --> 00:03:15.040 doesn't contain any neoclassic economics, it's pure statistics. So my view on this, 27 00:03:15.040 --> 00:03:19.520 given this possible objection, is that perhaps just rejecting the neoclassical explanation 28 00:03:19.520 --> 00:03:23.440 is a bit too easy. I think what we should really do is to ask what are the implications 29 00:03:23.440 --> 00:03:27.880 of Austrian Theory for the Predictability of Security Prices. 30 00:03:27.880 --> 00:03:31.960 Now regarding the second argument, the entrepreneurship, 31 00:03:31.960 --> 00:03:34.680 there are two possible objects, I think. 32 00:03:34.680 --> 00:03:37.520 First of all, financial markets clear much faster 33 00:03:37.520 --> 00:03:39.680 than most product markets. 34 00:03:39.680 --> 00:03:41.720 Ludwig von Mises himself pointed out 35 00:03:41.720 --> 00:03:44.720 that the stock market clears every day. 36 00:03:44.720 --> 00:03:48.040 At least it reads a temporary equilibrium, a plain state 37 00:03:48.040 --> 00:03:49.640 of rest every day. 38 00:03:49.640 --> 00:03:52.120 So if you want to benefit from this equilibrium, 39 00:03:52.120 --> 00:03:53.960 So you have to be very quick. 40 00:03:53.960 --> 00:03:58.520 Second of all, I would argue not all investors are entrepreneurs. 41 00:03:58.520 --> 00:04:02.200 So what we should ask ourselves as Austrian economists, 42 00:04:02.200 --> 00:04:05.440 what information are actually required for superior investment 43 00:04:05.440 --> 00:04:09.280 performance, and who are actually the entrepreneurs 44 00:04:09.280 --> 00:04:12.280 in financial markets? 45 00:04:12.280 --> 00:04:14.880 And these questions I'm going to address now 46 00:04:14.880 --> 00:04:16.760 in the time I have left. 47 00:04:16.760 --> 00:04:21.200 So to start with, we want to value securities, which 48 00:04:21.200 --> 00:04:29.080 There are titles to future earnings by business, either ownership titles or credit titles. 49 00:04:29.080 --> 00:04:31.880 So the question we have to ask ourselves, what is actually the income accruing to a 50 00:04:31.880 --> 00:04:35.960 business and to what extent is it predictable and by whom? 51 00:04:35.960 --> 00:04:41.840 So according to Rothbard there are four elements of income, interest, wages, rents and profit, 52 00:04:41.840 --> 00:04:46.880 but I will focus on profits here because I believe without having time to argue the point 53 00:04:46.880 --> 00:04:51.880 If you can predict profits, you can also predict the other elements. 54 00:04:51.880 --> 00:04:56.880 So in Austrian theory we don't talk much about investors. The investors are actually called capitalists. 55 00:04:56.880 --> 00:05:00.880 And they are clearly distinguished from entrepreneurs. 56 00:05:00.880 --> 00:05:05.880 Capitalists, they provide financial capital to entrepreneurs. 57 00:05:05.880 --> 00:05:09.880 Entrepreneurs transform financial capital into real capital. 58 00:05:09.880 --> 00:05:15.880 That means they combine capital goods with original factors of production in order to produce and sell lower-order goods. 59 00:05:15.880 --> 00:05:20.880 So, what is inseparable from the function of entrepreneur is the direction of factors of production. 60 00:05:23.880 --> 00:05:27.880 So, we actually have three cases. We have the pure capitalist on the one side, the pure entrepreneur, 61 00:05:27.880 --> 00:05:32.880 and we have the combination that Austrians are very fond of, which is the owner-entrepreneur. 62 00:05:33.880 --> 00:05:42.880 Now, the income, the capitalist earns interest, the entrepreneur earns a wage if managing the business involves some labour. 63 00:05:42.880 --> 00:05:44.880 The Theory of Money and Credit 64 00:06:12.880 --> 00:06:17.880 Entrepreneur, he can provide equity, or he is a lender, he provides debt. 65 00:06:17.880 --> 00:06:21.440 So let's look at the first case. 66 00:06:21.440 --> 00:06:25.760 Here we have the strange situation that one, the entrepreneur makes the decisions, but 67 00:06:25.760 --> 00:06:29.720 the other one, the capitalist bears the consequences, which is profit and loss. 68 00:06:29.720 --> 00:06:33.240 This is perhaps not a very pleasant situation, but logically it's possible. 69 00:06:33.240 --> 00:06:38.240 That's the situation you find yourself in every time you pay a lawyer or your doctor. 70 00:06:38.240 --> 00:06:42.880 For someone who makes a decision, you bear the consequences. 71 00:06:42.880 --> 00:06:48.280 The other case, if the capitalist is a lender, is even weirder. 72 00:06:48.280 --> 00:06:53.000 Because here, the entrepreneur makes decisions which generate profits or losses if everything 73 00:06:53.000 --> 00:06:54.000 goes well. 74 00:06:54.000 --> 00:06:57.800 If there are profits, the capitalist gets the interest, but the entrepreneur keeps the 75 00:06:57.800 --> 00:06:58.800 profit. 76 00:06:58.800 --> 00:07:04.280 If the prediction is not that good, and there's a loss, it's borne by the capitalist. 77 00:07:04.280 --> 00:07:08.320 Because first he won't get the interest that he expected and if the loss is high he won't 78 00:07:08.320 --> 00:07:12.760 even get the capital back. So this is a bad deal for the capitalist. He takes the risk 79 00:07:12.760 --> 00:07:19.040 but the entrepreneur gets the profit. And this is actually the pure entrepreneur as 80 00:07:19.040 --> 00:07:24.120 he was described by von Mises. He does not own capital, he just borrows it. If he makes 81 00:07:24.120 --> 00:07:32.120 a profit it's his. If he loses it's bad luck for the capitalist. So just exploring the 82 00:07:32.120 --> 00:07:39.120 The theoretical implications of these two functions, entrepreneur and capitalist, leads to some paradoxical situations. 83 00:07:39.120 --> 00:07:42.120 I call them the equity paradox and the debt paradox. 84 00:07:42.120 --> 00:07:47.120 The equity paradox says that the pure entrepreneur makes decisions that affect only the owner, 85 00:07:47.120 --> 00:07:53.120 so he doesn't have an incentive actually to generate profits and avoid losses. 86 00:07:53.120 --> 00:07:59.120 The debt paradox says the pure lender assumes the risk of losses but without the potential reward of profits, 87 00:07:59.120 --> 00:08:07.120 Where as the entrepreneur has actually an incentive to take excessive risks, a phenomenon we are very familiar with recently. 88 00:08:07.120 --> 00:08:16.120 So how can we solve this? One possible answer, and that's the answer given by most Austrian economists, actually they have to be the same. 89 00:08:16.120 --> 00:08:21.120 They may be theoretically different, but in practice they have to be the same, otherwise things don't work. 90 00:08:21.120 --> 00:08:27.120 That's the concept, for example, of the integral entrepreneur proposed by Professor Salerno, 91 00:08:27.120 --> 00:08:57.120 It is one solution, but I want to argue it's not the only one. For two reasons. First of all, it's logically possible, as we've seen, that they are separate. And also in practice, if you look at the complex corporate governance structures in real market economies, they are not always the same. Sometimes the functions are different. So the question is, is there any other solution? I would argue, yes, there's another solution, which is not identity of the two, but a part of the whole. 92 00:08:57.120 --> 00:08:59.480 and the partial sharing of the functions. 93 00:08:59.480 --> 00:09:01.880 By sharing the function, the capitalist tries to mitigate 94 00:09:01.880 --> 00:09:04.520 the serious incentive problems in the setup 95 00:09:04.520 --> 00:09:05.600 and there are two ways to do this. 96 00:09:05.600 --> 00:09:07.520 Either he insists that the entrepreneur 97 00:09:07.520 --> 00:09:10.120 provides some of the capital himself, 98 00:09:10.120 --> 00:09:11.480 so the entrepreneur has to become 99 00:09:11.480 --> 00:09:13.760 a little bit like the capitalist, 100 00:09:13.760 --> 00:09:17.200 or the capitalist controls the entrepreneurial decisions. 101 00:09:17.200 --> 00:09:20.200 That means the capitalist gets involved somehow 102 00:09:20.200 --> 00:09:23.300 into entrepreneurial decisions. 103 00:09:23.300 --> 00:09:32.800 So, if you take this into account, every capitalist considering investment actually has to make two choices and has three options. 104 00:09:32.800 --> 00:09:41.800 First of all, this is a bit slow, you have to deduct it from my time, do I want to assume the entrepreneurial function myself? 105 00:09:41.800 --> 00:09:52.800 So if I do this, then there is no problem, no need for control. I'm the integral entrepreneur that Austrians write about so much and lots of them say it's the only one. 106 00:09:52.800 --> 00:09:55.800 But unfortunately, it's not the only one. There are many other cases. 107 00:09:55.800 --> 00:09:59.800 If I don't, as a capitalist, want to assume the entrepreneurial function, 108 00:09:59.800 --> 00:10:02.800 the second question is, do I at least want to control the decisions? 109 00:10:02.800 --> 00:10:05.800 Do I want to control what this guy is actually doing with my money? 110 00:10:05.800 --> 00:10:09.800 If yes, then I become an inside investor. 111 00:10:09.800 --> 00:10:14.800 As a capitalist, I provide capital and I control his decisions. 112 00:10:14.800 --> 00:10:19.800 If not, I'm an outside investor. I just give the money and hope for the best. 113 00:10:19.800 --> 00:10:35.800 and I only rely that the entrepreneur has enough incentives to do a good job for me either because he has an equity stake or he's motivated by his wage or his reputation and what I can do is just diversify, just pick ten entrepreneurs and hope that some of them will do well. 114 00:10:35.800 --> 00:10:44.800 So what I'm proposing is that to see the full picture we should actually add one function to the capitalist and the entrepreneur which is something intermediate. 115 00:10:44.800 --> 00:10:48.800 I call it director now, because that's what we see in large corporations. 116 00:10:48.800 --> 00:10:52.800 The director controls entrepreneurial decisions on behalf of capitalists. 117 00:10:52.800 --> 00:10:55.800 So why is that useful? 118 00:10:55.800 --> 00:11:00.800 If we now explore the logical combinations of these three basic functions, 119 00:11:00.800 --> 00:11:04.800 we get the full picture of the institutions of a modern market economy. 120 00:11:04.800 --> 00:11:09.800 So in the center we still have the integral owner-entrepreneur that we are often also fond of, 121 00:11:09.800 --> 00:11:11.800 but it's just one case. 122 00:11:11.800 --> 00:11:16.800 We have now the pure director, which is a non-executive director. 123 00:11:16.800 --> 00:11:21.800 Then we have the combination of director and entrepreneur, which is the executive director. 124 00:11:21.800 --> 00:11:27.800 Then we have the pure entrepreneur, which is basically a corporate manager without equity stake. 125 00:11:27.800 --> 00:11:34.800 That's hard to swallow for Austin because the one guy we like, the other one we don't like so much, but logically they're actually the same. 126 00:11:34.800 --> 00:11:39.800 Capitalists and entrepreneurs would be a corporate manager with an equity stake. 127 00:11:39.800 --> 00:11:45.800 Now, capitalists who control entrepreneurial decisions would be inside investors. 128 00:11:45.800 --> 00:11:52.800 So it's either active owners, large shareholders, venture capitalists, private equity investors, or active lenders. 129 00:11:52.800 --> 00:11:57.800 That could be a bank giving a large corporate loan and appointing a representative to a corporate board. 130 00:11:57.800 --> 00:11:59.800 That was very common in Germany, for example. 131 00:11:59.800 --> 00:12:02.800 Or a hedge fund. They recently got into the lending business. 132 00:12:02.800 --> 00:12:08.800 Small. And then in the end we have the pure capitalist, which is the outside investor. 133 00:12:08.800 --> 00:12:18.800 The passive owner, a preference shareholder, another small shareholder, a passive lender, a bondholder, or even a bank giving a small business loan just based on a credit scoring. 134 00:12:18.800 --> 00:12:23.800 They don't deal at all with the management, they don't care what they decide, they just look at the data and give the credit. 135 00:12:23.800 --> 00:12:25.800 So why is this important? 136 00:12:25.800 --> 00:12:33.800 You see that almost all of these functions we have identified are to some extent involved in entrepreneurial decisions. 137 00:12:33.800 --> 00:12:35.800 Either they make them or they control them. 138 00:12:35.800 --> 00:12:49.800 So I would define all these functions together which are involved in decisions, the entrepreneurial group, and the only function here that's not part of the entrepreneurial group are the outside investors. 139 00:12:49.800 --> 00:13:04.800 So you see that I think the Austrian literature says, well, of course, the entrepreneurs, so they create profits, is correct as far as it goes, but it doesn't go very far because it's almost true to say yes, if the capitalist is also an entrepreneur, 140 00:13:04.800 --> 00:13:17.800 If you are an entrepreneur, then you can make entrepreneurial profits, what is really interesting, that's the question for me, the real question about value investing, what about the other guys, the outside investors, how can they generate superior profits? 141 00:13:21.800 --> 00:13:33.800 So this, I think we have to look at the entrepreneurial decision process to see actually what kind of information the outside investors have access to on which they can base their profit predictions. 142 00:13:34.800 --> 00:13:42.800 Just pick one decision in the middle. 143 00:13:42.800 --> 00:13:51.200 All decisions concern either reactions to exogenous changes or creation of endogenous changes. 144 00:13:51.200 --> 00:13:59.000 So there's one decision, whatever its source, it's always based on anticipation of future uncertain market conditions 145 00:13:59.000 --> 00:14:03.600 and it applies a price and a profit prediction. Of course that's private knowledge. 146 00:14:03.600 --> 00:14:33.600 So, if this is confusing, everything that's blue is private knowledge and only the red is public knowledge and the key message here is that it's actually very little what is public knowledge or becomes public knowledge in the process because once the entrepreneurial decision is made by the entrepreneurial group, there's constantly new information arrive and they can react, they can update their predictions, they can make new decisions and at the end, they have some result. They've seen whether, for example, the decision to enter a new market or to differentiate product, whether this has worked out or not. 147 00:14:33.600 --> 00:14:41.100 This is still not observable by outside investors because there are many decisions parallel and one after the other. 148 00:14:41.100 --> 00:14:51.100 The only thing that an outside investor can actually observe is then the overall result of all these decisions in a certain period as reflected in the financial statements. 149 00:14:51.100 --> 00:14:54.600 That's why you see the red on the right side. 150 00:14:54.600 --> 00:15:02.600 And the other information an outside investor has access to is basically either exogenous changes that affect the company. 151 00:15:02.600 --> 00:15:14.600 Yes, that's obvious to anyone or announced decisions by the entrepreneurial group, but it's always only a part of the information that will be announced with delay. 152 00:15:14.600 --> 00:15:24.600 So, to conclude, the current valuation of securities is always based on profit predictions. 153 00:15:24.600 --> 00:15:37.600 It reflects the current expectations of all market participants, including the entrepreneurial group, that means inside investors, and outside investors who have only access to public information. 154 00:15:37.600 --> 00:15:50.600 So, as you've seen, there's a lot of information that's only accessible to private, to inside investors, because one of the main reasons is that they actually generate this information themselves. 155 00:15:50.600 --> 00:15:56.400 themselves. So they know what were the realized results of previous decisions they made. They 156 00:15:56.400 --> 00:16:04.840 have updated profit predictions for more recent decisions. They know what are the most recent 157 00:16:04.840 --> 00:16:09.000 decisions they've taken that may not even be, they have no results yet, but they know 158 00:16:09.000 --> 00:16:14.520 what they decided. They know what planned adjustments they have in mind to direct to 159 00:16:14.520 --> 00:16:17.680 to some recent exogenous changes. 160 00:16:17.680 --> 00:16:20.280 And they even know what are the next planned 161 00:16:20.280 --> 00:16:21.960 endogenous changes they want to do. 162 00:16:21.960 --> 00:16:23.420 So nobody else knows that. 163 00:16:24.720 --> 00:16:26.680 So compared to that, the public information 164 00:16:26.680 --> 00:16:29.200 that's available to outside investors 165 00:16:29.200 --> 00:16:31.120 is actually very, very little. 166 00:16:31.120 --> 00:16:34.640 So as we said, it's basically cumulative results 167 00:16:34.640 --> 00:16:37.540 of decisions made in the past, so it's historical data, 168 00:16:39.080 --> 00:16:42.460 the public announcements of the entrepreneurial group, 169 00:16:42.460 --> 00:16:45.300 And finally, exogenous changes affecting the company. 170 00:16:45.300 --> 00:16:48.460 And I would argue that's actually the only source 171 00:16:48.460 --> 00:16:51.260 of potential profits for outside investors are these, 172 00:16:51.260 --> 00:16:52.220 exogenous changes. 173 00:16:52.220 --> 00:16:54.700 So if there's a war somewhere, the oil price goes up 174 00:16:54.700 --> 00:16:57.140 and you're the first trader to buy energy stocks 175 00:16:57.140 --> 00:16:59.020 and then 10,000 others, because that's the job 176 00:16:59.020 --> 00:17:02.020 they do the same, and you sell the share at the end 177 00:17:02.020 --> 00:17:03.820 of the day, then you have a profit. 178 00:17:03.820 --> 00:17:05.980 But the problem is that the other 10,000 179 00:17:05.980 --> 00:17:09.060 want to be the first as well. 180 00:17:09.060 --> 00:17:11.100 Of course, this kind of short-term trading profit 181 00:17:11.100 --> 00:17:13.000 is also possible for insiders. 182 00:17:13.000 --> 00:17:14.940 It's even, they have the additional chance 183 00:17:14.940 --> 00:17:18.020 to also trade before some of the changes 184 00:17:18.020 --> 00:17:19.900 that generate themselves are announced. 185 00:17:19.900 --> 00:17:22.140 That's classic insider trade, that's illegal, 186 00:17:22.140 --> 00:17:24.140 but that doesn't mean it doesn't happen. 187 00:17:26.260 --> 00:17:29.260 So, but more importantly, only the members 188 00:17:29.260 --> 00:17:31.760 of the entrepreneurial group have actually 189 00:17:31.760 --> 00:17:35.080 all information required to at least try 190 00:17:35.080 --> 00:17:37.020 to predict long-term profits. 191 00:17:37.020 --> 00:17:40.060 That's why they actually are in a position to do that. 192 00:17:40.060 --> 00:17:42.740 Compared to that, the information available 193 00:17:42.740 --> 00:17:44.420 to an outside investor is so limited 194 00:17:44.420 --> 00:17:46.900 that I would argue it's basically impossible. 195 00:17:46.900 --> 00:17:48.140 It's like tossing a coin. 196 00:17:49.580 --> 00:17:54.380 So my conclusion on this issue is actually that 197 00:17:56.020 --> 00:18:01.020 the argument of Austrian theory for the impossibility 198 00:18:01.180 --> 00:18:04.460 for outside investors to earn systematically superior returns 199 00:18:04.460 --> 00:18:06.960 is actually more convincing than the neoclassical. 200 00:18:06.960 --> 00:18:25.960 The empirical hypothesis resulting from the theorem is actually quite similar, I argue that if you look carefully at the implications of Austrian economics, outside investors cannot earn systematically superior returns based on an analysis of publicly available information. 201 00:18:25.960 --> 00:18:34.960 This is actually the same as the neoclassical, the semi-strong form of the random work theory, but the explanation is very different. 202 00:18:34.960 --> 00:18:41.960 In neoclassical theory, it's this thing that we, of course, we don't believe, that market price is efficient and all information is included. No. 203 00:18:41.960 --> 00:18:49.960 The osteo-explanation is that information, most of the relevant information is actually private to the entrepreneurial group. It's dispersed. 204 00:18:49.960 --> 00:18:59.960 And if there's really company with low valuation, the only thing that valuation will go up are future entrepreneurial decisions, which as actions are inherently unpredictable. 205 00:18:59.960 --> 00:19:15.960 The hypothesis on outside investors is again similar, based on Austrian theory I would say of course insiders, they can generate superior profits trading in their own securities, that's also admitted by the leading exponents of efficient market theory. 206 00:19:15.960 --> 00:19:27.960 Of course there's the possibility of gaining from inside information, but again the explanation is different, all that new classical economy can say well there must be some monopolistic access to information. 207 00:19:27.960 --> 00:19:32.960 But Austrians, they can say much more, actually it's not only access to some given information, 208 00:19:32.960 --> 00:19:35.960 the entrepreneurs are generating the information themselves. 209 00:19:35.960 --> 00:19:45.960 So to conclude, I think the Austrian argument against the possibility for outside investors to generate systematically superior returns is actually stronger 210 00:19:45.960 --> 00:19:49.960 than the new classical because it's based on realistic assumptions about dispersed information 211 00:19:49.960 --> 00:19:53.960 and not on unrealistic assumptions about market efficiency. 212 00:19:57.960 --> 00:19:59.960 Thank you very much.