Where’s the value in equity markets?

It is sometimes forgotten that equity markets exist not solely to enrich speculators, market makers and intermediaries. In the UK their historic purpose – at a time of both economic and empire expansion – was to bring together those with money to invest and businesses in need of investment.

A successful investment would reward the investor and help create wealth for entrepreneurs as well as work for many people, albeit often at what would today be considered very low rates of pay and in poor conditions.

The value of an equity is not necessarily the same as its traded price on any particular day. Its value will depend on many things. As finance, business and society become more interconnected and interdependent it is unhealthy to rely too much on market prices. Yet this is what happened over the last few decades as more powerful computers enabled more complex modelling.

Slowly but almost imperceptibly western economies became increasing financialised. Share price as a proxy for share value became the target for executives and investors – this encouraged short termism. Executives’ incentives had to be aligned with shareholders interests; this is a good idea but linking executive pay to share price was not.

Economies became dominated by financial services: the global banking sector reported more profits than any other sector in 2006 – $788 billion (£499 million), over $150 billion greater than the next most profitable sector: oil, gas and coal.

Global banking revenues were 6 percent of global GDP and its profits per employee were 26 times higher than the average of other industries. Unfortunately, the focus on finding financial profit meant that the traditional virtues of making things and supplying services that people need became under valued.

Do you remember how the share value of traditional business fell during the internet bubble? This did not benefit society. Studies suggest that most people in the western world got poorer over the last two decades. This is no coincidence but a direct consequence of financialisation.

Traditionally, the banking sector helped other businesses create value by giving access to finance and providing transaction services but increasingly this aspect of banking became less important to banks and the sector helped itself to value by playing markets with tacit support of governments and regulators.

Fair value is one example (such as when a bank reports a profit when the traded value of its debt declines) and we justify it on the basis that other ways of valuing are worse. But we also justify fair value because we believe in the truth of market prices and, underpinning this is, a belief in efficient markets.

The financial crisis can teach us many lessons and one of them is that markets can be anything but efficient and another is that price may not be a good indicator of value.

If we want avoid future bubbles and financial shocks we need to raise our game in how we understand value. Institutional investors and company boards should look for new ways of assessing value and others in society should expect this.